Part 2: SEP IRAs The government has afforded several tax-advantaged options for business owners to save for retirement. The purpose of this series is to educate doctors,including small business owners, about the most commonly-used plans for Independent Contractor (“IC”) income and small practice owners. (As your practice volume grows and you age, you may eventually supplement your 401k with a Defined Contribution plan, but the purpose of this series is for basic plans.) Choosing which type to use can vary from year to year, depending upon timing and other goals. In this 3-part series, we will examine the advantages and disadvantages of each.
What is a SEP IRA and when should I use one?
A SEP IRA, like a SIMPLE IRA, is a blended business-personal retirement account. The business aspect allows the owner of the business to govern participation and gives the owner of the business a deduction for employer contributions to the plan. The personal aspect means that employees are immediately vested in their accounts, which are in their own names. This means employees own 100% of the balance of their SEP accounts (are 100% “vested”) from day one of participation.
Unlike a SIMPLE IRA, the employer using a SEP IRA is 100% responsible for contributions to all eligible employee accounts. The employer can contribute up to 25% of compensation, not to exceed $56k in 2019. This means if you, the employer, contribute $56k to your SEP account, you must contribute 25% of pay to each eligible employee’s SEP account. This can get quite expensive, but don’t quit reading yet!
What you need to know:
- Until 1/1/20, a SEP was the only employer plan that could be established after the end of the calendar year for which it applies. [Beginning 1/1/20, solo-401k’s also have the same establishment deadline] You have until the due date of your income tax return, including extensions, to set up and fund a SEP. This is the biggest benefit of SEP IRA plans. In other words, you have until 10/15/20 to set up and fund a SEP IRA for 2019.
- As with a SIMPLE, employees are immediately 100% vested. Withdrawals before age 59 ½ will be assessed a 10% penalty unless you qualify for one of these exceptions. Rollovers to qualified retirement accounts are not taxed or penalized.
- Eligible employees are those who have
- Reached age 21,
- Worked for the business for the last 3 out of 5 years, and
- Received at least $600 in compensation for the year.
- There is no Roth option for SEPs.
- There is also no catch-up option for employees who are age 50+.
- Because a SEP is a pre-tax IRA, a balance in your account at the end of the year will cause some or all of a backdoor Roth IRA conversion to be taxed. However, if you roll over the balance in your SEP account before the end of the year, you will qualify for the tax-free Roth conversion. Options are to roll to a 401k or 403b (no taxes due) or to convert to a Roth IRA (will be taxed on the amount converted).
When to use a SEP:
- If you are not making back-door Roth IRA conversions or you plan to convert to a qualified retirement account before the end of each year
- If you have a small practice and want to reward loyal employees with high contributions to a low-maintenance, low-cost retirement plan
- If you find you need a deduction beyond the end of the calendar year and don’t already have a plan in place.
SEP IRAs are most often used by independent contractors who did not meet the solo-401k deadline to set up a retirement plan. In Part 3 of this series, we’ll take a look at the advantages and disadvantages of 401k plans.