If you want to establish a retirement plan for your business, you may want to consider establishing a Simplified Employee Pension (SEP). For starters, SEPs have a more liberal setup deadline than a qualified plan—those must be established by the end of your company's plan year (December 31 for plans maintained on a calendar year). By contrast, a SEP may be established by the business's tax-filing deadline, including extensions.
SEPs also offer several other attractive features that we'll review here, along with other factors to consider before choosing a SEP for your business.
Key Takeaways
- SEP IRAs are attractive for the self-employed, freelancers, and small businesses because they are easy to set up and administer.
- Employers can contribute up to 25% of each eligible employee's gross annual salary and up to 20% of their net adjusted annual self-employment income if they are self-employed, provided the contributions don't exceed $66,000 per person for the year 2023 ($61,000 for 2022).
- Certain categories of employees may be ineligible to participate in a SEP, including anyone who is under 21 or who makes less than $750 in wages from your business for the year 2024 ($750 for 2023).
- An employer may deduct plan contributions as a business expense.
- A SEP may not be desirable because it provides 100% vesting, it doesn't allow loans to be taken out against it, and employees may be eligible after as little as three months.
What Is a Simplified Employee Pension (SEP)?
A SEP is a retirement plan based on an individual retirement account (IRA) into which business owners can make pre-tax contributions for both themselves and their eligible employees. It is ideally suited for self-employed workers, freelancers, and small-business owners because it's easy to establish and administer.
Any business owner with one or more employees, or anyone with freelance income, canopen a SEP IRA. Unlike qualified plans, the SEP does not require nondiscrimination testing or filing of 5500 returns. Establishing a SEP IRA can be as easy as completing IRS Form 5305-SEP and providing a copy to employees.
Employees are responsible for establishing their IRA to receive employer contributions (employees do not make SEP contributions, but if the SEP IRA allows it, they may be able to make regular IRA contributions to their account, up to the maximum annual limit). SEP IRA accounts follow the same rules of investment, distribution, and rollover as traditional IRAs. However, an employer who sets up a SEP has no responsibility for assisting with investing plan contributions. Individual participants may select their IRA provider and direct their investments.
As with many other employer plans, an employer has until the tax-filing deadline of the business, including extensions, to fund the SEP.
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.
Contribution Limits
SEP IRAs have appealingly high contribution limits. Employers can contribute up to 25% of each eligible employee's gross annual salary and up to 20% of their net adjusted annual self-employment income if self-employed, provided the contributions do not exceed $66,000 for 2023 ($61,000 for 2022). Employer contributions must be based on the first $330,000 of compensation in 2023 ($305,000 for 2022) and are adjusted annually.
An employer can decide each year whether to contribute to the SEP, which can be an advantage for a new business that has not established a trend in its annual earnings. Because of this flexibility, an employer could decide to forgo the SEP contribution in years when profits are lower than anticipated. However, when SEP contributions are made, they must be based on the same percentage of compensation for all covered employees.
What's more, all plan participants who worked for the business during the year for which contributions are made must receive SEP contributions even if they leave their job or die before the contributions are made.
Ineligible Employees
Certain categories of employees may be excluded from participating in the SEP for the year, including those who:
- Are covered under a collective bargaining agreement (unionized employees)
- Are under age 21
- Earned less than $750 (indexed for inflation) for the year
- Worked less than three of the five preceding years
- Are nonresident aliens with no U.S. income
How SEPs Work
Here's an example: Under ABC Inc.'s SEP IRA, an individual must work three of the five preceding years to be eligible to receive a SEP contribution for the year. Jane worked for ABC Inc. on a part-time basis in 2019, 2020, 2021, and 2022.
Assuming Jane meets the other eligibility requirements, she is eligible to receive a contribution for 2024 because she worked for at least three of the five years preceding 2024. For SEP IRAs, a year of service can be any period, which means that an employee who worked for one week in a year is counted as having completed a year of service.
An employer may choose to use less restrictive eligibility requirements to allow more employees to participate in a SEP plan.
Deducting SEP Contributions
The type of business determines the type of form the employer uses to claim the deduction for SEP contributions.
- A sole proprietor claims the SEP contribution for themselves on IRS Form 1040. However, SEP contributions on behalf of the sole proprietor's common-law employees (the IRS term for an employee, not an independent contractor) are claimed on Schedule C.
- Partners in a partnership claim deductions for their individual SEP contributions on IRS Form 1040. For contributions made on behalf of common-law employees, the partnership claims the deduction on IRS Form 1065.
- For an S corporation, all SEP contributions are claimed on IRS Form 1120-S.
- For a C corporation, all SEP contributions are claimed on IRS Form 1120.
It is a good idea to consult with your tax professional to ensure the proper forms are filed to report and claim the deduction for SEP contributions.
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.
Reporting Requirements
For the employer, tax reporting is limited to reporting SEP contributions on the business's tax return. For individual participants, the IRA custodian or trustee reports SEP IRA contributions on IRS Form 5498 and distributions on IRS Form 1099-R.
Employers and employees should bear in mind that the custodians report contributions in the year they are received. If, for instance, ABC Inc. makes its SEP contributions for 2023 in May of 2024, Form 5498 may not correspond with the amount the employer reports for 2023. Employers should thus maintain their records to keep track of SEP contributions.
Disadvantages of a SEP IRA
From an employer's viewpoint, there are definite disadvantages of SEP IRAs.
Immediate Vesting
To reduce employee turnover and the cost associated with training new employees, some employers want their workers to be employed for several years before they are vested in the employer contributions. For SEP IRAs, however, contributions are immediately 100% vested, which means that future vesting is not a tool to lower employee turnover. As soon as they are deposited, the contributions belong to the employee.
No Loans Permitted
Unlike qualified plans—under which participants, including the business owner, may borrow up to the lesser of 50% or $50,000 of their vested balance—the SEP, like all IRA-based plans, does not have this feature.
Employee Eligibility Requirements
For a SEP IRA, a year of service is any period, however short. This can result in increased expenses associated with funding the plan, which may be a disadvantage, particularly for businesses that hire part-time or seasonal employees.
The Bottom Line
Like many small business owners, you may enjoy the simplicity and inexpensive administration of the SEP IRA. While it may be convenient to establish the SEP, you should consult your tax professional to ensure that the plan you choose is suitable for your business profile. If you prefer a qualified plan to a SEP IRA, but you missed the deadline to establish a qualified plan, you may fund the SEP and then roll over the balance to a qualified plan you establish later.
