Basi on Finance: Look at SEP for retirement plan
Any small closely held companies want to help their employees establish retirement programs. Without going to the expense of a formal profit-sharing plan or having an outside company administer a retirement program, closely held companies should look at simplified employee plans. A simplified employee pension plan, commonly known as a SEP, is an arrangement under which an employer makes contributions to the individual retirement accounts of its employees. If the employee does not have an IRA, he would have to open one. This type of plan is ideally suited for small closely held businesses as well as self-employed individuals. A SEP plan combines many of the advantages of more complex plans, such as 401(k) plans, but is as simple to understand as an IRA. Because of the simplicity of setting up a SEP, very few administration costs are associated with this plan, and you don't need an outside company to establish or administer it.
Choosing a SEP over a traditional IRAA SEP plan allows a much greater contribution, which in turn means a greater deduction than an IRA. An IRA deduction is limited to $2,000 per year. Under a SEP plan, an employer can contribute up to 15% of his employee's income, not to exceed $30,000. The plan works the same if you are self-employed. If your income is $40,000 and you contribute your maximum of $6,000 to a SEP IRA, your taxable income will be reduced to $34,000. Assuming a 28% tax bracket, this produces a tax savings of $1,680.
Clearly the most obvious benefit of establishing a SEP IRA is for future retirement income. Today, many Americans are troubled about the uncertainty of Social Security. With proper retirement planning, many of those uncertainties can be avoided. The advantages of a SEP include:
- The contributions are tax deductible. The business is not responsible for any taxes attributable to the investment once it is in the account of the individual employee.
- One advantage of this type of plan over other plans, such as a 401(k), is that the plan does not have to be permanent. What this means is that, at the end of every year, the company can make a determination of how much it is willing to contribute to each employee's account. This is especially useful for small closely held businesses whose income levels fluctuate from year to year.
- Another advantage of this type of fund is that once the money is put in an account, the employer has no further responsibilities. Each employee is responsible for the investments of his own account.
- Because this type of fund is so easy for the employer to establish and operate, many of the administrative costs and commissions that are associated with many other retirement plans are not present. Also, an employer does not have to fill out nearly as many documents for the government as he would with another type of plan.
- An employer can deduct the contributions he makes to a SEP for a previous tax year as long as he makes the contribution by the due date of the employer's tax return, including any extensions. Being able to postpone payments until the end of the business's tax filing extensions is very advantageous, especially for those companies attempting to do last-minute tax planning or those firms managing temporary cash-flow problems around April 15 for individuals and partnerships, or March 15 for corporations. By filing an extension, which can be for up to six months past the due date, the taxpayer essentially takes an interest-free loan from the IRS.
Not only are there advantages to the employer, but the employee benefits as well:
- The money that is put into an account by the employer, as well as the interest on the contribution, immediately belongs to the employee. Employees have the right to the money even if they quit or are terminated.
- The money contributed by the employer is not taxed to the employee until the money is withdrawn from the IRA. This also includes interest earned on the account.
- Employees are in full control of their individual accounts. They can have the money invested however they choose.
- In the case of an employee's death, the assets in the individual IRA account will go to whomever the employee has chosen as the beneficiary. This means that the money will not be included in his probate estate, as it passes directly from the IRA account to the beneficiary so designated when the account is established.
How to establish a SEPThe process to establish a SEP IRA in a business is quite simple. The first thing to do is to complete IRS Form 5305-SEP (visit the IRS' Web site at www.irs.ustreas.gov/prod/cover.html). This is a model SEP agreement. Once you have completed this form, all you have to do is:
1. Determine the amount you want to contribute to the SEP to begin, i.e., the first year's contribution. Again, the current limit is 15% of an employee's salary or $30,000, whichever is lower. The employer should also keep in mind the maximum compensation limit, which is $170,000 for the year 2000.
It appears that even if the maximum amount of 15% x $170,000 is contributed for the year 2000, the $30,000 limit will not be met.
2. The employer should note that Form 5305-SEP is merely a guide for the employer in establishing the SEP IRA. The form is not to be filed with the IRS but kept in the company's files. Some financial institutions have their own forms that can be used in place of the IRS form; however, you can be assured that by using the IRS form you are doing it correctly.
3. Make sure all employees have established an IRA at a financial institution. Make sure that this is a traditional IRA and not a Roth or Simple IRA. Next, the employer should send the predetermined amount to each employee's IRA account at the financial institution. The deposit should be directed to each account and not to the employee.
4. Once all of the above have been completed, the following information should be passed on to the employee:
- A copy of Form 5305-SEP or other form used;
- A statement informing the employee of the different rates that apply to the transfer and withdraw of funds for traditional IRAs;
- A statement that informs employees that when they become eligible to participate, the administrator of the SEP will furnish the participant, within 30 days of eligibility, a copy of the amendments and written explanation of its effects; and
- A statement from the administrator of any employer contributions made under the SEP to that participant's IRA by the later of Jan. 31 of the following year for which a contribution is made or 30 days after the contribution is made.
(Note: Reference to the "administrator" means the company official who is responsible for the administration of the program. An outside company can be hired to handle the details, but this adds an expense to the company.)
Employees who are determined to be eligible must be allowed to participate in the SEP IRA. An eligible employee as defined by the IRS is one who is at least 21 years old and has performed "service" for the employer in at least three of the immediately preceding five years.
It should be noted that employers are allowed to establish less restrictive guidelines than those listed above. However, they are not allowed to impose any guidelines that are more restrictive than those listed above. Service that has been provided by the employee includes any amount of time, whether full-time or part-time. All employees who are considered eligible must participate in the plan.
A SEP plan will not qualify unless the employee is free to withdraw all or any part of the employer's contribution at any time he wants to in the future. Ownership must vest immediately in the employee. Such withdrawals, however, are subject to all the usual distribution rules for IRAs, including the penalty tax for early withdrawals. Funds from a SEP can be withdrawn without penalty at age 59 1/2 by the employee.
A change that has occurred in the last three years has affected what was known as a "salary reduction" SEP IRA. A salary-reduction SEP IRA is essentially what the name implies; an employee was able to contribute a portion of his salary into his SEP account. Effective Jan. 1, 1997, employers are no longer able to set up salary-reduction SEPs. One exception to this rule is for employee-reduction SEPs that were established before 1997. If a plan was implemented before the new law went into effect, it is essentially grandfathered and allowed to continue.
Do yourself a favor and begin to save for you and your employees' future now. Take advantage of all that a SEP has to offer; there is no time like the present to plan for the future.