SEP Plan: Meaning, Types, and Rules

‍When it comes to setting up a retirement plan for self-employed individuals and small business owners, SEP plans stand out as one of the most popular options. SEP stands for Simplified Employee Pension and it is a type of employer-sponsored retirement plan that allows employers to make tax-deferred contributions to their employees’ retirement accounts. In this blog, we’ll discuss what a SEP plan is, the different types, the rules, eligibility requirements, and limits.

What is a SEP Plan?

A SEP plan is a retirement plan that allows employees to save for retirement through tax-deferred contributions. It is an employer-sponsored retirement plan and is one of the simplest and most cost-effective retirement plans available. A SEP plan is similar to a 401k plan in that it allows employers to make regular contributions to their employees’ retirement accounts. However, the main difference between a SEP and a 401k plan is that the employer has full control over the contributions made to the SEP plan. With a SEP plan, the employer makes all of the contributions to the plan, and the employees do not have the option to make contributions themselves.

The SEP plan is designed to benefit small business owners and self-employed individuals. It allows employers to make tax-deferred contributions to their employees’ retirement accounts without having to set up a complex plan such as a 401k. The SEP plan is also much less expensive to set up and maintain than a 401k plan.

How Does a SEP Work?

A SEP plan allows employers to make tax-deferred contributions to their employees’ retirement accounts. The employer can make contributions up to 25% of the employee’s salary, up to a maximum of $56,000 in 2021. The employee’s contribution limit is the lesser of $19,500 in 2021 or 100% of their salary. The employer must make sure that the contributions are made in a timely manner and in accordance with the SEP plan rules.

Types of SEP Plans

There are two main types of SEP plans: Traditional SEP plans and Simplified Employee Pension (SEP-IRA) plans. The Traditional SEP plan is the more traditional version of the SEP plan, and it allows employers to make tax-deferred contributions to their employees’ retirement accounts. The SEP-IRA plan is a more modern version of the SEP plan and it allows employers to make tax-deferred contributions to their employees’ SEP-IRA accounts.

Rules of SEP Plans

When setting up a SEP plan, there are certain rules and regulations that employers must follow. The most important rule is that the employer must make contributions to the SEP plan on behalf of all eligible employees. The employer must also make sure that all contributions are made in a timely manner, and that the contributions are made in accordance with the SEP plan rules.

In addition, employers must make sure that the SEP plan meets the IRS requirements for a qualified plan. This includes making sure the plan meets the requirements for vesting, contribution limits, and other IRS regulations.

SEP Eligibility

In order for an employee to be eligible to participate in a SEP plan, the employee must be at least 21 years old and must have worked for the employer for at least three of the last five years. In addition, the employee must have received at least $600 in compensation from the employer during the year.

SEP Plan Limits

The contribution limits for SEP plans are based on the employee’s salary and the employer’s contribution limits. The employer can contribute up to 25% of the employee’s salary, up to a maximum of $56,000 in 2021. The employee’s contribution limit is the lesser of $19,500 in 2021 or 100% of their salary.

SEP IRA Rules

SEP IRAs were created largely to promote retirement benefits among enterprises that would not otherwise set up employer-sponsored plans. However, not all businesses are capable of establishing them. Only sole proprietorships, partnerships, and corporations qualify.

#1. Income Restriction

In terms of participants, too much income can be a barrier—the 2023 qualifying salary ceiling is $330,000 in 2023.
However, unlike eligible retirement plans, SEP participants, including the business owner, are not permitted to borrow up to the lesser of 50% or $50,000 of their vested balance.

#2. Exclusion of Employees

Specific employees may be barred from participating in a SEP IRA by their company, even if they are otherwise eligible under the plan’s terms. Workers covered by a union collective bargaining agreement for retirement benefits, for example, may be excluded. Nonresident employees may also be excluded if they do not receive U.S. wages or other service payments from their company.

#3. Contributions and Withdrawals

SEP contributions and earnings are stored in SEP IRAs and can be withdrawn at any time, subject to the general IRA limitations. A withdrawal is taxed in the year it is received. If a person withdraws before the age of 59¹/₂, an additional 10% tax is normally levied.

#4. Transfers and Distributions

Contributions and earnings from SEPs can be transferred tax-free to other IRAs and retirement plans.
In addition, SEP contributions and earnings must eventually be distributed in accordance with the IRA-mandated minimum distribution standards.

How Do I Set Up a SEP IRA?

It’s simple to set up a SEP IRA account online. The initial step is to select an account provider.

The IRS then describes three stages for establishing your SEP IRA:

A formal written agreement should be created. You can accomplish this using IRS Form 5305-SEP or by contacting your account provider.
Inform qualified employees about the SEP IRA. You can supply them with a copy of IRS Form 5305-SEP or comparable information obtained from your account provider.
Set up individual SEP IRAs with the account provider for each eligible employee.

What should I do with my SEP IRA?

After you’ve opened the account, you can choose among the investments offered by your account provider. Typically, equities, bonds, and mutual funds are included in the decision. (You can start an IRA at a bank, but you’ll be confined to investing in certificates of deposit, which typically provide a lesser return than a diversified portfolio of stocks and bonds.)

Once the account is open and financed, you should invest it based on your age, anticipated retirement age, and risk tolerance. If you have a relatively strong stomach for market fluctuations and a long time until retirement, consider shifting your investment focus to stocks, specifically stock index funds, which monitor a segment of the market and hold a diversified mix of securities within that area.

The shorter time you have before retirement — and the less tolerance you have for a market downturn — the more money you should put into bonds and bond funds. Bond index funds are also available.

Is a SEP Plan a 401k?

No, a SEP plan is not a 401k. A SEP plan is an employer-sponsored retirement plan that allows employers to make tax-deferred contributions to their employees’ retirement accounts. A 401k plan is an employee-sponsored retirement plan that allows employees to make tax-deferred contributions to their own retirement accounts.

What is the Difference Between a SEP and a 401k?

The main difference between a SEP and a 401k plan is that the employer has full control over the contributions made to the SEP plan. With a SEP plan, the employer makes all of the contributions to the plan, and the employees do not have the option to make contributions themselves. In addition, the contribution limits for SEP plans are much higher than those for 401k plans.

What are the Benefits of a SEP?

The main benefit of a SEP plan is that it is a simple and cost-effective way for employers to provide retirement benefits to their employees. SEP plans are easy to set up and maintain, and they allow employers to make tax-deferred contributions to their employees’ retirement accounts. In addition, the contribution limits for SEP plans are much higher than those for 401k plans.

What are the Disadvantages of a SEP IRA?

One of the main disadvantages of a SEP IRA is that the employer has full control over the contributions made to the plan. This means that the employer can decide how much to contribute and when to contribute, and the employees do not have the option to make contributions themselves. In addition, the contribution limits for SEP plans are much higher than those for 401k plans, so the employer has to make sure that the contributions are made within the specified limits.

Which is Better: a Solo 401k or SEP?

The answer to this question depends on the individual’s circumstances. A Solo 401k can be a good option for self-employed individuals who have a steady stream of income and want to make the maximum contributions to their retirement accounts. However, a SEP plan can be a better option for those who have irregular income or are just starting out in business and want a simple and cost-effective way to provide retirement benefits to their employees.

What are the Pros and Cons of SEP IRA?

The pros of a SEP IRA include the fact that it is a simple and cost-effective way to provide retirement benefits to employees, the contribution limits are much higher than those for 401k plans, and the employer has full control over the contributions made to the plan. The cons of a SEP IRA include the fact that the employer has full control over the contributions made to the plan and the employees do not have the option to make contributions themselves.

Can I Contribute to a SEP IRA as well as a Conventional IRA?

Contributing to both a SEP IRA and a regular IRA in the same year is not prohibited by the government. It’s also worth noting that you don’t have to cut your SEP IRA contribution in order to contribute to a regular IRA.

Contributions to a traditional IRA, on the other hand, have income limits. Employees with employer retirement plans can only claim the maximum IRA deduction if their salary is less than $68,000 in 2022 and $73,000 in 2023.

If your income exceeds the restrictions and you aren’t qualified for a traditional IRA deduction, you can use the backdoor Roth approach to roll assets from your conventional IRA into a Roth IRA. To discover more about how this works, check our backdoor Roth post. You can enjoy tax-free distributions if you roll your money into a Roth and wait until your full retirement age.

The hitch is that all rollovers from regular to Roth IRAs must be done on a pro-rata basis. This means that if you had a $56,000 SEP IRA contribution and a $6,000 nondeductible regular IRA commitment, you cannot simply roll over the $6,000 investment. If you rolled over $6,000 (9.7% of the total of $62,000), the IRS would treat it as if you were rolling over $5,418 (or 9.7%) of the SEP and $582 (also 9.7%) of the non-deductible traditional IRA, which was not at all what you wanted. Unfortunately, you do not have the option of specifying which funds are rolled over.

The only method to transfer the entire non-deductible amount into a Roth IRA is to transfer all of your traditional assets (this includes the full value of your SEP IRA and other traditional IRA accounts)

Conclusion

A SEP plan is a great retirement plan option for self-employed individuals and small business owners. It is a simple and cost-effective way to provide retirement benefits to employees, and the contribution limits are much higher than those for 401k plans. However, the employer has full control over the contributions made to the SEP plan, and the employees do not have the option to make contributions themselves. It is important to understand the rules and regulations of SEP plans before setting one up, as well as the contribution limits, SEP eligibility requirements, and the difference between a SEP and a 401k plan.

In conclusion, a SEP plan can be a great retirement plan option for self-employed individuals and small business owners. It is a simple and cost-effective way to provide retirement benefits to employees, and the contribution limits are much higher than those for 401k plans. However, it is important to understand the rules and regulations of SEP plans, as well as the contribution limits, SEP eligibility requirements, and the difference between a SEP and a 401k plan before setting one up.

If you are interested in setting up a SEP plan for your business, it is important to consult with a financial advisor to make sure that you are setting up the plan correctly and in compliance with IRS regulations. With the right advice, you can make sure that you are taking advantage of the benefits of a SEP plan while staying in compliance with IRS regulations.

References

Investopedia
IRS.Gov