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SEP IRA PLANS
The Simplified Employee Pension Plan, often referred to as a SEP-IRA, is commonly used by self-employed individuals or businesses with a few employees who want a retirement plan that is flexible and easy to administer. A SEP can be established by sole proprietors, partnerships, or businesses (either incorporated or unincorporated). They can also be adopted by an individual with either full-time or part-time self-employment income, even if they are already covered by a retirement plan through another employer.
Contributions
Contributions to a SEP are made solely by the employer to each eligible employee's retirement account. The maximum amount that can be contributed can vary from 0% to 15% of compensation each year, up to $25,500 per participant (based on a maximum income of $170,000 effective January 1, 2000). The employer must contribute the same percentage of each eligible employee's compensation as he contributes for himself. However, as long as employees are notified in writing, the employer can elect to vary the contribution percentage from year to year, and may even skip a year of contributions without jeopardizing the SEP plan. The contributions are tax-deductible to the employer, and the investment earnings are not taxed to the employee until withdrawn, generally after age 59½. SEP-IRA's are not permitted to have a vesting schedule, so eligible employees are 100% vested in their plans once a contribution is made.
Calculating Contributions
Determining the contribution for regular employees is very straightforward: the contribution percentage elected for each given year (0%-15%) multiplied by each employee's gross W-2 wages, up to a maximum compensation of $170,000. However, for the self-employed individual, contributions must be based on "earned income," which is comprised of net business profits, reduced by one-half of self-employment tax, less your SEP-IRA contribution. An example of this calculation follows:
A. Net business profits $70,000
B. Deduct ½ of self-employment tax $ 5,355
C. Adjusted net business profits $64,645
(Subtract B from A)
D. Contribution Percentage .15
(from 0 to 15%, in decimal form)
E. Contribution Factor 1.15
(Add 1.00 to contribution percentage)
F. Adjusted earned income $56,213
(Divide C by E)
G. Enter maximum "Earned Income" $170,000
H. Enter smaller of F or G $56,213
I. Contribution Amount $ 8,432
(Multiply H by D)
Incorporated business owners (including S-corps) need to be aware that they would not use this formula to determine their contribution. Instead, they would be considered an employee of the company, and their contribution would be based on their W-2 wages only, not business profits. Also, it is a common misconception for a self-employed individual to think that they cannot use a SEP if they incorporate their business in the future. They can continue using a SEP, unless perhaps their individual business situation makes another type of retirement plan more advantageous.
It is very important to be cautious to not over-contribute to a SEP plan. Depending on the circumstances of the excess contribution, there can be taxes and penalties imposed by the IRS to the employer, and in some cases, to the employee as well.
Employee Eligibility
For a SEP plan, determining which employees are eligible is not necessarily based on full-time or part-time status. Other types of retirement plans may cover only full-time employees, but this is not the case with a SEP. An employer must make a contribution to those employees who meet all of the following requirements:
- Age: All employees who are at least 21 by the end of the plan year for which a contribution is being made.
- Years of service: All employees who have worked for the employer in any of 3 of the immediately preceding 5 calendar years, even if they did not work for the employer for the entire year.
- Compensation: All employees who have been compensated at least $450 (up from $400 in 1999) for the plan year.
Obviously, an employer can choose to be more lenient if desired, but the above requirements set forth the most restrictive he could be. The eligibility requirements can also be changed from one plan year to the next, provided the employer is not excluding an employee who has already become eligible. Also, in establishing eligibility, the employer needs to be aware that he must meet the requirements in the same way his employees would. For example, in a new business, the employer cannot immediately become eligible to participate in the SEP plan while making other employees complete three years of service. The only other provisions where an employer can elect to exclude employees would be in the case of non-resident aliens or those already covered through a collective bargaining agreement with their union.
Deadlines for SEP plans
The deadline to establish as well as contribute to a SEP-IRA is the employer's tax filing deadline, including extensions. Unlike some other types of employer-sponsored retirement plans, it does not have to be established by either calendar or fiscal year-end.
Administration of a SEP plan
SEP-IRA's were specifically designed to be easy and inexpensive for small businesses to administer. The employer's only responsibilities involve informing employees of the plan, often by simply distributing copies of the plan document, and making the necessary contributions by the appropriate deadline. Unlike qualified plans such as Keoghs or 401k's, there are no annual reports to file with the IRS.
Making Additional IRA Contributions
Participating in a SEP plan does not prevent the employer or the employee from also contributing $2,000 to a Traditional IRA. However, being covered by an employer-sponsored plan like a SEP may affect the deductibility of a Traditional IRA, depending on your adjusted gross income. If you do not qualify for an IRA deduction, you may want to consider contributing to a Roth IRA instead, if your income is under certain IRS guidelines. Either option is an excellent way to add to your retirement savings.
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