It’s easy to get confused by all the types of IRAs: Simple IRAs, Roth IRAs, SEP-IRAs. Let’s make it simple. If you are a small business owner, SEP-IRAs are your Superman, your Spirit Animal, your Slayer of the Tax Dragons. Because you can put away tax-free as much as 25% of your salary, all the way up to FIFTY-EIGHT THOUSAND DOLLARS (not a typo). We are going to teach you why SEP-IRAs are one of the best retirement plans for small business owners.
What’s a SEP anyway?
SEP stands for Simplified Employee Pension. They are employer sponsored pension plans, which means they are setup directly by the employer, not the employee. They are often referred to as SEP-IRAs since each participant must have an IRA set up as part of the plan. But wait, “what’s an IRA?”
An IRA (individual retirement arrangement, many times mis-defined as individual retirement accounts) is an account that allows you to put away money for retirement while helping you pay less tax. The strategy is: you take a deduction while you are in a high tax bracket, then when you’re older, take the money out and pay tax in a lower tax bracket. No surprise, the IRS has rules on how you may use IRAs to your advantage (if you would like more details on what IRAs are or how they work, please refer to our article on Traditional and Roth IRAs here).
SEPs are very popular will small businesses and entrepreneurs that are looking for strategies to pay less in tax, save for retirement, and put away more than the government limit for Traditional IRAs (which is currently only $6,000). They are very easy to setup, and we are going to show you how.
Who can setup a SEP?
Any employer that doesn’t already have an employer retirement plan (such as a 401(k) or Simple IRA) for their employees can set up a SEP. To be eligible and not get in trouble with the IRS, you must follow 4 simple steps:
Step 1: Create a written agreement for the plan.
You may be asking, “Romeo, where do I get a written agreement for the plan?” No worries, the IRS already has an example of one for you on their website (Form 5305-SEP). If you don’t want to pay someone to write one for you, you may use the one the IRS created as a template, you may download it here.
Step 2: Provide the information to your employees that are eligible.
Give your eligible employees (more on who’s eligible below) written information that states: your company has a SEP pension plan, how they qualify, and the method that you, the boss, uses to fund it (e.g., all eligible employees will receive 10% of their salaries as a SEP contribution in 2021).
Step 3: Make sure your company doesn’t already have another employer retirement plan in place.
Your small business cannot have both a SEP-IRA and 401(k) (or any other employer plan) at the same time.
Step 4: Setup an IRA account for each employee that is participating in the plan.
You are asking, “how do I set up the SEP-IRA accounts for my employees?” You or your employees may setup these SEP-IRA accounts at any financial institutions that currently allow you to set up an IRA. Here is a list of some institutes you can set up IRAs at:
I currently have mine at Wealthfront.
Which employees are eligible for a SEP-IRA?
For your employees to be eligible they must meet 3 basic requirements:
- Employees must be over 21 years old
- They were paid over $650 in 2021
- They have worked for you 3 out of the last 5 years (3-of-5 rule)
If any of your employees meet these requirements, they must be included in the SEP contribution plan. However, you may implement lower prerequisites if you like (e.g., employees can be over 18 instead of 21, they can work 1 out of the last 3 years instead of 3 out of 5, etc.). However, all the employees that meet the company defined prerequisites must be included in the SEP plan.
Keep in mind, any changes, or amendments you make to your plan must be provided to your employees 30 days before they take effect.
SEP-IRAs are employer-only profit-share plans. What does that mean?
Unlike other small business retirement plans a SEP-IRA is an employer-only profit-share. Other plans like 401(k)s and Simple IRAs allow both employee and employer contributions.
Those plans allow employees to put tax saving money from their own paychecks (usually referred to as pre-tax savings) into their retirement and the employer will have a matching contribution (typically 3%-6% of the employee’s salary) on top of the amount the employee puts in. This matching contribution is referred to as the employer profit-share.
Since SEPs are an employer-only profit-share plan, that means the employee doesn’t have to put any money in themselves. The employer profit-share is tax deductible for the small business.
How much do I have to contribute to a SEP-IRA?
SEP IRA contributions are based on percentage of salary. Whatever percentage you decide to fund for the profit-share, must be the same for all employees. Here’s an example: Tom owns ABC Inc. It’s a small business that employs himself, and 3 other employees. All employees are eligible for the SEP contribution. Tom decides to make contributions of 10% of employees’ compensation. Below is a table of the employees, their salaries, and the amount Tom must contribution.
| Name of employee | Yearly Salary of Employee | SEP Contribution based on 10% |
|---|---|---|
| Tom | $100,000 | $10,000 |
| Marianne | $25,000 | $2,500 |
| Steve | $45,000 | $4,500 |
| Violet | $13,000 | $1,300 |
| Brian | $6,000 | $600 |
| Totals | $189,000 | $18,900 |
Tom must contribute the same percentage of salary for all employees. As you can see, this can add up very quickly for a small business owners. That’s why many small business will choose different retirement plans based on high or low turnover (we will cover that below).
What are the SEP IRA contribution limits?
Like Traditional & Roth IRAs, the IRS sets SEP IRA contribution limits – i.e., the maximum you can contribute to SEP-IRAs every year. The limits are the maximum of:
- 20% of owner’s net income, if the owner is self-employed,
- 25% of employee salary and compensation,
- $57,000 for 2020,
- $58,000 for 2021 (this number is adjusted for inflation every few years)
I’m sure you noticed the difference between 20% for self-employed people and 25% for all other employees. We are going to break that down right now.
What’s it mean to be self-employed to the IRS?
Self-employed does not mean the same thing to you as it does to the IRS. If you own a Corporation (or S Corporation) the IRS does not consider you self-employed. That’s right, even though you may own the Corporation 100%, they still consider you an employee of the Corporation and not self-employed.
According to the IRS, somebody is self-employed if they carry on any business in which they are a sole proprietor, independent contractor, or member of an LLC. Another way to think about it is, you are only self-employed if you pay self-employment tax* on your profits. Corporations and S Corporations do not pay self-employment tax on their profits, they only pay FICA** on salaries and wages.
*self-employment tax is the 15.3% tax you pay for Social Security and Medicare when you’re not an employee (when you’re an employee, it’s called FICA). You get credit for Social Security and Medicare when you pay self-employment tax.
**FICA stands for Federal Insurance Contributions Act – it’s a fancy way of saying payroll tax. You get credit for Social Security and Medicare when you pay FICA.
SEP contributions for Corporations and S Corporations employees
SEP contributions for Corporations (or S Corporations) are straight forward, you just multiply the amount the employee is paid, times the percentage of salary you’ve decided to contribute toward the SEP. So, if your employee is making $100,000, and the business owner decides they’re going to make the maximum contribution of 25%, the SEP contribution is $25,000 ($100K x 25%). This doesn’t matter if you’re the owner of the corporation, or just an employee.
SEP contributions for owners of LLCs, Partnership Members, or Sole Proprietorships
If you’re in business for yourself and your business is not a Corporation, then your SEP-IRA contribution is calculated differently. In this case the max is 20% of your self-employed income, which is the amount of money you pay self-employment tax on. Let’s say Mark owned a sole proprietorship and made $100,000 of net income. He would only pay self-employment tax on $92,350*. His SEP maximum contribution would be $18,587 ($92,350 x 20%).
*This is a special limit that is calculated for self-employed business owners because they get a deduction for ½ of the self-employment tax that they pay. It’s extremely complicated, and is mostly important for your CPAs to understand since they will be advising you about the amount you should fund your SEP. But if you really want to know how that works, and would like an additional math headache, here is a link to the IRS website that further explains it.
Example of tax savings from a SEP-IRA
Here is an example of the potential tax savings from a SEP-IRA. Tom owns an S Corporation called ABC Inc. It’s a small business (S Corporation) that employs himself, and 3 other employees. Tom’s the only employee that has been employed by ABC over 3 years. Tom’s salary is $100,000 and his effective tax rate is 20%. Let’s also assume that the S Corporation has $75,000 of net income before he makes a SEP contribution.
Tom makes no SEP contribution: Tom’s total income is $175,000 (business income $75K + salary $100K). Since his effective tax rate is 20% he will owe the IRS $35,000 in tax ($175K of total income x 20% tax rate).
Tom makes the maximum 25% SEP contribution: Since Tom’s salary is $100k, his maximum contribution to his SEP is $25,000 ($100K x 25%). His SEP is tax deductible, so his net income for his S Corporation is now $50,000 ($75K of net income minus SEP contribution of $25K). Tom’s total income is now $150,000 (business income $50K + salary $100K). He will now owe the IRS $30,000.
As you can see Tom saves $5,000 in tax if he make the SEP contribution. This is how the rich save money and pay less tax. They try and give the IRS the least amount of tax legally possible. That’s because any extra dollar you give the IRS, you will never see again.
What are the deadlines for SEP-IRAs?
The deadlines for setting up a SEP-IRA for your business is your tax filing deadline (including any extension). That’s way better than Traditional and Roth IRAs, which deadline is April 15th (with no extension). This is extremely advantageous since a business owner may extend his or her tax return in April, fund the SEP contribution for the prior year during the summer, and then file their tax returns before the extension deadlines.
When are SEPs a bad idea?
If you have high turnover, or have a small business with relatively few employees, (or the owner is only employee) SEP-IRAs are your best option. Once you start having lower turnover (i.e. your employees are meeting the 3-of-5 rule), have a huge staff, and you’re trying to attract higher talent, it’s time to upgrade to a more robust retirement plan, such as 401(k)s or Simple IRAs. Don’t worry, we will be covering those in future articles.
Remember, the tax code is complicated, and so we covered the most important information about SEP-IRAs, but not everything. That’s why we recommend that you contact a CPA to go over any additional questions you may have in setting up a SEP-IRA for your small business.