SEP IRA

As the name suggests, a Simplified Employee Pension or SEP plan is a simple to implement and simple to operate retirement plan. SEP's have fewer administrative requirements and lower operating costs than the other types of retirement plans. For many doctors, lawyers, free-lance writers, artists, manufacturers representatives and other self-employed people, Simplified Employee Pensions (SEPs) may be too good a deal to pass up. They are also exempt from some of the restrictions that apply to other plans. There are, however, significant disadvantages to implementing a SEP in certain situations.

Although they are technically a type of Individual Retirement Arrangement (IRA), SEPs seem more like a cross between an IRA and a profit sharing plan. Like a profit sharing plan, the employer tax deduction limit is the lesser of 25 percent of compensation or $44,000. However, note that while compensation is capped at $220,000 in 2006, the maximum contribution is still only $44,000 in effect reducing the compensation cap to only $176,000. Also like a profit sharing plan, the employer has complete flexibility (within the above limits) to set the amount contributed. The employer may even skip a year or more if business is bad. Like an IRA, distributions cannot receive lump sum distribution forward averaging treatment for tax purposes like qualified plans.

The implementation process for a SEP plan can be as simple as establishing IRA accounts for each eligible employee. The company can contribute an amount up to the lesser of $36,000 or 25% of annual individual compensation to each account. All SEP contributions are fully vested immediately and since the account belongs to the participant they can access their money at any time if they are willing to suffer the tax consequences. Many employers don't like SEP plans for these reasons.

A SEP account is very easy to establish and maintain. A SEP may be established by a corporation (S or C), partnership, non-profit organization or sole proprietor. There is no complicated adoption agreement to complete or file with the IRS. In fact there's no need to file annual reports (i.e. Form 5500) with the IRS either. The form establishing a SEP is a very simple, one-page form that should be retained by the employer. A SEP may be "integrated with social security" which has the effect of skewing contributions toward higher paid people (who are usually the employer). Be careful though, the standard IRS form does not allow for integration. You must find a prototype that does.

One of the reasons SEPs are so simple is that there are very few choices available to employers. All SEP contributions are always 100% vested in the employees. For example, an employer who makes $50,000 per year has two employees who make $10,000 each. If the employer contributes 10% for himself he must contribute 10% each for the two employees. If one of the employees quits tomorrow, he takes the $1,000 with him.

The eligibility rules on SEPs are fairly strict. First, you cannot exclude employees over 21. Second, you must cover employees who have worked for the employer in three out of the last five years. Note, that means any amount of work (say, one afternoon) counts the same as an entire year's efforts. Third, you must contribute for anyone who meets the other criteria and makes more than a certain amount during the year (in excess of $450). That makes it virtually impossible to exclude part-time people. You should also realize that the same criteria apply to both employer and employees. If the business has only been in existence for one year and the employer wants the maximum exclusion of three out of five years, then the employer will have to complete two more years before he/she qualifies.

Features

• For self-employed individuals or small business owners with variable earnings.
• Easy to establish and requires minimal administration by the employer.
• Low cost.
• Annual contributions are not mandatory, which means the employer chooses the amount to contribute to the plan each year.
• Maximum Annual Contribution is 25% or $44,000 whichever is less (based on the first $220,000 of compensation)
• Deadline to Set Up/Contribute is Employer's tax filing deadline (usually April 15), plus extensions, for prior year deductibility

Tax Benefits

• All employer contributions are 100% tax-deductible.
• Distributions are taxed under IRA rules. click here for new IRA Distribution Rules

Distributions

Distributions are not subject to a 10% federal tax penalty if the individual:

• receives the distribution after age 59 1/2;
• uses the distribution (up to $10,000) to purchase a first-time home;
• uses the distribution for qualified education expenses;
• takes lifetime equal periodic payments;
• uses the distribution for health insurance during unemployment lasting at least 12 weeks; or
• uses the distribution for deductible medical expenses.
• becomes permanently disabled; or
• dies.

All other distributions before age 59 1/2 are subject to a 10% tax penalty and federal income tax.

SEP plans generally appeal to smaller companies that aren't concerned about the loss of control of the contribution dollars. The primary attraction are the low costs and minimal record keeping requirements. An important point to remember is that employers that previously sponsored a defined benefit plan are not allowed to establish a SEP plan.

SARSEP

If a company has fewer than 25 employees, a SEP plan can include an elective salary deferral option that works similar to a 401(k) plan. This arrangement is known as a SARSEP (Salary Reduction SEP) plan. Although there are no tax reporting requirements (5500 filings), a SARSEP must pass an annual discrimination test similar to the ADP test required in 401(k) plans. Employer contributions to a SARSEP can not be made on a matching basis.

A disadvantage to a SARSEP is that salary deferrals by highly compensated employees are considered as employer contributions subject to top-heavy minimum contribution rules (See top-heavy in glossary section). This may prevent a small business owner from having a no cost plan that is only intended for employee contributions, since the owner would have to make a 3% employer contribution to non-key employees in order to make a salary deferral contribution for themselves. In addition, the IRS Model SARSEP (form 5305-A) does not provide for top-heavy testing (60% or more of the total account balances to key employees) and automatically deems the plan top-heavy. This means that even if the group is large enough to test as not top-heavy, the top-heavy minimum contribution rules still apply if the 5305-A form is used. A prototype SARSEP document that specifically allows top-heavy testing must be used instead of the Model SARSEP 5305-A form.

A couple of other advantages of SEPs should be noted regarding their tax planning and investment flexibility. SEPs can be established and funded up until the company's tax filing deadline unlike other qualified plans. Further, since the employees own their accounts, they have and control a wide range of investment choices. SEPs can provide a simple and effective vehicle to provide for employee retirement. Of course, be sure to consult your tax advisor and investment professional before implementing any significant financial planning strategy.