SEP Plans Go Separate Ways
Simplified employee pension (SEP) plans are commonly used by self-employed individuals and others with part-time self-employment income. In addition, SEPs can offer many benefits to small companies, so business owners may want to consider using a SEP for themselves and the firm’s workers.
On your own
Self-employed individuals choose SEPs for several reasons. There are virtually no costs or paperwork to setting up and maintaining a SEP. Many financial firms offer them, and the investment options are broad. Contribution limits are generous, with a $52,000 maximum for 2014. (SEP contributions may be as high as 25% of compensation, but special rules effectively limit contributions to around 20% of your net self-employment income.)
In addition, SEPs offer a rare opportunity to make retroactive tax deductions. Each year, you can deduct SEP contributions made until the filing date of your tax return, including extensions.
Example 1: Beth Carson, a freelance graphic artist, qualifies for a $15,000 SEP contribution based on her 2013 earnings. On April 1, 2014, Beth contacts a mutual fund company and creates a SEP, funded with a check for $15,000. As long as Beth makes the contribution by the time she files her 2013 tax return on April 15, she can take a $15,000 tax deduction on that return. If Beth can’t make that deadline, she can request an automatic filing extension until October 15, giving her an extra six months to make a deductible SEP contribution.
Small companies also can use SEPs. Again, the simplicity of such plans, the flexibility, and the high ceiling for contributions may make SEPs appealing to business owners. Employers must fill out and retain IRS Form 5305-SEP to establish the plan, but there are no subsequent required filings with the IRS. The downside is that a SEP is funded entirely by employer contributions; SEPs are different from 401(k)s and similar plans, which are funded largely by employees’ salary deferrals.
To set up a SEP for your company, you merely have to sign a document with the financial firm you have chosen. Then you must notify each eligible employee about the plan and create an account (a SEP-IRA) for each qualified employee at the financial firm.
Once the plan is established, your company must make equivalent contributions for each eligible employee, as a percentage of compensation.
Example 2: ABC Corp. has two co-owners and four employees. If the owners want maximum SEP contributions of 25% of their pay, the company also must contribute 25% of pay to the SEP-IRAs of the other four employees. (See the Trusted Advice box for guidelines for which employees must be included in a SEP.)
Fortunately, SEP-IRAs are flexible. Even if ABC makes a 25% contribution in a given year, it can make a contribution of any percentage of pay in the following year. The company also can skip contributions altogether, if cash is tight.
With a SEP, business owners have plenty of time to decide about contribution levels. You can set up and make deductible contributions to a SEP plan as late as the due date (including extensions) of your company’s income tax return for that year. Therefore, your company still has time to set up a SEP plan and make deductible contributions for 2013.
When a company has a SEP plan, it must include all employees who
have done all of the following:
- Reached age 21
- Worked for the company in at least 3 of the last 5 years
- Received at least $550 in compensation from your business for the year, subject to annual cost-of-living adjustments in later years
Your company can impose less restrictive requirements, such as reaching age 18 or working there for 3 months. Certain union members and nonresident aliens may be excluded.