9 minute read
Simplified Employee Pensions (SEPs) are simple to run, low-cost individual retirement accounts (IRAs) for small businesses and self-employed individuals. Contributions to SEPs — or SEP IRAs, as they’re often called — grow tax deferred until those funds are withdrawn in retirement, at which time they are taxable to the plan participant.
SEP IRAs can provide employees with great retirement benefits, but they can also act as tax planning tools for small business owners.
SEP IRAs, like other pension plans, are funded by the employer. Employers make annual voluntary contributions to their employees’ SEP IRAs, calculated as a percentage of their compensation. Employers have the discretion to change the contribution percentage each year (and can even elect to forgo contributions altogether), but whatever percentage they choose must be applied across the board to all employees.
Employers can take a business deduction for SEP contributions, and their employees’ plans grow tax deferred until they pull from those funds in retirement, at which point their withdrawals are taxed as ordinary income.
SEPs are available to almost any employer and self-employed taxpayer, but they’re used most often by smaller businesses that are drawn to their simplicity. To establish a SEP IRA, a business must do three simple things:
And fortunately, beginning in 2020, small businesses are eligible for a tax credit to help offset the cost of establishing a new retirement plan. The Setting Every Community Up for Retirement Enhancement (SECURE) Act gives employers with 100 or fewer employees a credit worth up to $5,000 each year for three years to cover plan costs.
In 2021, the maximum contributions an employer can make to each employee’s SEP IRA is 25% of the employee’s compensation, but no more than $58,000 annually.
Self-employed individuals face similar limitations. The individual’s business can contribute up to 25% of business net income (calculated as Schedule C net profits without considering the deduction for self-employment tax) up to a maximum of $58,000.
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Employers can set different eligibility rules if they so choose, but there are certain rules they must follow at a minimum. Employees will be automatically enrolled in their employer’s SEP IRA if they meet these three requirements:
SEP IRAs are retirement plans that are qualified under the Employee Retirement Income Security Act of 1974 (ERISA). For employers to sponsor ERISA-qualified plans, they must:
A few benefits of SEP IRAs are:
Employers can deduct contributions they make to ERISA-qualified plans, including SEP IRAs. These deductions can reduce business income and, in turn, reduce tax liability for owners.
Each year, employers can determine how much they want to contribute to employees’ plans. This amount must be a percentage of employees’ salaries, up to 25%. Employers can also elect to forgo contributions altogether.
SEP contributions made by the employer are capped at $58,000 per employee (or 25% of their salary, whichever is lower). In contrast, annual contributions to traditional IRAs are capped at $6,000 (or $7,000 for employees 50 and older).
Small businesses can reward their employees for exceeding revenue targets by contributing to their SEP IRAs at the end of the year. If they instead choose to pay out those earnings as bonuses, they would owe more in payroll taxes.
Because contributions are discretionary, a business can use SEP IRA contributions in tax years that they need to reduce their taxable income.
The Department of Labor ensures ERISA-qualified plans comply with minimum operating standards, which make SEP IRAs (and other qualified plans) less risky than many other investments individuals might want to make when planning for retirement.
Businesses that offer retirement plans, especially those with proper oversight and low costs like SEP IRAs, can more easily entice new workers.
The downsides of SEP IRAs are:
Even though employers are given the freedom to change contribution percentages each year, they cannot contribute different percentages to different employees. Contributions must be based on the same salary percentage for all eligible employees.
Most SEP IRAs are fully funded by the business and generally do not allow employees to contribute to their own plans. Other retirement accounts, like 401(k)s, allow employees to defer a portion of their salary into their retirement savings.
SEP IRAs are just one retirement plan among many. Let’s review a few simple aspects of SEP IRAs in comparison to other common retirement plan choices for small businesses.
| SEP IRA | Traditional IRA | 401(k) | SIMPLE 401(k) | |
| Who Can Contribute? | Generally, only employers contribute to SEP IRAs | Employers cannot contribute to their employees’ traditional IRAs | Both employers and employees can contribute to 401(k) | Both employers and employees can contribute to SIMPLE 401(k)s |
| Maximum Employer Contributions (in 2021) | 25% of compensation, up to $58,000 | N/A | 100% of compensation, up to $58,000 | Dollar-for-dollar matching contribution up to 3% of compensation, or a nonelective contribution up to 2% of compensation |
| Maximum Employee Contributions (in 2021) | N/A | $6,000 ($7,000 for age 50 or older) | Employees can defer up to $19,500 of their salary into their 401(k) | Employees can defer up to $13,500 of their salary into their 401(k) |
Want to see how SEP IRAs can affect taxable income? Take a look at Corvee Tax Planning software. Our software can show how contributions you make to a SEP IRA can change your business and individual taxable income. Contact us today for a demo.
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