A CREDO TAX PLANNING STRATEGY SOLUTION

SEP IRA: An Ideal Retirement Plan for Small Business Owners and Self-Employed Individuals

This whitepaper serves as your guide in understanding SEP IRA, the moving parts of retirement, how it works as a retirement plan and its tax friendly incentives for both small-scale businesses and self-employed individuals.

In 2022, the limit contribution for the simplified employee pension (SEP) IRA is $61,000 (up from 2021’s $58,000) with all employees entitled to receive proportional contributions. These contributions are tax-deductible for sole proprietors and employers. SEP IRA serves as low-hassle way for owners of small businesses in obtaining tax-advantaged savings while contributing for their employees. Way simpler as compared to other complex plan (like 401(k)), but with higher contribution limits (as compared to Traditional IRAs), SEP IRA is ideal for businesses with less than 10 employees.

WHAT IS A SEP IRA?

Simplified Employer Pension Plans or SEP IRAs are retirement plans that allow self-employed individuals and business owners to gain numerous benefits from it.  For businesses, aside from being 100% tax-deductible, the plan also allows them the following:

  • Be able to share up to the lower 25% of each employee’s compensation or $58,000 in 2021 and $61,000 in 2022.

  • Eligible to flexible contribution as the percentage of employee contribution can vary from year to year.

  • Able to consolidate with other retirement plans excluding a Roth IRA or accounts that also have after-tax contributions.

  • Defer taxes until you withdraw. The withdrawals made before age 59 ½ will yield a 10% penalty aside from the tax.  Withdrawals to pay medical bills or purchase a house are exempted.

SEP IRA BENEFITS FOR SMALL BUSINESSES

Potential Tax Benefits

Employers who aim to help their employees prepare for retirement (but may have hesitated because of perceive perceived expenditure) can contribute up to $5,000 annually for three years under the newly expanded tax credit. Employers who are eligible for this can claim a tax credit that is equivalent to 50% of the qualified start-up costs up to the valid limit for the first three years of the SEP IRA plan.

Minimal Administrative Costs

Requiring a little paperwork and low start-up costs, SEP IRAs allows small business owners to contribute for themselves and for their employees. These contributions are normally tax-deductible to the business.

Yearly Flexibility in Contributions

With SEP IRAs, small business owners have the flexibility to contribute more when their business is strong and decrease contributions when things are tighter. When deciding on the eligibility of employees, you may either follow the standard requirements of the IRS or you may set your own rules that are less restrictive.

Helping Employees Plan for the Long-Term

With the wide array of potential investments that SEP IRAs offer, employees can usually transfer or roll over funds to and from a SEP IRA into or from their other retirement accounts with the goal of consolidating savings.

Contribution Amount Flexibility

Currently, the maximum limit of contribution for SEP IRA is $58,000 (will be $61,000 in 2022) or 25% of the eligible compensation of employees (whichever is less). For business owners, the contribution they can make for themselves is 20% of the net earnings from self-employment according to the SEP IRA rules), whichever is less. Deferral contributions can only be made by the employer on behalf of the employees. And the contributions made are generally tax-deductible for the business. Depending on the business’ climate, employers can make significant contributions to a SEP IRA than a Traditional IRA.

Limited Liability

The fiduciary duties of employers are lessened because participants choose their own investments after establishing their SEP IRA accounts.

TAX PLANNING WITH SEP IRA

SEP-IRAs contributions are tax-deductible to the self-employed or to the business owner who makes the contributions. This is how SEP IRAs play the role in tax planning:

  • Any investment income earned inside the SEP-IRA is tax-deferred.

  • The contributions can be made after the end of the tax year.

  • Participants have control over how the contributions are invested.

  • The remaining fund can be rolled over to traditional IRAs.

  • The plan can be utilized in addition to traditional IRAs and Roth IRAs.

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  • Any investment income earned inside the SEP-IRA is tax-deferred.

  • The contributions can be made after the end of the tax year.

  • Participants have control over how the contributions are invested.

  • The remaining fund can be rolled over to traditional IRAs.

  • The plan can be utilized in addition to traditional IRAs and Roth IRAs.

  • Excess contributions can be carried over and deducted in the following year.

  • SEP contributions increase deductions, thus lowering taxable income (which then results to lower tax calculation).

  • SEP contributions for self-employed persons are subtracted as an adjustment to income.

Income adjustments lower AGI (adjusted gross income) which is impacting to numerous AGI-sensitive deductions and tax calculations. SEP contributions helps to qualify for a particular tax break since it lowers the AGI.

Reduction of Federal Income Taxes Through SEP IRA

Funded using pre-tax dollars, a SEP IRA can reduce tax liabilities in explicit ways.

Self-employed individual contributing SEP IRA for himself: When a self-employed person contributes to his own SEP IRA, these contributions are deducted as an adjustment to income on Form 1040, line 10a, using Schedule 1. When an individual’s AGI is reduced through SEP contributions, the taxable income is reduced as well (and so is the federal income tax). The self-employment tax is not impacted by SEP contributions because that is computed prior to the calculation of SEP contributions. So a self-employed individual reduces income tax merely by contributing to his own SEP IRA.

A self-employed individual contributing to the SEP IRAs of his employees: When a small business owner contributes to his employees’ SEP IRAs, his business expenses are boosted which result to lower net profit, thereby reducing both the employment and income tax.

In addition to the mentioned tax benefits, SEP IRA contributions are exempt from FIC (Social Security and Medicare taxes). This means that the employer-employee does not pay FICA on the SEP contributions.

Investment Income Earned Inside the SEP-IRA is Tax-Deferred

SEP contributions can indirectly reduce other taxes that are computed based on AGI or taxable income (including the AMT or alternative minimum tax and the 3.8% net investment income tax).

Just like in any other retirement savings plans, the investment income produced on funds inside the SEP IRA is tax-deferred. Given this, the interest, dividends, and capital gains generated inside the SEP IRA are not included in an individual’s annual tax return. Tax is merely imposed when money is allocated from the SEP IRA. Investment income can be reinvested without needing to pay tax on earning first since it is tax deferred. These tax-deferred computing results to the accumulation of a larger account balance over time.

With this tax deferral capability, an individual can move income and its corresponding tax liability to a future time. Moving income to some point in the future can give the individual control on the level of income by deciding on the schedule and amount of distribution from the SEP IRA. Such control on the income amount allows an accurate control of the tax. Preferably, individuals would like to deduct contributions when he is on a relatively high tax bracket and take distributions in a future time when he belongs to the lower tax bracket.

Benefit from the Setup and Funding Due Dates

SEP plans can be funded and adopted until the tax return’s due date (extensions are granted). What is notable about SEP is that funding it gives self-employed individuals to increase their deductions for last year by spending money on the current year. A self-employed individual who is filing a Schedule C can set up a SEP and contribute funds to a SEP-IRA as late as April 15th (no extension is allowed), or October 15 (with an extension), and have the contributions subtracted on their tax return for the previous calendar year.

Those who do not have a retirement plan yet, a SEP plan can be set up for the current year and make it effective on the last tax year. If SEP IRA is funded by the due date of the return, the contribution amount can be decided once all the tax impacts are sufficiently known.

Contributions can also be spread out over a longer period of time to take advantage of the funding due date as a way for businesses to budget their retirement savings.

Funds can be contributed for a particular tax year starting on January 1 of that year and ending as late as October 15 of the next year (total of 21 months and 15 days).

Sample Scenario:

Anna is a self-employed fashion designer who is filing a Schedule C and is completing her tax return in September. She requested an extension prior to April 15 (the due date of her return is October 15). To increase her deductions (she aims to lower her tax liability), she opened a SEP IRA. Given this scenario, Anna can deduct her contributions on her tax return for as long as the SEP plan is adopted and funds are contributed prior to or on October 15.

Anna, in contrast, could fund a solo 401(k) or other retirement plans for small businesses if she has adopted the plan in a previous tax year. This makes SEP IRAs appealing because it can be adopted and funded after the close of the tax year.

SEP IRA DUE DATES

SEP IRA TAX IMPACT AT FEDERAL LEVEL

SEP IRA FAQs

What are the requirements to be SEP IRA eligible?

Businesses under any type of structure such as sole proprietors, partnerships, or corporations are qualified to enter the retirement plan.  Also, employees who are 21 years old and above and are earning $600 and up for the present year and have worked for the company for at least three years should be included in the retirement plan.

On the other hand, SEP IRA can also allow the business to cover for the employees who do not meet the eligibility requirements.  Such employees are those covered by union contracts and those who receive less than $600 of income for the current year.

How to be eligible for SEP IRA
Businesses under any type of structure such as sole proprietors, partnerships, or corporations are qualified to enter the retirement plan.  Also, their employees who are 21 years old and above and are earning $600 and up for the present year and have worked for the company for at least three years should be included in the retirement plan.

On the other hand, SEP IRA can also allow the business if they wish to cover for the employees who do not meet the eligibility requirements.  Such employees are those covered by union contracts and those who receive less than $600 of income for the current year.

Do contribution rates vary from year to year?
Yes. The employer can set a percentage of compensation that is used when computing on the amount of contribution to the SEP IRA of each participant. This can range from 0% to 25% and it must be the same for all plan participants. This rate can be changed every year to give businesses the flexibility to budget the fund for retirement benefits (based on the business’ financial condition for the year).
Can a SEP IRA be Rolled Over to Another Retirement Account?
Yes, participants are granted full control over where they want their money kept and how they wish to invest it. SEP IRAs can be rolled over to other retirement accounts:

  • A Traditional IRA
  • Another SEP-IRA
  • A pre-tax 401(k) plan
  • A pre-tax 403(b) plan
  • A Roth IRA

 

How should you treat excess SEP contributions?
Any excess contribution amount to a SEP IRA can be carried over and deducted in the following tax year. But it may be subject to the 10% excise tax for over-contributing to a retirement plan. Performing SEP IRA calculations before making any final contributions assigned for the tax year would help in the prevention of making over-contributions.
Limitations of SEP IRAs
  • Only the employer are allowed to contribute for the eligible employees’ SEP IRA.
  • Taking loans from the SEP IRAs are not allowed.
  • SEP IRAs have no catch-up stipulation that enables older participants to contribute more.
SEP IRA Contribution Amount
The business’ maximum deductible contributions to its employees is $58,000 in 2021 and $61,000 in 2022 or 25% of all of the compensation (whichever is lesser).  The contribution amount is computed depending on the type of plan participant.

For employees: The employer’s contribution rate (up to 25%) is multiplied to the annual compensation paid to each employee (subject to maximum dollar limit). How the contribution amount is calculated depends on whether the plan participant is an employee or self-employed. Employers are not required to report the SEP contributions on each employee’s Form W-2. But the check box on Form W-2 box 13 should be checked to specify that the employee is covered by a retirement plan.

For self-employed individuals: Including partners in a partnership, computing for the contribution amount requires assessing of the compensation and adjusting of the contribution rate. Compensation is measured for the year by calculating the net earnings from self-employment.

  • Net Earnings Calculation from Self-Employment: Net profit should start from Schedule C (line 31), Schedule F (line 34), Schedule K-1 (for Form 1065, box 14, code A). Then subtract the deductible portion of the self-employment tax (Form 1040, line 22). The difference is the net earnings from self-employment. The Deduction Worksheet for Self-Employed (Chapter 5 of Publication 560) is used to compute for this. Take note that self-employed individuals have a lower contribution rate as compared to that of the employees. Based on the tax code, the contribution amount and net earnings are mutually dependent on each other. The IRS has developed an indirect way for computing the contribution amount by adjusting the contribution rate.
  • Contribution Rate Calculation for a Self-Employed Individual: 1. Start with the uniform contribution rate of the plan, 2. Add 1 to the contribution rate, 3. Divide the uniform contribution rate by one plus the uniform rate. The result of this is the contribution rate for self-employed individuals. If a filer for Schedule C sets up a SEP IRA with a contribution rate of 25% for all plan participants, the amount that can be contributed for employees is 25% of each employee’s compensation for the year. This means that the self-employed person can contribute 20% for his own SEP IRA (25 ÷ 1.25 = 0.20).

Note: See the Rate Table for Self-Employed in chapter 5 of Publication 560 for other conversion amounts.

When should SEP IRAs be funded?
To establish the SEP IRA, the business have to complete the following steps.

  1. A written agreement is the primary requirement to initiate the SEP IRA. This may include Form 5305-SEP and SEP IRA contribution agreement.  Both can be easily accessed on the IRS website.  In such instances, financial institutions can also offer approved prototype SEPs.
  2. Qualified employees should be given details of the SEP. This may include the agreement as well as the instructions.  Such info that the employees should be given are:

 

  • All amendments to the retirement plan will be handed out by the SEP administrator within 30 days from the date that it was implemented.
  • Participating employees will receive a report of the contributions made by the employer every 31st of the next year.

 

  1. Employees who are eligible should have their own SEP IRA account set up. We’ve known that these employees are already 21 years of age or above, earn $600 or more in the present year, and already worked for the company for a minimum of three years of the past five years. The SEP IRA of the employees can be established through any financial institution.  Automatically, the employee is 100% vested in contributions through his or her employer.
  2. Employers can also fund and create a new SEP retirement plan until the filing of tax returns.
Do participants have control on how SEP contributions are invested?
Yes. The funds on the SEP IRA can be managed by the individual once contribution is made. The account holder has the liberty to decide how the funds will be invested, if he wants to roll over the funds to another IRA, or if he wishes to take distribution from it.

Before the age of 59 ½, distributions from a SEP-IRA are taxable and may be subject to a 10% surtax on distributions that take place.

Self-employed individuals can also choose the financial institution where they want to open the SEP IRA and invest their funds as they see fit.

Employees who are granted SEP IRA by their employer is fully invested in the contributions and can decide which investments are fit for their SEP IRA.

Can you still participate in a SEP IRA even if you already have a traditional IRA or Roth IRA?
Yes, you can still participate in a SEP IRA even if you already have a traditional IRA or Roth IRA.

  • With SEP IRA, you are covered by a retirement plan at work which has an impact on the amount that can be deducted for a Traditional IRA. The modified AGI for the year determines the amount of a traditional IRA contribution.
  • Roth IRA eligibility is based on the individual’s modified AGI for the year.
  • Through funding a SEP IRA, self-employed individuals can lower their AGI which can make them eligible for a Roth IRA or a deductible traditional IRA.
  • Self-employed individuals can possibly contribute to a traditional IRA and/or Roth IRA and/or SEP-IRA for the year giving them the flexibility to decide on the amount that they will contribute to each retirement plan type.
What plan works for my business?
There is no doubt that a retirement plan is a necessity.  The employers are only left with the question, “what plan is perfect for my business?”

There is no shortcut to knowing which one will work just right for your company.  So, before you hop in the world of SEP, equip yourself with all the knowledge by digging into the options available and types of plans.  We are your friendly neighborhood when it comes to SEP.  Give us a call if you would like to learn more or know what options you have.

SEP IRA Termination
Terminating SEP IRA is possible when your company grows and reaches a certain size or if you want to transition to another retirement account type. This should be discussed with the plan administrator and should be consulted with a tax professional or financial advisor. There’s no need to notify the IRS when terminating a SEP IRA.
Considerations before adopting a SEP
  • Review Publication 560 Chapter 2 for the IRS’ detailed explanation of simplified employee pension plans.
  • Review the model SEP plan (Form 5305-SEP) or comparable model plans that is offered by your chosen financial institution.
  • Assess who among your employees must be covered by the SEP plan (eligibility information are detailed in Publication 560).
  • Evaluate the disclosures that should be made to employees (also detailed in Publication 560).
  • Review the contribution amount that you can potentially make to SEP IRA.
  • Review how contributions will be deducted on the tax return and how that it will impact your tax calculations.
  • Review the comparison and difference of SEP against other small-business retirement plans, such as 401(k) and SIMPLE plans.
  • Explore financial institutions that manage SEP plans and review their paperwork, costs, and investment options.
  • Consult with a tax professional like Credo to gain a better understanding of the impacts of each plan.

 

CONSULT WITH CREDO

Our team at Credo is the right resource when you finding the right approach to help your valued employees prepare for investment while ensuring that your company has a healthy financial future. We will help you understand SEP IRA and all of the moving parts of retirement, especially when it comes to tax and other financial benefits.

 

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