What is a SEP?

SEP stands for “Simplified Employee Pension”.  The SEP IRA is one of the most common employer sponsored retirement plans used by sole proprietors and small businesses.

Special Establishment Deadline

SEP are one of the few retirement plans that can be established after December 31st which make them a powerful tax tool.  For example, it’s March, you are meeting with your accountant and they deliver the bad news that you have a big tax bill that is due.  You can setup the SEP IRA any time to your tax filing date PLUS extension, fund it, and capture the tax deduction.

Easy to Setup & Low Plan Fees

The other advantage of SEP IRA’s is they are easy to setup and you do not have a third-party administrator to run the plan, so the costs are a lot lower than a traditional 401(k) plans.  These plans can typically be setup with 24 hours.

Contributions limits

SEP IRA contributions are expressed as a percentage of compensation.  The maximum contribution is either 20% of the owners “net earned income” or 25% of the owners W2 wages.  It all depends on how your business is incorporated.  You have the option to contribution any amount less than the maximum contribution.

100% Employer Funded

SEP IRA plans are 100% employer funded meaning there is no employee deferral piece.  Which makes them expense plans to sponsor for a company that eligible employees because the employer contribution is uniform for all employees.  Meaning if the owner contributes 20% of their compensation to the plan for themselves they must also make a contribution equal to 20% of compensation for each eligible employee.  Typically, once employees begin becoming eligible for the plan, a company will terminate the SEP IRA and replace it with either a Simple IRA or 401(k) plans.

Employee Eligibility Requirements

An employee earns a “year of service” for each calendar year that they earn $500 in compensation.  You can see how easy it is to earn a “year of service” in these types of plans.  This is where a lot of companies make an error because they only look at their “full time employees” as eligible.  The good news for business owners is you can keep employees out of the plan for 3 years and then they become eligible in the 4th year of employment.  For example, I am a sole proprietor and I hire my first employee, if my plan document is written correctly, I can keep that employee out of the SEP IRA for 3 years and then they will not be eligible for the employer contribution until the 4th year of employment.

Read This……..Very Important…..

There is a plan document called a 5305 SEP form that is required to sponsor a SEP IRA plan.  This form can be printed off the IRS website or is sometimes provide by the investment platform for your plan.   Remember, SEP IRA plans are “self-administered” meaning that you as the business owner are responsible for keeping the plan in compliance.  Do cannot always rely on your investment advisor or accountant to help you with your SEP IRA plan. You should have a 5305 SEP for in your employer files for each year you have sponsored the plan.   This form does not get filed with the IRS or DOL but rather is just kept in your employer files in the case of an audit. You are required to give this form to all employees of the company each year.  It’s a way of notifying your employees that the plan exists and it lists the eligibility requirements.

Compliance Issues

The main compliance issues to watch out for with these plan is not having that 5305 SEP Form for each year the plan has been sponsored, not accurately identifying eligible employees, and miscalculating your “net earned income” for the max SEP IRA contribution. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.