Simplified employee pension (SEP) plans—also known as SEP/IRAs since they make use of individual retirement accounts—are pension plans intended specifically for self-employed persons and small businesses. Created by Congress and monitored by the Internal Revenue Service, SEPs are designed to give small business owners and employees the same ability to set aside money for retirement as traditional large corporate pension funds. SEP plans are available to all types of business entities, including proprietorships, partnerships, and corporations.
As employer-funded retirement plans, SEPs allow small businesses to direct at least 3 percent and up to 15 percent of each employee's annual salary into tax-deferred IRAs on a discretionary basis. SEP plans are easy to set up and inexpensive to administer, as the employer simply makes contributions to IRAs that are established by employees. The employees then take responsibility for making investment decisions regarding their own IRAs. Employers thus avoid the risk and cost involved in accounting for employee retirement funds. In addition, employers have the flexibility to make large percentage contributions during good financial years, and to reduce contributions during hard times. Like other tax-deferred retirement plans, SEPs provide a tax break for employers and a valuable benefit for employees.
In many ways, SEPs can be more flexible and attractive than corporate pensions. They can even be used to supplement corporate pensions and 401(k) plans. Many people who are employed full-time use SEPs as a way to save and invest more money for retirement than they might normally be able to put away under IRS rules. In fact, an article in Forbes magazine called SEPs a "moonlighter's delight," in that they enable full-time employees to contribute a portion of their self-employment income from consulting or free-lancing outside of their regular jobs.
RULES GOVERNING SEPS
The rules governing SEPs are fairly simple but are subject to frequent changes, so annual reviews of IRS publications 560 (retirement plans for the self-employed) and 590 (IRAs) are recommended. As of 2000, SEPs could be set up using a simple form (IRS Form 5305-SEP) and—unlike larger, more complicated pension plans—did not require a separate trustee. The maximum allowable tax-deductible SEP contribution per employee is 15 percent of net compensation or $30,000, whichever is lower. In general, eligibility is limited to employees 21 or older with at least three years of service to the company and a minimum level of compensation. The maximum level of compensation for SEP eligibility is $170,000.
A similar program is the Savings Incentive Match Plan for Employees (SIMPLE) IRA. SIMPLE plans became available in January 1997 to businesses with less than 100 employees, replacing the discontinued Salary Reduction Simplified Employee Pension (SARSEP) plans. They are intended to provide an easy, low-cost way for small businesses and their employees to contribute jointly to tax-deferred retirement accounts. An IRA set up as a SIMPLE account requires the employer to match up to 3 percent of an employee's annual salary, up to $6,000 per year. Employees are also allowed to contribute up to $6,000 annually to their own accounts. In this way, a SIMPLE IRA is similar to a 401(k), but it is generally less complex and has fewer administrative requirements.
Companies that establish SIMPLEs are not allowed to offer any other type of retirement plan. The main problem with the plans, according to Stephen Blakely in Nation's Business, was that "Congress is already drafting legislation that would make SIMPLE less simple and more costly for the very businesses the plans were created to serve."
OWNERS BENEFIT LESS THAN NONOWNER EMPLOYEES
A note of caution is in order. A small business owner who wants to establish a SEP—or any other qualified retirement plan—for him or herself must also include all other company employees who meet minimum participation standards. As an employer, the small business owner can establish retirement plans like any other business. As an employee, the small business owner can then make contributions to the plan he or she has established in order to set aside tax-deferred funds for retirement, like any other employee. The difference is that a small business owner must include all nonowner employees in any company-sponsored retirement plans and make equivalent contributions to their accounts. Unfortunately, this requirement has the effect of reducing the allowable contributions that the owner of a proprietorship or partnership can make on his or her own behalf.
For self-employed individuals, contributions to a retirement plan are based upon the net earnings of their business. The net earnings consist of the company's gross income less deductions for business expenses, salaries paid to nonowner employees, the employer's 50 percent of the Social Security tax, and—significantly—the employer's contribution to retirement plans on behalf of employees. Therefore, rather than receiving pre-tax contributions to the retirement account as a percentage of gross salary, like nonowner employees, the small business owner receives contributions as a smaller percentage of net earnings. Employing other people thus detracts from the owner's ability to build up a sizeable before-tax retirement account of his or her own. In the case of a SEP plan, the business owner's maximum annual contribution is reduced to 13.04 percent of income (compared to the 15 percent maximum that applies to nonowner employees), to a maximum of $25,500.
Still, a SEP plan offers significant advantages for self-employed persons and small business owners. It allows a much greater annual pre-tax contribution than a standard IRA (at $2,000 or less, depending on the individual's financial status and participation in other retirement plans). In addition, individuals can contribute to their existing IRAs and 401(k)s, and still participate in a SEP plan.