How a SEP IRA Can Reduce Your Tax Bill
As a self-employed professional or small business owner, you may be wondering about the options that are available to you for saving for retirement. One option that our clients often turn to is a Simplified Employee Pension (SEP) account, or SEP IRA.
Here is a brief overview of the advantages of a SEP and how it can help to reduce your tax bill.
What is a SEP IRA?
A SEP IRA is an IRA that is especially designed for small business owners with one or more employees or individuals who earn income from being self-employed. A SEP IRA is also tax-deferred. This means you don’t pay taxes on your contributions until you withdraw money from the account after you retire.
Another major difference between a SEP IRA and other types of retirement accounts is that the employer makes contributions to the SEP and not the employee.
While you might be the only qualified employee in your particular circumstances for the SEP, a SEP isn’t only designed for your own contributions. In fact, you are also required to make the same percentage contribution for all of your employees who are qualified to participate in the plan, as well. As a result, SEP IRA accounts allow you to help your employees save for retirement.
How to Qualify for a SEP IRA
Generally, business owners qualify for a SEP plan so long as they have profits in their business. This also includes the self-employed owner of a business, as well as, sole proprietors, who are treated as employers for retirement plan purposes.
In addition, any employee that meets the following criteria is required to be allowed to participate:
- Are age 21 or older;
- Worked for your business in at least 3 of the prior 5 years;
- Earned at least $600 in compensation from your business for each of those 3 years.
The catch with a SEP IRA is that if the owner has one, employees must be allowed to contribute as well and have the same benefits. However, employers are permitted to exclude unionized employees and nonresident aliens from participation in a SEP plan. Employers may also decide to set up less restrictive rules for the SEP plan, such as lowering the age requirement to 18 years so that employees who are under age 21 are not excluded.
When to Set Up a SEP IRA
You are permitted to set up a SEP for any year as late as the due date of your income tax return for that year (including extensions). Since contribution limits are based on W-2 earnings, contributions can be made to the SEP plan as long as the individuals have received compensation during the year.
Contribution Requirements for SEP IRA Plans
For self-employed individuals, compensation is defined as the net earnings of the business. Therefore, if the business’s net earnings show a loss, the compensation limit is zero and the employer may not contribute to the SEP plan for that year. In addition, employers of new businesses are not permitted to make SEP plan contributions until the business generates income.
Advantages of SEP IRA Plans
Access to the benefits of a SEP IRA could create a strong incentive for employees to work for your business. Here are some of the other top benefits of a SEP:
- All small businesses with qualified employees, including sole proprietors, partnerships, and corporations, can set up SEPs. In most cases, you do not have to file any documents directly with the IRS.
- Low startup and operating costs as compared to conventional retirement plans.
- You are don’t have to make contributions to the plan every year. The employer retains the authority to decide when and how much to contribute to employees’ SEP IRAs.
SEP IRA Contribution Limits for 2018
Thanks to higher contribution limits, a SEP IRA offers an advantage over a traditional IRA or Roth IRA. For 2018, the maximum SEP IRA contribution limits have been increased.
Business owners are permitted to contribute up to 25% of income per qualified employee, or $55,000, whichever amount is lower. You must continue to contribute to the SEP IRA for a participant, even if they are over age 70 ½. Unlike other types of IRAs, SEP IRAs do not permit catch-up contributions.
How to Set Up a SEP IRA
There are three major steps to set up a SEP:
Execute a Written Agreement to Provide Benefits
The first step is to create a written agreement to provide benefits to all employees that are eligible for the plan. The written agreement must include the name of the employer, the requirements for employee participation, the signature of the official that is responsible for the plan, and a definite allocation formula.
The IRS offers a model SEP plan document Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement. This form is for use by your business only. Do not file this form with the IRS.
This form can only be used to create a plan for the current calendar year. If there are some other circumstances that prohibit you from using this form, most banking or insurance institutions that provide SEP formation can help you draw up a suitable written agreement.
Issue Information About the Plan to the Participants
Once you have the written agreement, you must provide your eligible employees with the following information:
- Notice that you have adopted the SEP
- The requirements for receiving an allocation
- The basis on which employer contributions will be allowed to the SEP
Set Up Each Employee’s SEP IRA
A SEP IRA must then be set up by or for each of your eligible employees. Although the SEP contributions are required to go to traditional IRAs, employees have the sole responsibility of making investment decisions about their SEP IRA accounts.
Choosing the financial institution that will be responsible for maintaining your SEP is a serious decision. This is because the company will become a trustee of your plan. You may select from a list of banks, insurance companies, and mutual funds that have been pre-approved by the IRS.
Deducting SEP IRA Contributions
SEP IRA accounts offer some significant tax advantages. Typically, you are permitted to deduct the contributions that you make each year to each of your employee’s SEP-IRA accounts. The deduction limit is the lesser of your contributions or 25% of the compensation paid to the participants in 2018. This not to exceed $55,000.
You also have the option to carryover SEP contributions that are in excess of your SEP IRA deduction limit. This allows you to deduct these amounts in later years. These deductions should be taken on Schedule C for sole proprietors, Form 1065 for partnerships, or Form 1120 for S corporations.
Additionally, you may also be eligible for a tax credit for each of the first three years that your SEP IRA account is open and you make contributions. Connect with one of our tax strategists to discuss whether a SEP IRA makes sense for you.