What is a SEP IRA?
SEP IRA stands for Simplified Employee Pension Individual Retirement Plan. It is a simple and easy to administer type of retirement account that combines some of the appeal of a profit sharing plan and a pension plan and puts them within the reach of the small business owner and the self employed worker. They function in much the same manner as a Traditional IRA as far as taxation issues go and are subject to strict limitations on who can participate and what the maximum contributions per year can be.
A SEP Plan is a plan established by an employer under Internal Code Section 408(k). A SEP IRA is a type of retirement plan that allows employers to fund pre-tax IRAs for eligible employees. For 2013, under Internal Revenue Code Section 404(h), the maximum contribution that can be made to a SEP plan is 25% of compensation up to $51,000 for each eligible employee.
How are SEP IRA Contributions Made?
Under a SEP IRA Plan, an employer SEP contribution is made directly to the employee’s Traditional IRA contribution and the employer receives a deduction for the employee contribution. The deduction is taken on the employer’s income tax return for the tax year for which the SEP contribution was made.
Why do Employers Establish a SEP IRA?
There are several benefits of maintain a SEP plan.
1. Cost Effective: A SEP plan is generally less costly and administratively burdensome then the majority of company sponsored employee retirement plans. For example, there is no annual IRS Form 5500, Annual Return/Report of Employee Benefit Plan, reporting requirements or bonding requirements like a 401(k) qualified retirement plan
2. Flexible Contributions: Contributions to a SEP plan are flexible as the employer can set the percentage amount that would apply to all eligible employee SEP IRA contributions. Unlike, a 401(K) qualified retirement plan, there are no ERISA or Safe Harbor rules to satisfy.
3. Employee Access: With a SEP IRA, the employee would have access to the assets at all time. Unlike a 401(k) qualified retirement plan, no triggering event is required for an employee to access their retirement funds.
4. Employee Control. With a SEP IRA, the employee would generally have greater control over the retirement assets as a result of the assets being held in an IRA and not in a trust. The level of control the employee would have over the SEP IRA assets would be based off the IRA custodian holding the assets and the type of available custodian approved investments.
5. Tax-Deferred Earnings: Earnings generated on SEP IRA remain tax-deferred until distributed.
Disadvantages of Establishing a SEP IRA vs. Other Retirement Plans
1. Limitation of Annual Contributions: An Individual 401k may provide a larger contribution compared to a SEP IRA at the same income level
2. No Catch-Up Contributions: For those age 50+ there isn’t an additional catch-up provision like there is with the Individual 401k.
3. Loans are not permitted
4. Lack of Employee Control: The real disadvantage of the SEP-IRA, especially when compared to a Simple IRA plan, is that it is limited to the contributions of the employer of the employee’s earnings. The employee cannot put any funds into the IRA. The Simple IRA type of pension plan allows the employee to make contributions and the employer is permitted to make matching contributions also. This restriction in the SEP-IRA takes away a bit of control from the employee and limits the options of the employer.