As a small business owner you, like no other, understand the importance of having a retirement plan for your company. An attractive retirement plan helps your business recruit and retain employees, while allowing you to participate in their retirement future. Aside from that, having a retirement plan allows you to deduct the contributions you make on your business’s tax return. That alone is a very good incentive to have a retirement plan.
Usually when a business owner considers establishing a retirement plan, the first thing that comes to his or her mind is a 401(k) plan. And it’s no wonder why, there are more than 500,000 401(k) plans across the country. However, despite all the advantages of the 401(k) plan, it has inherited some disadvantages that may be too heavy for your business to carry. For example, 401(k) plans can be very costly to establish and operate. In addition, complex rules that govern them require a lot of reporting and nondiscrimination compliance. These two factors usually lead to small businesses postponing the setting up of a 401(k) plan until times are better.
Realizing the difficulties associated with 401(k) plans, Congress introduced several additional retirement plans for small businesses. These plans are less costly to establish and most importantly, easier to administer and manage. One such plan is the Simplified Employee Pension (SEP) IRA.
A SEP IRA is a retirement plan that can be established by businesses of any type or size, including a sole proprietor. Under the SEP IRA plan, the employer contributes the same percentage of each eligible employee’s salary to the IRA account. These contributions are tax-deductible and not included in employees’ taxable income. However, employee contributions are not permitted which means that you as an employer play a very important role in the financial future of your employees.
Unlike the Traditional IRA, the SEP IRA has a much higher contribution limit. Which is 25% of an employee’s compensation or $53,000 whichever is less. For example, if you are a sole proprietor and your annual salary is $100,000, the maximum contribution you can make to your SEP IRA is $25,000. But if your salary is $250,000 per year, the maximum contribution you can make is $53,000 not $62,500. As you can see, high contribution limits, as well as easy plan establishment, and administration make the SEP IRA very appealing to many small business owners.
Additional advantages of the SEP IRA are:
- No responsibility for employee’s investment results: Each SEP IRA account is established under the name of the participant, so there is no need to set up a trust. The employee has full control over the account and chooses what to invest their money in.
- Discretionary contributions: Contributions are not mandatory and can be stopped any given year. For example, if your business had a bad year, you can simply stop making contributions and put that money back into your business. It is a huge advantage that only a few retirement plans have.
- SEP IRA and Traditional IRA contributions are treated separately: In other words, you may still contribute to your Traditional IRA on top of the SEP IRA contributions.
- Social Security integration is permitted.
Since we’ve pointed out the advantages, it would not be right to omit some disadvantages of the SEP IRA plans.
- Immediate vesting: All contributions towards employee’s account are 100% vested.
- Obligation to making contributions for all eligible employees, even if the employee is not employed on the last day of the year or older than 70 ½.
- Loans are not permitted: There is no option to borrow from the plan.
- Weak eligibility requirements: In order to participate in the SEP IRA the employee must be at least age 21, earn at least $600 (for 2016) during the current year, and perform services for the employer for at least three year of the last five years. That means that if you have a seasonal business and hire part-time employees during that period, they will all have to be covered by the plan. This in the end means an increase in costs.
- Creditor protection: The SEP IRA plan is not a qualified retirement plan. That means that under ERISA law, assets under the SEP IRA are not protected from creditors like they are with qualified plans.
Establishing a SEP IRA
As I previously mentioned, it is extremely easy to establish the SEP IRA. All you need to do is adopt a written agreement by signing one of the following documents:
- IRS Form 5305-SEP
- A prototype SEP form approved by the IRS which you usually can get from the financial institutions
- Design your own SEP plan document
Once you formally adopt the SEP agreement the next step is to notify all eligible employees, provide them with information about the plan, and set up an SEP IRA account. You can establish the account as late as the due date (including extensions) of the business’ income tax return for the year you want to establish the plan.
Employer Deduction Limit
The maximum amount of contributions to employees’ SEP IRA account that you can deduct on your business’ tax return is 25% of compensation. However, the deduction limit and the maximum contribution limit for a self-employed individual (unincorporated business) is calculated slightly different and is based on net self-employment income, which is not covered here.
The opportunity to deduct contributions from business’ taxable income is a huge advantage and incentive for the small business owner. In fact, it can be treated as the government subsidy for a percentage of the contributions you make. For example, let’s consider your business has a taxable income of $1,000,000 that is subject to a 34% tax rate. If your company doesn’t have a retirement plan, its tax liability is $340,000.
But now consider that you contributed $100,000 total towards your employees’ SEP IRA accounts. That means that you can deduct these contributions from your taxable income and reduce it to $900,000. Which in effect reduces your tax liability to $306,000 or $34,000 less if you didn’t have an SEP IRA. This tax saving of $34,000 is essentially nothing more than the government subsidy. Not bad, right?
Essentially, a SEP IRA is the same as a Traditional IRA, except for the contribution limit. All other rules are the same, including distribution rules. If you withdraw the money before age 59 ½ be ready to pay a tax plus a 10% penalty. In addition, the SEP IRA is subject to required minimum distributions rules meaning that upon reaching age 70 ½ you will be forced to take the money out of the account.
The SEP IRA is a very powerful retirement plan that often overlooked by many small business owners. It is much simpler and less costly to establish, manage, and administer. There is no paperwork or reporting to the IRS involved, which is not the case for 401(k) plans. A high contribution limit of $53,000 also makes the SEP IRA comparable to the 401(k) plan. Another important advantage that distinguishes the SEP IRA from the 401(k) is the nonobligatory contributions. You are not required to continue making contributions and can stop them at any time, which is extremely important for growing or cyclical businesses.
Obviously, the SEP IRA is not without its shortcomings. The key negative is that the small business owner has to bear all of the expenses associated with contributions since employee contributions are not permitted. But as I mentioned earlier, you can always stop making contributions until you feel confident that the business can afford them again. With the 401(k) you simply don’t have this option.
For the small business owner whose business is just picking up and hasn’t matured yet, but would like to retain employees and make a contribution towards their retirement, the SEP IRA can indeed be a great alternative to a 401(k) plan.