by Denise Appleby, CISP, CRC, CRPS, CRSP, APA
Originally published January 2013. Updated with 2016 numbers
If you own a small business and are looking for a way to reduce your 2016 taxable income, you may do so by funding a SEP IRA for you and any eligible employees. Compensation allowing, up to $53,000 can be sheltered from income tax for each individual who participates in the plan[i].
Plan Establishment Deadline
SEP IRAs can be established and funded as late as the tax filing deadline of your business, including extensions. This means that you still have time to establish and fund a SEP IRA for 2016, if you filed for an extension.
A SEP IRA is funded purely with employer contributions, i.e. contributions made by the business on behalf of the employees, including the business owner. The maximum amount that can be contributed to an employee’s account is the lesser of 25% of the employee’s compensation- such as W-2 wages, or $53,000. For this purpose, compensation is capped at $265,000. (The percentage is 20% of modified net profit, if your contribution is based on Schedule C income, which would be the case if your business is unincorporated)
Generally, the same percentage of compensation must be allocated to each eligible employee when making SEP IRA contributions. For instance, if you choose to make a contribution of 10% of compensation, each eligible employee must receive a contribution of 10% of compensation. However, this is the basic and most commonly used formula.
Depending on the features available under the SEP Agreement, you may choose another allocation formula, including: a flat dollar formula, where each eligible employee receives the same dollar amount, regardless of compensation; or the social security integration formula, which allows a higher percentage of contribution to certain employees. The latter usually requires the assistance of a professional who is versed in the area of social security integration.
Employees Must get Funded Too
A common mistake is for business owners to make contributions to only their SEP IRAs, instead of including their employees when allocating contributions. However, steps must be taken to ensure that contributions are made for all eligible employees. This can be accomplished by reviewing the plan’s eligibility requirements and ensuring that all eligible employees receive contributions for the year.
If contributions are made to your SEP IRA and none are made for other eligible employees, retroactive contributions plus earnings may need to be made to the eligible employees’ accounts.
One of the most attractive features of a SEP IRA is the fact that contributions are discretionary. This means that you can choose not to make contributions in some years, which is a welcome option when profits are low or nonexistent.
Choose Eligibility Requirements Wisely
When completing the SEP IRA Agreement, careful consideration must be given to the eligibility requirements that are chosen. In general, you can exclude employees who:
- Have not reached age 21 during the year for which the contribution is being made.
- Have not earned at least $600 for the year
- Have not worked at least 3 of the 5 preceding years
Employees covered under a collective bargaining agreement and certain nonresident aliens may be excluded from the plan.
If you want to cover current employees (including yourself) immediately and subject future employees to more restrictive eligibility requirements, you have the option of using a SEP Agreement that provides such an option.
Setting Up The SEP Plan
The SEP IRA is the easiest employer sponsored retirement plan to establish. At a high level, the steps include the following:
- The employer completing and signing the SEP Agreement
- The employer notifying employees about the SEP Plan, including eligibility requirements. In some cases, this can be accomplished by providing employees with a copy of the employer’s SEP Agreement
- Each eligible employee establishing a traditional IRA to receive SEP contributions. Some IRA custodians will require a copy of the employer’s SEP Agreement and will flag the account as a ‘SEP IRA’, so that interested parties are aware that the IRA is eligible to receive SEP contributions.
SEP contributions can be made to each eligible employee’s SEP IRA by the tax filing deadline of your business, including extensions. Individual employee’s SEP IRAs need not be opened until the contributions are being made, unless the employee wants to make other IRA contributions to the account.
Proceed With Caution
While the SEP IRA is the easiest plan to establish, there is always the potential for costly mistakes to be made. Check with your financial advisor before completing SEP documentation, and to review the plan each year to ensure compliance.
© Appleby Retirement Consulting Inc.
[i] The amount is much higher for a defined benefit plan. These are more complex and usually require the assistance of a TPA and actuary to establish and maintain.