By: Gene Walden, Senior Finance Editor December 10, 2019
Small business owners can offer employees (and themselves) a tax-deferred retirement savings plan similar to the plans offered by larger corporations – but without incurring the high start-up and operating costs of a conventional retirement savings plan such as a 401(k).
A Simplified Employee Pension Plan (SEP) is similar to corporate retirement plans such as 401(k)s in that:
- Both are funded with pre-tax contributions
- Investments within both plans grow tax-deferred
- Withdrawals in retirement are taxed at your ordinary income rate in the year of the withdrawal
However, there are also some important differences. While 401(k) plans are funded with the pre-tax compensation from employees (sometimes supplemented with a full or partial match by the employer), all contributions made to a SEP must come from the employer on behalf of the employees.
An employer could make an annual contribution of up to the lesser of 25%1 of each employee’s compensation2 or $56,000 for 2019 or $57,000 for 2020.
Here are several other key facts to know about a SEP for small business owners:
- If the employer makes contributions on their own behalf, they must also make contributions on behalf of all eligible employees.
- Employees are always 100% vested in (or, have ownership of) all SEP-IRA money.
- The employer can adjust the contribution each year as the situation warrants.
- Any employees who are at least age 21 years old and worked for you at any time in three out of the prior five years must be included in the SEP plan.
- For instance, someone who worked for you in 2014, 2017 and 2018 would be eligible for your plan, and you would be required to make a contribution for him or her for the 2019 plan year.
- If you want to stash away 15% of your compensation for yourself, you must also contribute an amount equal to 15% of that employee’s compensation to his or her SEP IRA. Although the contribution comes directly from the company rather than from the employee’s wages, the employees own and control their own accounts.
- If you are an employee with a SEP IRA account, you can:
- Keep your money in the SEP IRA
- Transfer your money to a Traditional IRA, Roth IRA (this is a taxable event), or another SEP IRA
- Roll over your money to another SEP IRA, a 401(k), a 403(b) or 457(b) account in which you participate if the receiving plan accepts rollovers.
- Participants must start taking required minimum distributions at age 70 ½. (See: Ready for Age 70? Make the Most of Required Distributions)
- Employees who take a distribution before age 59 ½ would be required to pay income taxes and possibly a 10% early distribution penalty. The 10% penalty may not be imposed if certain conditions apply, such as a permanent disability. The money may also be used for a down payment for first time home buyers or to help pay your children’s higher education costs. See the full list of exceptions.
Self-employed individuals can also open a SEP plan for their retirement savings. (See: Self-Employed Workers Can Also Benefit from Tax-Deferred Retirement Plans)
How to set up a SEP for your business
Establishing a SEP for your business involves maintaining a plan document. The IRS provides a prototype document called the 5305-SEP, Simplified Employee Pension. That is a matter that you may choose to handle through your tax advisor or on your own. (For more details, see IRS article How Do I Establish a SEP?)
Once your business has completed the required IRS form, you and your employees would be able to open SEP IRA accounts with a qualified financial institution to receive the contributions and enable participants to invest their funds. While contributions come from the employer, each employee owns and controls their own SEP IRA account.
At Thrivent Mutual Funds, we recommend you consult your tax advisor to make sure you’re getting the most out of your investments. Thrivent Mutual Funds and their representatives cannot provide legal or tax advice.
1 Self Employed owners who file Schedule C are limited to 20% of net earned income
2 For Schedule C filer, it would be net earned income; for Schedule C or Sub S Corporation filer, it would be W-2 income.