A simplified employee pension (SEP) is a written plan that allows small-business owners to make retirement contributions to traditional IRAs (SEP-IRAs) set up for themselves and for each eligible employee. These contributions may be deducted from your business’s income and excluded from your employees’ income. A SEP may not only provide you a tax-advantaged way to save for your own retirement, but may also help you attract and retain qualified employees by providing for their retirements. And it may help your business avoid some of the complexities posed by certain other employer-sponsored retirement plans.
You can establish a SEP if you’re an employer or you have self-employment income. “Employer” includes a sole proprietor, a partnership, a C corporation, an S corporation, a limited liability company, and a limited liability partnership. You don’t need employees to set up a SEP, but if you do have them, all eligible employees must be included as SEP participants.
A SEP may not only provide you with a tax-advantaged way to save for your own retirement, but may also help you attract and retain qualified employees by providing for their retirements. And it may help your business avoid some of the complexities posed by certain other employer-sponsored retirement plans.
Setting up a SEP plan is fairly easy. You may be able to establish a SEP by (1) simply signing IRS Form 5305-SEP, Simplified Employee Pension — Individual Retirement Accounts Contribution Agreement; (2) adopting a prepackaged prototype SEP from a bank, insurance company, financial institution, or other company; or (3) creating a custom-designed SEP. The easiest way is to use Form 5305-SEP. You can use this Form if you don’t maintain any other retirement plans, don’t use leased employees, and meet certain other IRS requirements. You have until the due date of your business’s federal income tax return (including extensions) to set up a SEP and make contributions. By contrast, an ordinary IRA contribution can’t be made later than the due date of your federal income tax return, with no extensions (generally April 15). So if you’re self-employed and file for an extension you could have until October 15 to make a SEP contribution to your SEP-IRA.
In general, you must include all employees who have (1) reached age 21, (2) worked for you at least three of the last five years, and (3) received a minimum amount of pay (at least $650 for 2022) from you for the year the contribution was made. An employee who meets the criteria above in any year must be covered under the SEP for that year even if he or she is not employed by you at the end of the year.
In order to avoid discrimination rules, most employers determine a contribution percentage for a year, and apply that same rate to all employees. However, contribution formulas can be more sophisticated and can even be integrated with Social Security (you’ll likely need professional assistance if you adopt a nonstandard contribution formula). Your contributions to the SEP are pre-tax dollars. This means that your employees can exclude your contributions from their gross income. In addition, the funds can grow tax deferred. Employer contributions and earnings are taxed when distributed from the SEP-IRA.
You can contribute up to 25% of compensation or $61,000, whichever is less, to an employee’s SEP-IRA in 2022 (up from $58,000 in 2021). Generally, when calculating the amount you can contribute in 2022, you can consider only the employee’s first $305,000 of compensation (up from $280,000 in 2021).
If you’re self-employed, contributions to your own SEP-IRA are calculated differently. While the above limits also apply to you, your compensation is considered to be your net earnings from self-employment. Basically, your net earnings from self-employment represent the net income you earned in the business that established the SEP, less the deduction for contributions to your SEP and the deduction allowed to you for one-half of the self-employment tax. This effectively reduces your maximum contribution rate to 20% of compensation or $58,000 (in 2021), whichever is less.
SEPs are not like 401(k) plans — your employees cannot elect to contribute pre-tax dollars to a SEP-IRA from their pay.* However, your employees can make normal annual IRA contributions to their SEP-IRAs, just as they can to any other traditional IRA. But SEP-IRAs cannot accept Roth contributions.
SEPs offer several advantages:
*Prior to 1997, SEPs could include salary reduction arrangements (SARSEPs), under which employees could elect to have you contribute part of their pay to their SEP-IRAs. New SARSEPs, however, can no longer be established (although those established before 1997 can continue to operate provided there are no more than 25 eligible employees at any time during the prior taxable year).
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