If you are a business owner looking for a fast and easy way to reduce your tax burden this year, SEP-IRAs are one of my favorite recommendations. SEP is the acronym for Simplified Employee Pension plan. And while the truth is that no qualified plan is really “simple” – SEPs come pretty close. The web address above will take you to the FAQ page at the IRS’s web site that gets into some of the nitty gritty. Here is the executive summary:
- Must be a written plan. Many small employers can adopt the IRS Model SEP by using Form 5305-SEP which you can get on the IRS web site (www.irs.gov). Or you can ask your financial institution if they have a prototype SEP document that you can use. And of course, you can go it alone and create your own…but it has to comply with law, so see a benefits administrator. Provide a copy of the plan to all eligible employees. The deadline to establish a new SEP plan is the due date of the company’s tax return including extensions – so for new SEPs now, the final date for establishment and funding is September 15, 2011.
- Eligible employees. All employees who are at least 21 years old during the year; have worked for the employer in at least three of the last five years; and have earned at least $550 (2010 and 2011 – this is adjusted periodically) from the employer during the plan year. You can be less restrictive but not more restrictive.
- Contribution limits. A SEP is an EMPLOYER CONTRIBUTION only – the employee DOES NOT CONTRIBUTE. The employer may make a contribution to an employee’s SEP-IRA of up to 25% of wages, not to exceed a contribution of $49,000 in 2010 and 2011. You read that right – you can sock away $49,000 tax deductibly and you have until September 15 to fund the plan. It is NOT taxable income to your employees until they withdraw the money from the SEP-IRA. The contribution is NOT taxed for Social Security and Medicare. Employees love SEPs. If you are self employed (and file Schedule C or SE in your individual tax return), you cannot do 25% of gross revenues, but rather a percentage of net self employment income. IRS Publication 560 provides a worksheet.
- Contribution Rules. The employer must contribute the same percentage to all eligible employees. So – if you are a single employee/shareholder of an S corporation, and you take payroll of $100,000, you can fund a SEP-IRA with up to $25,000. If you have five employees who are all eligible and you contribute 25% of your wages to your SEP-IRA, then you must fund SEPs for the employees also at 25% of their gross wages. That can get pricey. You do not have to do 25% — you can do 3% or 10% or whatever – you just have to do the same percent for all eligible employees. Unlike other qualified plans, if you decide to do a SEP this year, you are NOT obligated to fund one next year. Also – there is no annual reporting requirement and no top-heavy testing. Read that : no/very low cost to manage the plan.
- Where does the money go? Every eligible employee sets up his/ her own account at whatever financial institution he/she chooses. All the employee needs to set up the account is a copy of the plan document. When the account is established, the employee will provide you, the employer, with the name of the institution. You will make a check payable to the institution – NOT THE EMPLOYEE!! – and the employee will deposit the check. Your responsibility ends at that point. The employee is in total control of the SEP-IRA account. Period. Is that easy, or what?
- Partnership/LLC rules. Because SEP-IRAs are formed at the entity level, the partnership or LLC taxed as a partnership must establish the SEP-IRA. It gets complicated quickly for partners and members, especially if there are also eligible employees. Guaranteed payments and draws become an immediate problem. It works but get help.
- Is a SEP the best option? Maybe yes, maybe no. If you are on your own in your company, you may want to investigate establishing a Solo 401(k) plan. 401(k)s may allow you to put away larger sums of money without higher payroll taxes – to really load a SEP, you need very high wages. 401(k)s are more administratively challenging, requiring annual compliance reporting and perhaps mandatory contributions. AND they have to be set up by December 31…which is coming like a freight train. No such deadline for SEPs.