Simplified employee pension plans, as their name implies, allow employers to offer employees retirement benefits with ease in the setting-up process as well as participation and administration. SARSEPs, a form of SEPs, are no longer available but may be maintained if already in existence.
Employers looking for a relatively straight-forward, inexpensive way to offer employees retirement benefits can use a simplified employee pension, or SEP to do so.
Is a SEP right for you? If you fall into one of these categories, you should consider setting up a SEP:
- persons who are regularly employed by a company but who "moonlight" for themselves as independent contractors (In fact, that's why some commentators have referred to SEPs as a "moonlighter's retirement plan.")
- sole proprietors who have no employees — for these folks, establishing a SEP is as simple as walking into a bank or brokerage firm and setting up an individual retirement account (IRA), known as a SEP-IRA.
- any business that won't know its financial condition until tax time (because SEPs are the only type of employer-sponsored retirement plans that can be established after the employer's tax year has ended, and where contribution amounts can be determined after you see what your profits will be for the year)
- persons or companies providing financial services who might want to use a SEP to provide clients with combined plan and investment services (one-stop shopping for retirement plan and investment services is attractive to busy clients)
Conversely, you should stay away from SEPs if you:
- want to set up a retirement plan that gives you a lot of flexibility; in allowing employers to set up SEPs, Congress traded off flexibility for lower costs and fewer administrative burdens
- foresee wanting to contribute in a given year more than the limit Congress has placed on annual SEP contributions, the lesser of 25 percent of compensation up to $260,000 or $52,000 for 2014 ($255,000, or $51,000 for 2013; these amounts may be adjusted annually)
- have high income and you don't want to be limited by the rules that base allowable SEP contributions on compensation
To set up a SEP, you need to take three steps, in the following order:
- Determine your contributions allocation formula.
- Establish IRAs for all your eligible employees.
- Complete IRS Form 5305-SEP (or create your own document with similar information in it).
There are also several administrative issues involved in offering a SEP, including:
- providing employees with information about the SEP
- keeping track of limits on contributions
- knowing who can participate in a SEP
- understanding the rules related to vesting in a SEP
The Contribution Allocation Formula
In setting up a SEP, you have to decide what percentage of compensation you'll use to determine your SEP contributions. This number, known as a contribution allocation formula, is really just a fancy name for figuring out which percentage you will use.
Generally, your SEP contributions must be made in an amount that is the same percentage of total compensation for every employee. Note that this requirement merely obligates you to use the same percentage for every employee; it does not require you to use the same percentage every year (or even to contribute every year).
As a practical matter, you'll want to wait until you know how much money you have available for SEP contributions (usually after the books are closed at the end of the year) before determining the percentage.
After you have determined the percentage and made the contributions, you must give written notice to each participant detailing your contributions to their SEPs. The notice must be made by the later of January 31 of the year following the year for which a contribution is made, or 30 days after the contribution is made.
The next step in setting up your SEP is establishing IRAs for your employees.
Setting Up Employee IRAs and Completing Form 5305-SEP
The simplest means of setting up employee SEP IRAs is to contact a bank, savings and loan association, insurance company, federally insured credit union, brokerage house, or mutual fund company. Whichever one you contact will supply you with the written documents you need. The language in the IRA shouldn't really vary from one source to another. You should make your choice based on whichever one delivers the best service for the lowest rates. Be sure to run your choices by your business financial adviser.
Who is eligible for an IRA? To be eligible to set up an IRA, your employees must meet two requirements:
- They must be under age 70 1/2.
- They must have compensation or be a spouse of a person earning compensation.
You should note that there is no minimum age restriction. Children, therefore, are eligible to have an IRA, as long as they meet the compensation requirement. Children employed by your business, however, are eligible for a SEP only if you have set the minimum age requirements low enough to include them.
The next step in setting up your SEP is completing Form 5305-SEP.
Completing Form 5305-SEP
The IRS has developed an extremely helpful one-page tax form that meets all the requirements of a SEP plan. It does not require any special document preparation other than simply filling in a few lines on the form, signing it, and dating it.
To be able to use Form 5305-SEP, you must meet the following requirements:
- You must not maintain any other retirement plan and must not have maintained a defined benefit plan at any time in the past.
- Each eligible employee must have established an IRA.
- You must not use leased employees.
- You cannot be a member of an affiliated service group, a controlled group of corporations, or trades or businesses under common control, unless all eligible employees of all the members of such groups, trades, or businesses participate in the SEP.
- You must pay the cost of the SEP contributions (which means that you cannot provide for elective employee contributions).
You should note that even if you fall into one of the categories above, you can still set up a SEP; you just can't use Form 5305-SEP.
Do not file Form 5305-SEP with the IRS. The form is merely intended to help you set up a SEP. You should fill it out, sign it, and date it and keep it with your business records. Once you have filled out the form, you don't have to do anything else with it, which means that you do not have to file Form 5305-SEP with the IRS, and you do not have to file any annual information returns (as most other types of plans are required to do).
Once the plan is set up, you must communicate information about the plan to your employees.
Providing Information to Employees
If you set up a SEP plan, all eligible employees must be given the following information:
- a copy of Form 5305-SEP (assuming that you use 5305-SEP)
- a statement that IRAs, other than the IRAs into which employer SEP contributions will be made may provide different rates of return and different terms concerning, among other things, transfers and withdrawals of funds from the IRAs
- a statement that, in addition to the information provided to an employee at the time the employee becomes eligible to participate, the SEP administrator must furnish each participant within 30 days of the effective date of any amendment to the SEP a copy of the amendment and a written explanation of its effects
- a statement that the administrator will give written notification to each participant of any employer contributions made under the SEP to that participant's IRA by the later of January 31 of the year following the year for which a contribution is made or 30 days after the contribution is made
SEP Participation and Contribution Limits and Vesting
If you have a SEP, be aware that there are strict rules regarding participation. The law mandates that any employee who has reached age 21, has worked for you in at least three of the preceding five years, and has received at least $550 from you for the year (this amount may be adjusted annually for inflation) must be allowed to participate in your SEP. You can write your plan to be more generous if you like (for example, allow employees under 21 or with fewer than three years of service to participate).
There are a couple of points you should remember about participation:
- You must contribute on behalf of all employees who meet the SEP eligibility requirements during the year in which the contribution is made, including those who no longer are employed by you and those who died during the year, even if you do not know their whereabouts.
- If former or current eligible employees close their IRAs prior to your contributions, you must establish another IRA on those employees' behalf. You must also send a notice to such employees at their last known address telling them that you established an IRA on their behalf. These rules also apply to eligible employees who refuse to open IRAs.
There are rules limiting SEP contributions as well.
Limits on Contributions
Again, the maximum annual contribution you can make to a SEP is the lower of 25 percent of an employee's pay up to $260,000 or $52,000 (for 2014; these amounts may be adjusted annually for inflation).
If you're self-employed, the limits are slightly lower. When figuring the deduction for employer contributions made to your own SEP-IRA, compensation is your net earnings from self-employment, which takes into account:
- the deduction allowed to you for one-half of the self-employment tax, and
- the deduction for contributions on behalf of yourself to the plan.
The end result is that you will have to reduce the contribution rate called for in your plan by using a table and worksheets provided by the IRS in Publication 590, Individual Retirement Arrangements (IRAs).
Vesting in a SEP
When an employee becomes vested in a retirement plan, it means that he or she has participated in a plan long enough or has provided enough years of service to an employer such that the employee becomes entitled not only to the contributions that the employee might have made (which is not applicable in a SEP) but also to the contributions made by the employer. In plans other than SEPs, if an employee is not vested in a plan, the employee is not entitled to the contributions made by the employer.
In traditional pension plans, employers generally set up a vesting schedule. For example, they might provide that an employee is 33 percent vested after three years, 66 percent after four years, and 100 percent after five years. SEPs are different. The employee's right to employer contributions in a SEP is always 100 percent vested. Therefore, your employee has the full ownership right to the contributions in the account at all times.
Even so, there are penalties for early withdrawals. Since SEPs are based on IRAs, the IRA penalties apply. If an employee who has not reached age 59 1/2 makes an early withdrawal, the employee will have to pay a 10 percent penalty tax. In addition to the 10 percent tax, the employee must include the distribution in income for the year in which it was received. As with regular IRAs, penalties can be avoided if the employee rolls the amount over into another IRA within 60 days.
SARSEPs Are No Longer an Option for Retirement Unless Already Set-Up
Salary reduction simplified employee pension plans (SARSEPs) are a type of pension plan that, as of 1997, are no longer available. Those who already have such plans can continue to contribute to them, and add accounts for new employees, but no new SARSEPs can be set up.
SARSEPs are SEPs that act like 401(k) plans in the sense that employees who participate in the SARSEP can elect to have salary-reduction contributions made to the SEP, just as they can in a 401(k) plan.
The amount that can be deferred in a SARSEP is $17,500 or 100 percent of compensation, whichever is less, for 2013 and 2014 (this amount may be adjusted annually for inflation). Additional catch-up contributions are allowed for employees who have reached age 50. Catch-up contributions are limited to $5,500 for 2013 and 2014 (this amount may be adjusted annually for inflation).
To participate in a SARSEP, an employee must be at least 21, must have worked for you in at least three of the preceding five years, and must have received at least $550 in compensation for the year in which the contribution was made. The compensation amount may be adjusted annually for inflation.
The election to use a SARSEP is available only if:
- at least 50 percent of the employees who are eligible to participate elect to have amounts contributed to the SEP; and
- you have no more than 25 eligible employees.