Simplified employee pension (SEP) individual retirement accounts are tax-deferred retirement savings plans designed to allow business owners a more straightforward method of contributing to employee accounts.
In essence, a SEP-IRA is a collection of traditional IRAs organized under one broad employer plan that allows for employer contributions—something that traditional IRAs do not allow. There are standard tax benefits for employer contributions, and most of the tax rules for the individual accounts are the same as those applied to traditional IRAs.
Key Takeaways
- Simplified employee pension (SEP) individual retirement accounts are tax-deferred accounts through which employers can contribute to their employees’ retirement accounts.
- For SEPs, standard tax benefits apply to employer contributions, and most of the tax rules for individual accounts are the same as those applied to traditional IRAs.
- A SEP-IRA does not require the start-up and operating costs of most employer-sponsored retirement plans.
- Generally, 100% of all employer contributions are tax-deductible to the business.
SEP-IRA Taxes for Employers
Employers are allowed to make annual contributions to their employees’ individual accounts as long as they do not exceed the lesser $61,000 for 2022 ($58,000 for 2021) or 25% of total employee annual compensation.
A SEP-IRA does not require the start-up and operating costs of most employer-sponsored retirement plans and is thus an attractive option for many business owners. Also, a SEP-IRA plan allows an employer to contribute to their own retirement at higher levels than a traditional IRA would allow. Lastly, workers can start a SEP for their self-employed business even if they participate in an employer’s retirement plan at a second job.
A self-employed business owner who establishes a SEP-IRA must use a special calculation provided by the Internal Revenue Service to determine contribution limits towards their own account.
Generally, 100% of all employer contributions are tax-deductible to the business. If the total contributions exceed 25% of all employees’ compensation, however, the surplus would not be deductible on the business tax return.
If a SEP-IRA fails to meet the plan’s requirements, as stated in the Internal Revenue Code, the tax benefits to the business are forfeited. The only way to avoid the loss of tax privileges is to complete one of the IRS correction programs: the Self-Correction Program (SCP), the Voluntary Correction Program (VCP), or the Audit Closing Agreement Program (Audit CAP).
SEP-IRA Taxes for Employee Accounts
The tax-deferral benefits for an employee’s SEP-IRA are similar to those of traditional IRAs: Contributions to the account are made with pre-tax earnings, and all investment growth in the account occurs tax-free. Once an individual reaches age 59½, that individual becomes eligible to withdraw funds from the SEP-IRA without incurring a tax penalty. The penalty for premature withdrawals is 10%.
If a distribution is made for unreimbursed medical expenses and exceeds 10% of the individual’s adjusted gross income (AGI) for 2021, the distribution is not subject to early withdrawal penalties. There are similar exceptions for account owners who become disabled and for those who need to pay for medical insurance.
Similar to traditional IRAs and any qualified account with pre-tax contributions, a SEP-IRA carries a required minimum taxable withdrawal on an annual basis beginning the tax year after the account owner turns 72. The amount of the minimum withdrawal is calculated by the IRS based on the year-end account balance and the life expectancy of the account owner.
Employees have the option of rolling over their SEP-IRA funds into another qualified account, such as a traditional IRA, without incurring any additional tax penalties.
SEP-IRAs are deferred tax accounts, meaning you use pre-tax dollars today (and take a deduction), but must pay the ordinary rate of income tax upon withdrawals (whether early or during retirement). The rationale is that one’s income tax bracket will be lower in retirement when overall income is lower, providing a tax advantage.