Michael is a financial planner and has a master's degree in financial services.
This lesson provides an overview of a SEP IRA, a retirement plan typically used by small businesses. In the lesson, you'll get a definition of the term and see an outline of the requirements, rules, and contributions.
SEP IRA Overview
Let's meet Bob, who recently opened a home interior design company called Bob's Designs. Being a single dad, Bob cannot afford to hire any employees right now, but hopes that as his business grows he can afford to hire. Bob just left his job working for another firm that had a retirement plan, but since Bob is going solo, he's wondering how to save for retirement. He needs something that is relatively simple to implement and maintain so he can focus on growing his business.
While out to lunch with a potential client, the client mentioned that Bob should look into a SEP IRA. The potential client couldn't remember exactly what SEP IRA stood for, but thought it had the word simplified in it. As soon as Bob returned home, he searched online for SEP IRA and learned it stands for Simplified Employee Pension Individual Retirement Account. Bob is interested, but needs to know more to make an informed decision.
Simplified Employee Pension Individual Retirement Account doesn't quite sound simple to Bob, but he's still interested. Bob is primarily looking for an account dedicated for retirement savings, and Bob would also like a tax deduction, if possible. This is part of the definition of a SEP IRA. A SEP IRA is a type of individual retirement account established by employers to which employers make tax-deductible contributions on behalf of all eligible employees, including the owner.
The definition somewhat clears things up for Bob. He now knows that any contributions he makes to the accounts will be tax-deductible. He likes this aspect, though he wonders if he must make contributions each year. If business is bad, can he skip a year? Let's find out.
Requirements of a SEP IRA
Bob isn't sure where to begin. After further research, he learns that there are a few steps involved in setting up a SEP IRA.
The first step is to execute an agreement to inform his employees of the plan, even if he is the only employee. The simplest way to do this is to use a document called IRS model Form SEP-5305. This can be downloaded from the IRS's website and details the plan Bob's Designs is establishing. It says a few things, notably that Bob's Designs cannot maintain another qualified retirement plan, such as a profit sharing plan, at the same time it maintains the SEP plan. If Bob wants to get fancy and change the form, he can design his own form, but that may cost more time and money than Bob desires for right now.
The second step is to provide each eligible employee with information about the plan. Typically, providing the employees with the completed IRS model Form SEP-5305 satisfied this requirement. The term eligible employee typically means someone that reaches at least age 21, earns at least $550 for the year (note that this amount may be increased in future years due to indexing), and has worked for Bob's Designs for three out of five years prior to the year for which the contribution is being made.
Of course, since this is a new plan for Bob's Designs, when Bob is determining the terms that consist of an eligible employee, he won't want to exclude himself. Employers may choose eligibility requirements that are less restrictive than the ones stated. As far as compensation taken into consideration, most employees will have their SEP contribution based their W-2 wages. The owner's compensation is typically determined by using their Schedule C or K-1, so Bob may want to talk to his accountant about his own compensation. For 2014, compensation in excess of $260,000 is not considered for SEP contributions.
The third step is to ensure a SEP IRA is established by each eligible employee. Bob works with a local company to set up his account.
Rules of the SEP IRA
Each employee, including Bob, must set up a SEP IRA in order to accept Bob's Designs' contributions. Since the basis for the SEP IRA is a traditional IRA, it is subject to many of the same rules. Bob isn't familiar with a traditional IRA, either, so he searches for the rules of a traditional IRA.
Two of the most important rules are for distributions (when Bob or an employee takes out money) and documentation. For documentation, typically Bob and his employees will need Bob's Designs tax identification number (TIN) in addition to the name and address of the business to establish an account.
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Bob learns that when he or any future employees withdraw money from their account, taxes will be owed. Bob thinks that this makes sense though, especially since he as the employer received a tax deduction when the contributions were made. Further, if Bob or his employees are under 59 1/2 when they make the withdrawal, they may be subject to a penalty. Bob makes note to tell his employees and himself that they should talk to their accountant before taking out any money.
Bob wondered earlier if he as the owner of Bob's Designs must make contributions each year. Bob learns that contributions are made on a discretionary basis, meaning the employer chooses each year whether or not to make a contribution.
The next logical question, of course, is how much can Bob's Designs contribute? Bob's Designs may contribute up to 25% of the eligible employee's compensation, provided the contribution does not exceed $52,000 in 2014. The amount is also indexed. This does not mean that Bob's compensation is limited to $260,000, just that for determining how much Bob's Designs can contribute to the SEP IRA is limited. In 2014, Bob's Designs pays Bob $260,000. Bob's Designs can then contribute $52,000 (the maximum) to Bob's SEP IRA.
Bob's Designs can choose from several formulas to allocate contributions to their employees, but these are outside of the scope of this introductory lesson. Employees are not permitted to contribute to SEP IRAs.
Bob's Designs has until its tax-filing deadline, including extensions, to contribute the funds to each employee's SEP IRA. It's important to note that contributions are immediately 100% vested, which means any contributions deposited are the employee's, regardless of their length of employment with the business.
Bob has determined that although the name Simplified Employee Pension Individual Retirement Account is rather frightening, he is interested in establishing one for himself. The fact that he can save a good portion of his salary is appealing. Bob's Designs can contribute up to $52,000, if Bob's salary is high enough. And the paperwork requirements do not seem too burdensome, other than the IRS model Form SEP-5305. He understands if he hires employees he may have to contribute to their accounts, but for now, this plan seems right.
Bob also likes that his business receives a tax deduction for what it contributes to his account, although he understands he will pay taxes on what he distributes down the road. The flexibility of the SEP IRA is also appealing, because if Bob's Designs has a bad year, it can forego the contributions. Once Bob's Designs makes a contribution, it is the employee's. Only Bob's Designs as the employer can make contributions. Since Bob already set up the business, he has a business name and tax identification number to give the company helping him establish his SEP IRA. Bob is excited to get started.
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