As a small-business owner, you may decide that a retirement plan is a good way to recruit and retain employees. You may also want to set up a retirement account for yourself. This educator aims to explain some of the major retirement-plan options available to you and your business.
The simplest retirement plan available is a Simplified Employee Pension (SEP) plan. A SEP plan requires the least amount of paperwork and offers important benefits to you and your employees. A SEP plan must be in writing and offered to all eligible employees. In most cases, the IRS requires you to document the plan by completing Form 5305-SEP.
With a SEP plan, you open an individual retirement account (IRA) for each eligible employee and make contributions to the accounts. Employees are not allowed to contribute to their SEP-IRAs. The employer is responsible for funding all amounts. Because individual retirement accounts are the investment vehicle, SEP plans are also called SEP-IRA plans. You can establish a SEP-IRA plan up to the date that you file your income tax return for the current year.
Your contributions to employee SEP-IRAs grow tax-deferred the way other qualified retirement accounts do. Similarly, IRS rules for regular IRAs govern the taking of distributions from SEP-IRAs.
Employees pay an early-withdrawal penalty if they take distributions before they are eligible. In most cases, early distributions are those made before the employee reaches age 59-1/2. SEP-IRAs cannot be designated as Roth IRAs and contributions to a SEP-IRA do not count toward the annual contribution limits of traditional or Roth IRAs.
As the employer responsible for contributing to a SEP-IRA plan, you are allowed to deduct the amount of contributions from taxable income. Deductions may be restricted in some cases. The self-employed rate on net earnings governs the amount of contributions to a SEP-IRA plan that you can deduct. For additional information, see IRS Pub. 560.
If you are self-employed, you can also contribute to your own SEP-IRA. You may want to understand what the IRS calls net earnings from self-employment, which determines the amount you can contribute to your own SEP-IRA. The IRS considers you self-employed if you are either a sole proprietor or partner actively participating in a trade or business.
Generally, you can contribute up to the lesser of 25% of annual compensation or $53,000 in 2015 to the SEP-IRA of each common-law employee. Contributions made to a SEP-IRA are not included in compensation. (If your retirement plan includes a salary-reduction plan, you may be subject to different limits. See IRS Pub. 560 for more information.)
For 2015, the maximum compensation amount for calculating allowable contributions is $260,000. This amount is indexed from time to time to changes in inflation. As a result, the most you can contribute in 2015 to a SEP-IRA (including your own SEP-IRA) is $53,000.
If you contribute more than the allowable amount to a SEP-IRA, you will be taxed on the amount of excess contributions. The IRS allows you to carry over excess contributions to subsequent years but the tax applies each year that excess contributions exist.
Predecessors of SEP-IRAs are called SARSEP plans. SARSEP plans are SEP plans created before 1997 and include a salary-reduction plan. With a salary-reduction plan, an employee authorizes his employer to deposit a portion of pretax salary in a tax-advantaged account.
An employer is allowed to maintain a SARSEP plan if it meets certain conditions. These conditions require that at least half its employees use the salary-reduction plan and that the company had 25 or fewer employees that were eligible to use a SEP-IRA with the employer at any time in the preceding year.
Contribution limits to a SARSEP in 2015 is the lesser of $18,000 or 100% of annual compensation (subject to the same 2015 limit of $260,000). For those who will be age 50 or older during 2015, the contribution limit is the lesser of $24,000 or 100% of annual compensation. SARSEPs are subject to the same contribution limits (called elective deferrals) that govern 401(k) plans and other defined-contribution plans. The Economic Growth and Tax Relief Reconciliation Act authorized increases in elective deferrals.
In addition to the tax-deductible features and low administrative costs, SEP-IRA plans provide employees with immediate vesting and a choice of investment options. You need to weigh the benefits of these features with the restriction on employee contributions. Nonetheless, SEP-IRA plans remain a popular retirement plan for small businesses.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.