Simplified Employee Pensions (SEPs): Legal Insights

Simplified Employee Pensions, known as SEPs, represent an easy, low-cost retirement plan option for employers. Instead of establishing a separate retirement plan, in a SEP the employer makes contributions to his or her own Individual Retirement Account (IRA) and the IRAs of his or her employees, subject to certain percentages of pay and dollar limits. Employers who establish SEPs can – make tax deductible contributions to their own and their employees’ IRAs. Omit or reduce contributions in years when contributions are unaffordable and vvoid the administrative costs and the reporting requirements of conventional plans. Whether a SEP is appropriate for your business will depend on factors such as revenue, firm size and the age, compensation and retirement needs of the business owner and work force. You may want to discuss other retirement plan options with a professional advisor.

What is a SEP-IRA?

SEPs are retirement programs established by you, as an employer, which allow you to provide retirement benefits for yourself and your employees without paying the start-up and operating costs of conventional plans.
SEPs allow an employer to establish and make contributions to IRAs. The two critical differences between SEP-IRAs and other IRAs are (1) SEP contributions are generally made by employers, not employees and (2) the amounts contributed to SEPs can be much larger than the amounts contributed to IRAs. As a general rule, up to 15 percent of each employee’s pay, including your own, can be put into a SEP-IRA each year.

Here are some of the advantages for you as an employer. A SEP can provide a significant source of income at retirement. Contributions to a SEP are tax deductible and your business pays no taxes on the earnings on a SEP’s investments. You are not locked into making contributions in future years. You can decide each year whether to pay into the SEP and how much to contribute. Once you put money into a SEP you have no further responsibility for the amounts contributed. The funds are managed by a financial institution. A SEP can be established and operated without the administrative expenses, consulting fees or commissions usually associated with maintaining a conventional retirement plan. You ordinarily do not have to file any documents with the government. SEPs can be set up by sole proprietors, partnerships and corporations, including S corporations. You can deduct contributions to a SEP for a previous tax year if you make contributions by the due date of the employer’s tax return, including any extensions.

Advantages for Employees of a SEP

The money you contribute to your employees’ SEP accounts, as well as the investment earnings, belongs to them, even if they stop working for you. Employers’ contributions to the SEP-IRA are not included in employees’ income for income tax purposes. Employees pay no taxes on the amounts in their SEP accounts until they start withdrawing the funds. In case of an employee’s death, the assets in a SEP will go to someone the employee has chosen. Employees can change the financial institution where their SEP is invested. SEP contributions can continue until employees retire, but they must start withdrawing assets from a SEP when they reach age 70?.

How to Set up a SEP

You can set up a SEP by using the Internal Revenue Service’s “Model SEP” agreement Form 5305-SEP. All you have to do is the following things – Fill out Internal Revenue Service Form 5305-SEP, a quarter-page form with six blank spaces. This form is not filed with the Internal Revenue Service.
Decide the percentage of pay you want to contribute to the SEP. The contribution is limited to 15% of pay or $24,000* (for 1997), whichever is smaller. A uniform percentage of pay must be contributed for each employee. This number is indexed for inflation each year. Set up an IRA at a financial institution to receive your SEP contributions. An IRA can be set up by or for your employees to receive the contributions you make for them.
Mail the SEP contributions to the financial institutions. Give employees eligible to be included in the SEP a completed copy of the Form 5305-SEP and the other documents and disclosures listed in the instructions, including an annual statement to each participating employee of the amounts contributed to their account for the year.

You cannot use the IRS “Model SEP” if you currently maintain any type of qualified retirement plan or have ever maintained a pension plan for yourself and your employees that promised to pay specific benefits at retirement — a “defined benefit” pension plan. You also cannot use the Model SEP if you have any eligible employees for whom accounts have not been established. For this purpose, eligible employees include certain individuals who have a specific relationship to the employer.
For example, eligible employees for purposes of SEP contributions include “leased employees”, and members of an “affiliated” or “commonly controlled” group of employers of which you are a member. These are technical terms that are defined in the Internal Revenue Code. For example, the term ” leased employees” is defined in section 414(n) of the Code. The term, “affiliated group” is defined in Code section 1504, and the term “controlled group” is defined in Code section 1563. If you believe any of these terms apply to you, you should consult a professional advisor.
Although using the IRS Form 5305-SEP is an easy way to set up a SEP, you do not have to use this model agreement. Many financial institutions have their own SEP arrangements that have been approved by the Internal Revenue Service. In addition, employers may design their own SEP subject to the legal requirements.

If you use a non-model SEP, the law allows you to take into account Social Security contributions you made for your employees. If you want to do this, consult your professional advisor.

Who Must Be Included in a SEP

Generally, any employee who performs services for certain affiliated or commonly controlled employers (see the discussion on page 6 regarding these terms) must be included in a SEP. However, there are five exceptions to this general rule. Employers may exclude from the SEP – Employees who have not worked for the company during three out of the last five years.
Employees who earn less than a specified amount per year. This number is indexed for inflation each year. Employees who have not reached age 21 during the calendar year for which contributions are made. Employees covered by a collective bargaining agreement, if retirement benefits were the subject of good-faith bargaining. Non-resident immigrants who do not earn U.S. source income from you.

SEP Investments

Financial institutions authorized to hold and invest SEP contributions include banks, savings and loan associations, insurance companies, certain regulated investment companies, federally-insured credit unions and brokerage firms. SEP contributions can be put into stocks, mutual funds, money market funds, savings accounts and other similar types of investments.

You and your employees will receive a statement from the financial institutions investing your SEP contributions both at the time you make the first SEP contributions and at least once a year after that. Each institution must provide a plain-language explanation of any fees and commissions it imposes on SEP assets withdrawn before the expiration of a specified period of time.