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What Are SEP IRAs?
A simplified employee pension plan (SEP) is a
deferred-compensation arrangement that is similar to a profit-sharing plan.
It can be set up by employers and self-employed individuals, as well as sole
proprietorships and partnerships. Employers receive tax deductions for plan
contributions made to employees’ accounts, and employees do not pay taxes on
SEP contributions until they begin taking distributions in retirement. Thus,
SEPs can be attractive to both the employer and the employee.
Companies that institute SEPs agree to contribute on a
nondiscriminatory basis to IRAs maintained by employees. Employers are
required to provide benefits to all employees who are eligible. Employees
are eligible if they are at least 21 years old, earn at least $500 each year
(indexed for inflation), and have been employed by the company for three out
of the five years prior to the year for which the contribution is being
made. Employers also have the option of selecting eligibility requirements
that are less restrictive, but they must be applied to every employee.
Employer contributions are limited to the lesser of $45,000
or 25% of an employee’s compensation (in 2007). Contributions are made on a
discretionary basis, which means that the employer can decide each year
whether or not to contribute, as well as how much to contribute.
SEP contributions are made to separate IRAs for eligible
employees. Employees are responsible for setting up their own traditional
IRAs to receive employer contributions, which are immediately 100% vested,
and employees direct their own account investments.
When participants start taking distributions from a SEP IRA,
the rules are essentially the same as those for a traditional IRA.
Distributions are taxed as ordinary income and cannot be taken before the
age of 59½ without incurring a 10% federal income tax penalty, except in the
case of extenuating circumstances. [For example, penalty-free distributions
are allowed if an individual is unemployed, buying a first-time home
($10,000 lifetime max), or cannot pay medical expenses.] SEP IRA account
owners must begin taking minimum distributions after reaching age 70½.
If you are a small-business owner or are self-employed, a SEP
IRA may be a good option for you, because contributions may be tax
deductible and this type of plan is easy to establish and administer. If you
are an employee of a company that offers a SEP IRA, you can benefit by the
potential to receive employer-paid contributions. If you are a business
owner, always make sure to discuss your retirement plan options with a
financial professional before deciding on a method.
© 2007 Emerald Publications
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