Advantages Of The SEP IRA

The SEP IRA is a retirement plan designed to benefit self employed individuals and small business owners. Sole proprietorships, S and C corporations, partnerships and LLCs qualify.

A SEP IRA has broad appeal due to its high annual contribution limits, completely discretionary and flexible annual contributions and minimal administration. SEP IRA plans can be established by a one person business or by a business owner with employees.

• Most frequently a SEP IRA is established by a business owner without employees and is discussed in detail below.
   
• In special situations a SEP IRA may be an ideal retirement plan for a business owner with employees.

Simplified employee pension (SEP) plans enable small businesses to provide retirement benefits with lower costs and less reporting requirements than other qualified retirement plans.

SEPs offer some attractive benefits for employers and employees alike.

How Do SEPs Work?

A simplified employee pension plan is basically a group of individual retirement accounts maintained for employees.

Under a typical SEP plan, the employer establishes IRAs for all participating employees. The employer then contributes to the IRAs, subject to the contribution limits for SEPs — not IRAs. Employer contributions are limited to $40,000 per year. The company’s contributions are not counted as current income for the employee.

SEP plans provide an effective retirement planning option for employees. They also provide the employer with an effective tax shelter.

Salary-Reduction Option

Employees can also fund a SEP through a pre-tax salary reduction. Under a salary-reduction SEP, or SARSEP, employees can elect to defer up to $11,000 of their salary to the plan (in 2002). Employee funding further reduces costs to the employer.

This salary-reduction feature enables a SEP to work much like a 401(k) plan. Note that no new SARSEP plans may be established after 1996, but contributions can continue to existing plans.

SEPs are designed to provide a number of advantages.

They have a significantly lower setup cost to the employer than regular pension or profit-sharing plans. They also offer simpler reporting and record-keeping requirements.

For employees, SEPs offer substantially higher contribution limits than regular IRAs. This enables employees to accumulate more for retirement.

The retirement benefits in a SEP are fully vested as soon as they are contributed. This makes a SEP completely portable. Departing employees can roll their SEP balances into an IRA or have them transferred to a retirement plan sponsored by their new employer.

Simplified employee pensions can provide significant retirement benefits to employees while minimizing setup and administrative costs for employers.

SEP IRA for a self employed business owner without employees

The calculation of how much can be contributed to a SEP IRA is dependent on whether your business is a corporation and you receive a W-2 as compensation or if you are taxed as a sole proprietorship and receive compensation as personal income. Examples of both are shown below.

Business owner receives compensation as W-2 income

An S or C corporation, an incorporated partnership or a LLC electing to be taxed as a corporation pays the business owner a W-2 salary. In this situation, the annual SEP IRA contribution can be between 0% to 25% of the owner's W-2 salary up to the SEP IRA contribution limit. SEP IRA contributions are generally 100% tax deductible as a business expense.

Business owner receives compensation as personal income

When a SEP IRA is established for a unincorporated business such as a sole proprietorship, unincorporated partnership or a LLC electing to be taxed as a sole proprietorship, annual contributions are made into your SEP IRA account between 0 to 20% of your net adjusted self employment income (or net adjusted business profits). SEP contributions are flexible and the percentage of contribution can be changed at any time and may be skipped in a bad year. SEP IRA contributions are generally 100% tax deductible from personal income.

When is the SEP IRA setup and contribution deadline?

Generally a SEP must be established and funded by your tax filing deadline. Generally, filing extensions extends the period for establishing and funding the SEP plan. For a sole proprietor April 15th would be the deadline to establish and fund a SEP for the prior tax year. If an extension was filed a sole proprietor can establish and fund a SEP IRA by October 15th.