What is a simplified employee pension (SEP)?
A simplified employee pension is also known as a SEP. It is a type of employer-sponsored retirement plan that some companies choose to establish in order to provide a fringe benefit to their employees. A SEP allows employers to contribute money to their employees’ retirement while also making contributions to their own. Each participant in a SEP plan will have a SEP IRA or a SEP annuity established for him or her.
What is a SEP IRA?
What is a SEP IRA? A simplified employee pension individual retirement arrangement is an employer-sponsored retirement plan that business owners and self-employed people can set up. The individual accounts are established for the participates in the simplified pension plan.
The employees control their own SEP-IRA accounts. Under the SEP IRA rules, workers who are eligible for the simplified employee pension plan must be allowed to participate, and the employers make the contributions to their employees’ accounts.
Simplified employee pension statistics
According to data from the Investment Company Institute, 7.6 million households in the U.S. owned an employer-sponsored retirement account in 2017, which includes SEP-IRAs and SIMPLE individual retirement arrangements. Employer-sponsored individual retirement accounts were the third most common behind traditional individual retirement arrangements and Roth accounts.
SEP plans are good for self-employed people and business owners that have few or no employees. These plans allow the business owners to make much higher annual contributions than they can with traditional accounts. However, the SEP IRA rules state that if the employers have eligible employees, they must contribute a percentage to each employee’s SEP-IRA account that is equal to the percentage that the business owners contribute to their own accounts.
How do the SEP IRA rules limit this type of retirement account?
The SEP IRA rules make simplified employee pension plans unique. They also place some limits on this type of retirement account. Some of the important SEP IRA rules that you should know include the following:
- Only employers are allowed to contribute to the simplified individual pension plans, and employees cannot make contributions to them;
- Employees who are at least 21 years old and who have worked for the employer for at least three out of the past five years and who have made at least $600 each year are eligible to participate;
- Employers must set up accounts for every employee that is eligible;
- Employers can contribute up to $56,000 to an employee’s plan or 25 percent of compensation, whichever is lesser; and
- Employers who contribute to their own SEP-IRAs must contribute an equal percentage to the accounts of their eligible employees.
Who is eligible for a SEP-IRA?
Self-employed people and business owners are eligible to establish simplified employee pension plans. If they have employees, the employees might also be eligible. Under the SEP IRA rules, employees are eligible to participate in your simplified employee pension plan if they meet the following criteria:
- Are 21 or older
- Have worked for you for at least three years out of the past five years
- Have earned at least $600 per year from your company
Employees cannot make contributions to their accounts. Instead, as the employer, you make the contributions and set up the SEP-IRA accounts for your employees. The percentage that you contribute to all of the SEP-IRA accounts must be uniform, including your own. For example, if you contribute 25 percent of your income to your own retirement account in your simplified employee pension plan, you must also contribute 25 percent of each of your eligible employees’ compensation to their individual SEP-IRA accounts.
What are the advantages and disadvantages of a simplified employee pension?
Simplified employee pension plans have several advantages and disadvantages. For self-employed people, the plans offer the ability to contribute much more than they could to traditional individual retirement accounts or Roth accounts.
Self-employed people and business owners can contribute 25 percent of their compensation up to $270,000 or $55,000, whichever is less. There are also some disadvantages to the plans. Employers must contribute the same percentage of their employees’ incomes as they contribute to their own accounts. The contributions are fully vested as soon as they are made, which means that they belong to the employees immediately. If the employees quit, they will be able to take the employer’s contributions with them.
SEP IRA rules: Limits and contributions
Employees are not allowed to make contributions to their SEP retirement plans. Only the employers are allowed to make contributions. The employers may contribute up to a maximum of $55,000 per year or 25 percent of the annual compensation up to $270,000, whichever is less.
An employer who contributes to his or her own SEP retirement plan must contribute an equal percentage to the accounts of all of the eligible employees. Contributions are not mandatory, however. An employer can set up a plan and choose to not make any contributions during a year.
SEP IRA contribution deadline
The SEP IRA contribution deadline is the tax filing date. For years in which it falls on April 15, business owners can make contributions to their simplified employee pension plan up to April 15. If you file an extension, your tax filing deadline and your SEP IRA contribution deadline would then fall on Oct. 15, giving you additional time to make contributions for the prior year.
If you want to reduce your taxable income, you can set up a SEP right before the tax filing deadline and make your contribution. This can help you to reduce your taxable income so that you can pay less in taxes.
Withdrawals and penalties
Like other types of retirement plans, including 401(k) plans, SIMPLE plans, and traditional plans, you are not able to make withdrawals from your SEP-IRA before you turn age 59 1/2. If you do, you will have to pay the applicable taxes along with a 10 percent early withdrawal penalty unless the reason for the withdrawal meets an exception.
You also must begin taking distributions from your simplified employee pension when you reach age 70 1/2. You will be taxed on the distributions at your then-current tax rate.
Comparisons to other retirement plans
Comparing a simplified employee pension to other types of retirement plans can help you to determine whether a SEP is the best type of plan for you or if you should instead choose another type. Here are some comparisons of some of the most popular types of retirement plans.
SEP IRA vs traditional individual retirement arrangements
A SEP may be a better plan for someone who is self-employed than a traditional individual retirement arrangement because of the higher contribution limits. Here are the differences between these two types of plans.
| SEP | Traditional individual retirement arrangement |
|---|---|
| Pre-tax contributions | Pre-tax contributions |
| Pay taxes when money withdrawn | Pay taxes when money withdrawn |
| For self-employed people and their employees | For any individual |
| Only employer can make contributions | People can contribute to their own traditional accounts |
| Employer can contribute 25 percent of the income or $56,000, whichever is less | Account holders can contribute %6,000 if they are under age 50 and $7,000 if they are older than 50 |
| Penalties on withdrawals before 59 1/2 | Penalties on withdrawals before 59 1/2 |
SEP vs Roth IRA
If you are trying to decide between a SEP and a Roth, here are some comparisons of these two different types of retirement plans.
| SEP | Roth IRA |
|---|---|
| Pre-tax contributions | After-tax contributions |
| Pay taxes when money withdrawn | Pay taxes when money contributed |
| For self-employed people and their employees | For any individual |
| Contribution limit of 25 percent of compensation or $56,000, whichever is less | Contribution limit of $6,000 if younger than 50 or $7,000 if older than 50 |
| Required minimum distributions beginning at age 70 1/2 | No required minimum distributions |
| Penalties on withdrawals before 59 1/2 | No penalties on withdrawals of the principal before 59 1/2 |
SEP vs 401k
A SEP and a 401k have several important differences. Here is a brief look at both of these types of retirement plans.
| SEP | 401(k) |
|---|---|
| Ideal for sole proprietors, freelancers, and very small businesses | Can be established by businesses of any size |
| Pre-tax contributions | Pre-tax contributions |
| Pay taxes when money withdrawn | Pay taxes when money withdrawn |
| Employers can contribute either 25 percent of the compensation or $56,000, depending on which is lesser | Contribution limit of $19,000 by an employee or $25,000 after age 50 |
| Penalties on withdrawals before 59 1/2 | Penalties on withdrawals before 59 1/2 |
| Relatively low set up and administration costs | More expensive to set up and administer |
SEP IRA vs SIMPLE IRA
SEP and SIMPLE plans are both employer-sponsored plans. However, there are some differences between a SEP IRA vs SIMPLE IRA.
| SEP | SIMPLE |
|---|---|
| Pre-tax contributions | Pre-tax contributions |
| Pay taxes when money withdrawn | Pay taxes when money withdrawn |
| For self-employed people and their employees | For self-employed people and their employees |
| Employers can contribute 25 percent of the compensation or $56,000, whichever is lesser | Contribution limit of $13,000 if younger than 50 or $16,000 if older than 50 |
| Penalties on withdrawals before 59 1/2 | Penalties on withdrawals before 59 1/2 |
Terminating a SEP plan
Terminating your plan is a straightforward process. You are not required to notify the IRS that you are ending your plan. You can simply notify the financial institution that holds the accounts and let them know that you are terminating the plan and will no longer be making contributions to it.
Under the SEP IRA rules, you are able to terminate the plan at any time. Once it is terminated, you can stop making further contributions to your account and to those of your employees.
Creating, operating and maintaining a simplified employee pension plan
To create a simplified employee pension, you will first need to choose the financial institution that will serve as the trustee of the SEP-IRA accounts. You will then need to execute a written agreement, give your employees information about the plan, and set up their individual SEP-IRA accounts.
The plan can be set up as late as when your taxes are due. The SEP IRA rules mandate that you add every eligible employee to your plan and make uniform contributions by the percentage to each account.
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