Businesses have a wide variety of retirement account options for owners and employees. The most common example is the 401-k. This blog concentrates on a less well-known option called SEP-IRA which stands for Simplified Employee Pension Individual Retirement Account. We are going to call them SEP for the rest of this article. They are really cool and work well for business owners because they are inexpensive to setup and maintain, owners and employees get to build a retirement nest egg and the business gets a tax deduction. It’s a win-win-win.
Whose money is going into the SEP? The company puts the money in and gets a tax deduction for the same amount. The contribution does not create taxable wages for the employee, and nothing is withheld from their paycheck.
There are strict contribution requirements that must be met to keep the SEP in good standing with the IRS. The first requirement to consider deals with contribution limits. For the 2020 tax year, the maximum contribution per employee is the lesser of 25% of their compensation or $57,000. The $57,000 limit increases annually based on cost of living adjustments, however the 25% remains constant. Another important requirement deals with equality amongst employees. The same percentage of compensation must be applied to all employees, so if the owner gets 25% of his compensation then all other employees also get 25% of their compensation. The dollar amounts do not have to be the same, just the percentages. There are other important requirements that are not discussed in this blog.
One major benefit of SEP is they are easy to setup, administer and report. There are numerous companies to facilitate the setup and administration. All it takes is a Google search. A knowledgeable CPA will help you make sure everything is properly reported to the IRS. All it takes is a call to our office.
Another benefit of SEP is the flexibility in timing and amount with regard to funding. The SEP does not have to be funded until the due date (including extensions) of the tax return, so if your company wants to make a SEP contribution for 2020, the actual deposit doesn’t have to be made until 2021. Even better the SEP does not have to be funded at all. When times are bad the company can skip a year or more to keep the cash flow inside the business. Once things turn around, the company can go right back to funding the SEP.
One major drawback to SEP is that most of them require the employer to contribute the same percentage of compensation for all employees, so it’s not like the owner can set one up just for themself and leave everyone else out (unless the owner is the only employee). If the owner makes $100,000 per year and the Administrative Assistant makes $40,000 per year, both amounts are subject to the same percentage of SEP funding. If the owner gets 25% then so does the assistant. In this case the company would deposit $25,000 to the owners SEP account and $10,000 to the assistants. The more employees a business has, the more cash flow will be required to fund everyone’s SEP.
Another drawback is what happens if the employee really needs the money in the SEP before they reach retirement age. If they are younger than 59.5 years old and do not have a reasonable excuse, there will likely be a 10% early withdrawal penalty on the amount of the withdrawal. Reasonable excuses include but are not limited to death of the account holder, disability and using the funds for approved expenses like certain medical and education expenses. There are other important drawbacks that are not discussed in this blog.
SEP are a great option that every business owner should consider. They reduce taxable income, make employees happier and provide stability in retirement for everyone at the company. Contact us today for more information on the reporting requirements that keep your business in compliance with the rules.
Joe Wright CPA PLLC provides the information in this blog as a general guide. Tax laws are extremely complex, and every taxpayer is unique. Some or all of this information may or may not apply to you. We provide simplified situations to clarify some of the major aspects and highlights of the topic at hand. Some of the language used is casual and may be misconstrued. Please make an appointment with us soon to discuss your particular circumstances.