Simplified employee pension (SEP-IRA)

The simplified employee pension (SEP) is a definedcontributions pension plan. The SEP is also known as a SEP-IRA because companies contribute to INDIVIDUAL RETIREMENT ACCOUNTs (IRA) for their employees. A defined-contributions plan allows companies or their employees to determine how much will be invested in a pension. These differ from defined-benefits plans, which regulate how retirement INCOME is disbursed. SEPs appeal to small businesses that often do not have the time or CAPITAL to manage a defined-benefits plan. Defined-contribution plans such as SEPs derive from the EMPLOYEE RETIREMENT INCOME SECURITY ACT of 1974 (ERISA). In creating SEPs, Congress was responding to the fact that nearly all companies of 5,000 or more employees provided some type of pension or RETIREMENT PLAN, while few companies of under 100 employees did not. Congress legislated that any business with 25 employees or fewer could set up an SEP, including CORPORATIONs, PARTNERSHIPs, and sole PROPRIETORSHIPs. SEPs are regulated by the Internal Revenue Code, Title 26, section 408(k). SEPs are attractive to small-business owners and the self-employed because they are relatively easy to set up, inexpensive to manage, and tax deductible. Employees benefit because contributions are made by their company and can be far greater than those allowed by ordinary IRAs: up to 15 percent of an employee’s annual salary or $30,000, whichever is less. In addition, employees may contribute $2,000 annually to an SEP as they would to any other IRA, although they are not required to invest anything. Setting up a SEP is simple. The employer must fill out IRS Form 5035-SEP—the Simplified Employee Pension– Individual Retirement Accounts Contribution Agreement— and distribute it to all eligible employees. Eligible employees are those who have worked for the company for three of the previous five years, earned more than $450 (annually adjusted for INFLATION), and are 21 years of age or older. They may not be part of a COLLECTIVE BARGAINING agreement or nonresident immigrants. The employer must then determine what percentage of salary will be contributed to the SEP. The amount can vary from 0 to 15 percent, but the percentage must be the same for all eligible employees. Self-employed company owners may contribute up to 13.04 percent of their salary. There is a $170,000 salary maximum after which the 15 percent contribution is no longer allowed. In lean years, employers are not required to contribute anything, removing one impediment to setting up a retirement plan in the first place. Salary deductions are not allowed as contributions to a SEP. Prior to 1997, companies could deduct employee wages and invest them in a Salary-Reduction Simplified Employee Pension (SARSEP), but that is no longer the case. Employees who were invested in a SARSEP before 1997 are still able to contribute through payroll deduction, but no new SARSEPs can be created. Once employees have been notified of the company’s intention to begin a SEP, either the company or the employees will set up an IRA at a financial institution. Financial institutions comprise banks, SAVINGS AND LOAN ASSOCIATIONS, INSURANCE companies, and CREDIT UNIONs, among others. Stocks, MUTUAL FUNDS, money market funds, and savings accounts are all acceptable INVESTMENT vehicles. Employees are fully vested from the moment the SEP is created, meaning they are entitled to the full amount the company has contributed to their account. Other types of pensions may require the employee to wait as long as five to seven years before they are so entitled. An SEP is a tax-deferred retirement savings account; employees will not be taxed on the investment as long as the funds remain in the account. Just as with a regular IRA, an employee may withdraw funds once they are 59½ years of age, at which time he or she will be taxed. Withdrawal prior to retirement will be taxed at a rate of 10 percent, unless it is placed or rolled over into another IRA within a year. If the employee becomes disabled, the distribution tax will be waived. All employees are required to begin withdrawing by the time they turn 70½. Employees may name a beneficiary to receive their distribution should they die prematurely. Business owners benefit from enrolling their employees in an SEP for a number of reasons. An SEP is considered a tax-deductible business expense. Set-up requires minimal effort, and there are no ANNUAL REPORTs to file with the INTERNAL REVENUE SERVICE, keeping administrative costs low. Employers can also tailor an SEP by annually reviewing the percent of salary that they contribute and adjusting that figure according to their company’s present fiscal situation. Also, once contributions are made, investment decisions become the responsibility of the employee, thus reducing the company’s LIABILITY for poor investment returns. The employer does not need to convince employees to participate as in some other plan, because the company is required to contribute for all eligible employees, whether they agree or not. Even if an employee terminates his or her EMPLOYMENT or dies before the year’s end, he or she will still be vested. There are drawbacks to SEPs. Business owners must consider carefully whether it makes financial sense to set up an SEP, because although the cost of administering the plan is small, the company is the sole contributor. Additionally, employees are fully vested in an SEP from the outset and can roll the money over at any time into another IRA. This reduces the leverage employers might have to retain employees as they would with a pension that vests employees gradually. Employees may change jobs, taking their pension with them. Employers must also be careful to compensate all employees at the same rate and are forbidden from requiring that employees take a cut in pay to enroll. Part-time employees who meet the criteria must be included, and in the case of bankruptcy, the vested party may not be able to protect his or her investment from creditors. There are a number of alternatives to the SEP. For instance, 401(K) PLANs are extremely popular and allow employees to contribute up to 15 percent of their income along with company matching, but they are expensive and cumbersome to administer. Employees in companies of 100 or fewer workers can contribute up to $6,000 annually to a savings incentive match plan (simple), but the company is required to contribute a percentage as well. The KEOGH PLAN permits deferring 25 percent of salary (up to $30,000) from taxes each year. Keogh contributions are higher than SEPs, but they are more difficult and costly to administer. Business owners must carefully assess their present position and select the plan that provides the greatest benefit for both the company and its employees. In general, a 401(k) plan may be more attractive to a larger company undaunted by the administrative costs. A simple plan may appeal to self-employed individuals with low income and no employees or with high income and a few employees. An SEP would more likely attract a self-employed, highincome individual with few or no employees.