Setting up a SEP Plan


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SEP IRAs vs. other retirement plans

SEP IRA vs. 401(k)

It can be difficult for small businesses to choose between a 401(k) and a SEP IRA. In the end, it depends on the size of your business and your needs and circumstances. For self-employed individuals with a high income, a SEP IRA offers a convenient way to save for retirement that can be easier and more affordable than other options. Those with a side gig who already contribute to an employer-sponsored 401(k) or other retirement plan may also benefit.

A 401(k) may be a better option for businesses that have many employees or plan to increase its number of employees. Since employers are required to make equal contributions to all eligible employees, a SEP IRA can get costly quickly if there are a large number of employees . A 401(k) may also be a better option for business owners who want to allow employees to save for their own retirement from their paychecks.

SEP IRA vs. IRA (Traditional and Roth)

The biggest benefit of choosing a SEP IRA instead of a traditional or Roth IRA is the higher contribution limit. With a SEP IRA, you can set aside the lesser of 25% of your compensation or a maximum of $58,000 each year for 2021 ($61,000 in 2022). The contribution limits for traditional and Roth IRAs are much smaller at $6,000 per year (or $7,000 if you’re age 50 or older). SEP IRAs also allow for employer contributions, whereas traditional and Roth IRAs do not. SEP contributions are tax-deductible for business owners who open accounts.

Anyone can open a traditional or Roth IRA account. In fact, you can technically have all three accounts if you meet the qualifications. With a traditional IRA account, like a SEP account, your contributions are pre-tax. That means you pay no taxes up front, but when you withdraw money for retirement, it will be taxed as ordinary income.

Roth IRAs consist of after-tax contributions so they are not taxed as ordinary income when withdrawn after retirement. However, they also have an income limit. To be eligible to contribute to a Roth IRA in 2021, single tax filers must have a gross income of $140,000 or less ($144,000 in 2022), and married filers must have a household income of $208,000 or less ($214,000 in 2022).


The SECURE Act and Small Businesses

In December of 2019, former President Donald Trump signed the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which is designed to improve retirement security for many Americans.

Under the Act, small business employers will receive a tax credit for automatically enrolling workers into their retirement plans. Under the SECURE Act, small employers will get a tax credit to offset the costs of starting a 401(k) plan or SIMPLE IRA plan with auto-enrollment in addition to the start-up credit they already receive.

The bill also widens access to multiple employer plans for small businesses because employers no longer have to share “a common characteristic,” such as being in the same industry. Also, employer-sponsored retirement plans will be available to part-time workers who are eligible after one full year with 1,000 hours worked or three consecutive years with a minimum of 500 hours worked.

Deducting Plan Expenses

A business owner may be eligible to receive a tax credit for expenses incurred when establishing a SEP and also may be able to deduct plan expenses, including contributions made to the plan.

How to Set Up a SEP IRA

It’s relatively easy to establish a SEP IRA.

You can open one at almost any bank, mutual fund company or brokerage firm. If you have employees, this financial institution will serve as trustee of the SEP IRA and hold each worker’s retirement plan assets.

You will need to follow these three steps:

Execute a written agreement to provide benefits to all eligible employees. Educate employees about the agreement. Set up an IRA account for each employee.

The written agreement must include your name, the requirements for employee participation, the signature of a responsible official and a set allocation formula.

Pro Tip

You may be eligible for a tax credit of up to $500 per year for each of the first three years for the cost of starting a SEP IRA.

The IRS provides a model SEP document on its website, Form 5305-SEP. Alternatively, you can use a prototype document provided by a mutual fund, bank, or other qualified financial institution. Or you can create your own.

The financial institution is required to provide a plain-language explanation of any fees and commissions it imposes on SEP asset withdrawals. As the plan sponsor, you should monitor the financial institution to ensure it is doing everything it is required to do and that its fees are reasonable for the services it provides.

If you use Form 5305-SEP, you must give your employees a copy along with instructions. This includes requirements for receiving a distribution from the plan and under what conditions you will allocate contributions.

After you make your first contribution, you and your employees will receive a statement from the financial institution. You should continue to receive a statement each year after that.

Who Is Eligible for a SEP IRA?

SEP IRAs are most often used by self-employed people, entrepreneurs and small-business owners with few employees.

Things can get complicated if you have more than a handful of employees. That’s because a SEP IRA requires you to contribute on behalf of your employees, and those contributions must be the same percentage as your own.

For example, if you want to save 10 percent of your pay for retirement, you must also contribute 10 percent of each employee’s compensation to his or her plan. If you make $70,000 a year, you can contribute $7,000 to your SEP IRA plan, but if your employee earns $40,000 a year, you must also contribute $4,000 to his or her plan.

An employee is eligible to participate if he or she is at least 21 years old and has worked for the company for three of the last five years. The employee must also receive at least $600 in compensation during the year.

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Tax-Deductible Contributions

As a small business owner you can deduct your contributions for yourself and your employees from your company’s federal taxable income. The individual traditional IRA contribution if made – may or may not be deductible depending on individual tax filing status and modified adjusted gross income.

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Pros and cons of a SEP IRA

The SEP IRA is a popular retirement plan for the self-employed because it offers many useful advantages, but it’s not the perfect plan for everyone.

Advantages of a SEP IRA

  • Provides a way for you to save for retirement: If you’re self-employed, you might not have many options for tax-advantaged retirement savings, and this can help.
  • Tax-deferred: Your contributions are made with pre-tax dollars, so you receive a tax deduction today and only pay taxes when you withdraw.
  • Easy to set up: A broker offering SEP IRAs can guide you through a few simple steps after you fill out one IRS form.
  • Make bigger contributions: Contribution limits are higher than traditional and Roth IRAs, as well as more than what you can contribute to a 401(k).
  • Flexibility: You don’t have to contribute every year (whether for yourself or your employees).

Disadvantages of a SEP IRA

  • Employees must be treated the same as you: This is an employer-only contribution. Employees don’t make their own contributions and you must contribute the same percentage of employee compensation as you do to your own SEP account.
  • No catch-up contributions: If you’re over the age of 50, there are no catch-up contributions like you see with IRAs and 401(k)s. (However, the higher contribution limits of a SEP IRA might outweigh this negative.)
  • No Roth option: Those who prefer socking away money with after-tax contributions and enjoying tax-free withdrawals are out of luck. There is no Roth option, so while your money will grow tax-deferred, you will still be on the hook for taxes when you take distributions. You’ll also be subject to required minimum distributions later.

How Much Do You Have to Contribute for Employees?

You must contribute the same percentage of income for your employees as you do for yourself. For instance, let's say you contribute 20% of your eligible compensation to the plan. In that case, you must also make a contribution for each eligible employee in the amount of 20% of their eligible compensation.

Employees are eligible for contributions if:

  • They have worked for you three out of the past five years.
  • They earn more than $650 in 2021.
  • They are age 21 or older.

You have until your tax filing deadline (plus extensions) to make contributions to your SEP for the previous year. The IRS has a great section on SEP IRAs that covers additional rules.

Establish a SEP Plan

The first action you’ll need to take is to choose a financial institution to serve as trustee of the SEP-IRAs that will hold each employee’s retirement plan assets. These accounts will receive the contributions you make to the plan.

Set-up steps for a SEP

There are three steps to establishing a SEP.

  1. Execute a written agreement to provide benefits to all eligible employees.
  2. Give employees certain information about the agreement.
  3. Set up an IRA account for each employee.

Written agreement

The written agreement must include the name of the employer, the requirements for employee participation, the signature of a responsible official and a definite allocation formula.

The IRS has a model SEP plan document, Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution AgreementPDF. Do not file this form with the IRS.

You may not use Form 5305 – SEP if you:

  • Maintain any other qualified plan (except another SEP – a plan is “maintained” even if no contributions were made during the year),
  • Use the services of leased employees,
  • Want a plan year other than the calendar year, or
  • Want an allocation formula that takes into account Social Security contributions you made for your employees.

If you can’t use the Form 5305-SEP, you may use a prototype document. A mutual fund, insurance company, bank or other qualified institution usually provides these. You may also have a SEP individually designed for your business.

Provide information to participants

You must furnish your eligible employees:

  • Notice that you have adopted the SEP
  • Requirements for receiving an allocation
  • The basis on which the employer contribution will be allocated

If you use Form 5305-SEP, you must give your employees a copy of the form and its instructions. The model SEP is not considered adopted until each employee is provided with the following information:

  1. A statement that IRAs other than the one the employer contributes to may provide different rates of return and contain different terms.
  2. A statement that the administrator of the SEP will provide a copy of any amendments within 30 days of the effective date along with a written explanation of its effects.
  3. The administrator will give written notification to the participant of any employer contributions made to a participant’s IRA by January 31 of the following year.

If you use a prototype or individually designed plan you must give all eligible employees similar information.

Set up a SEP-IRA for each employee

A SEP-IRA must be set up by or for each eligible employee. They may be set up with banks, insurance companies or other qualified financial institutions. All SEP contributions must go to traditional IRAs. Employees are responsible for making investment decisions about their SEP-IRA accounts.

You and your employees will receive a statement from the financial institutions investing your SEP contributions both at the time you make the first SEP contributions and at least once a year after that. Each institution must provide a plain-language explanation of any fees and commissions it imposes on SEP assets withdrawn before the expiration of a specified period of time.

Timing of setting up a SEP plan

You can set up a SEP for a year as late as the due date (including extensions) of your business income tax return for the year you want to establish the plan.

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What Are the Disadvantages of SEPs?

SEPs have a few disadvantages for small business owners as well. These include:

  • Employees are 100% vested in employer contributions once they are made. No vesting schedule may be attached to SEP contributions. If an employee leaves the day after the contribution is made, it is theirs. In addition, let’s say they leave part-way through the year, and you make a contribution for that calendar year. In that case, you must make a contribution for them based on the amount of eligible compensation they had up until the time they left.
  • You must make the same percentage contribution for all eligible employees. In a formal profit-sharing plan, you can classify employees into groups and have the ability to make different contribution amounts for different groups.