Can you combine a SEP with a defined benefit plan? The surprising answer


SEPs are very popular plans. But they are a bit inflexible. This is especially true when trying to combine them with other retirement plans, like defined benefit plans or cash balance plans.

In an effort to maximize retirement contributions, people often try to contribute to both a SEP and a defined benefit plan. Then they find out later that there may be an issue.

In this post, we take a close look at these two types of plans and discuss issues associated with combining a SEP and a defined benefit plan.

If you are looking to set up a cash balance plan or defined benefit plan and already have a SEP in place, make sure you reach out to us. We can help you determine if you have a SEP that can be combined. 

Why a SEP in the first place?

A SEP is a plan that basically acts like a profit sharing plan. The contributions are made based on one of the two following structures:

(1) A model traditional SEP-IRA that is executed on an IRS form. This is often referred to as a “model” SEP; or

(2) A master or prototype traditional SEP-IRA that has received a favorable IRS opinion letter. This is commonly referred to as a “non-model” SEP.

We will discuss what these distinctions are shortly. But at the end of the day, #1 above does not allow for the combining of plans, while #2 does.

Many people set up SEPs years back when their business was smaller and they weren’t looking for large tax deductible contributions. In addition, SEPs seem to be very popular with CPAs and financial advisors.

I think this is mostly because you could set them up and fund them before the date the company filed it’s tax return. So it made it easy to get in a contribution before the filing tax deadline.

In reality though, SEPs are really not the best plans for most business owners. Since it really just operates like a profit-sharing plan, you can get the same profit-sharing allocation that a 401(k) plan can get.

Book a FREE 30 Minute Call!

Schedule a FREE call and we’ll show you how we structure plans for maximum tax efficiency.

But with the 401(k), you also get the deferral. So for the small business owner, a solo 401(k) is clearly the best choice. The only advantage I see is that SEPs are exempt from the filing requirements of form 5500.

The table below outlines some of the contribution and other requirements associated with SEPs and defined benefit plans.

Can you combine a SEP with a defined benefit plan or cash balance plan?

This is one question we get asked all the time. The answer is: it depends. You need to understand the difference between model SEPs and non-model SEPs.

You actually can combine the two plans, but the SEP has to be a non-model SEP that is not subject to IRS form 5305 requirements.

Money on an abacus

In addition, it is limited to 6% for any non-PBGC covered plans. Since most plans are solo plans or for small professional groups (physicians, lawyers, etc), they are not covered by the PBGC. So the 6% rule is in place.

Why are there different types of SEPs?

As a general rule, most SEPs are model plans. As such, they cannot be combined with a cash balance plan or defined benefit plan.

If you thinking of establishing a defined benefit plan and you already have a SEP in place, don’t fund it yet. Wait until you decide exactly what you want to do so that you don’t have funding issues. 

What is a model SEP?

If you adopt an IRS model SEP using Form 5305-SEP, you do not need any IRS approval. This form essentially becomes your plan document.

You are basically certifying that these are terms that you agree to and you will follow the rules and requirements outlined on the form. It’s rather straightforward.

You may satisfy the written plan requirement by simply adopting the IRS model SEP using Form 5305-SEP. You do not have to file Form 5305-SEP with the IRS. Just keep it for your records. 

Get a FREE IllustratioN!

Just give us a little information and we’ll get you a custom illustration in 24 hours.

In most cases, the custodian that you selected to set up the plan (Vanguard, Fidelity, etc) has completed Form 5305 for you as part of the set up process. You should have received this form with your set up documents.

The IRS clearly states that you cannot use Form 5305-SEP if you currently have any other qualified retirement plan. A defined benefit plan or cash balance plan falls under the qualified plan umbrella. You can see the IRS position right here.

What is form 5305?

Form 5305-SEP is used for model SEP plans and is used by an employer to provide retirement benefits to all eligible employees. The IRS guidance for a simplified employee pension (SEP) falls under section 408(k).

Let’s take a closer look at what is a model SEP and a non-model SEP. For a SEP to exist, you must first execute a formal written agreement (or plan) to provide retirement benefits to all eligible employees under a SEP. This requirement is often satisfied by adopting an IRS model SEP using Form 5305-SEP.

In addition, using a plan under Form 5305-SEP will generally exempt you from annual filing requirements under form 5500 that are required for most plans. This will save a few headaches.  

What is a non-model SEP?

Many financial institutions and custodians use other approved plans that I would call prototype SEP documents. This means that the IRS has specifically issued an opinion letter that has approved the custom plans.

The company can actually use individually designed plan documents. However, the IRS doesn’t really have an approval process for these documents. So in practice, it isn’t really feasible.

Get Started for $990

Set up for 2021 or 2022

Based on our review, the companies listed below have non-model SEPs and can be combined. But before you think you are in the clear, review your plan documents and make sure you didn’t receive a form 5305. Also, talk to the custodian. These plans can change, so it’s always recommended to do a compliance check. Here is the list we are aware of:

  • Merrill Lynch
  • Charles Schwab
  • American Funds
  • Morgan Stanley

If you have any other plans that you want us to take a look at or that we can add to the list, just leave us a comment below. We would be glad to take a look and add it to the list.

What about excess SEP contributions?

Let’s look at an example of an excess contribution addressed on a 2020 tax return.

Jessica, age 38, made an excess contribution in 2020 of $2,000. This excess was withdrawn by April 15, 2021, the due date of her tax return. At the same time, she withdrew the $100 of interest income that was earned on the $2,000. She has to include the $100 in her taxable income for 2020 (the tax year in which the excess contribution occurred). She also has to pay the additional tax of $10 (the 10% additional tax on any early distributions because she isn’t yet 59 1/2 years old). The good news is that she does not have to report the excess contribution as taxable income nor is she required to pay the 6% excise tax on the excess contribution. Jessica will receive 1099-R that will show the earnings are taxable for 2020.

For more information on employee tax treatment of excess contributions, see Pub. 590-A.

Takeaway

Even if you have a non-model SEP, don’t think that you are in the clear. That’s because in many cases you may have already funded your SEP based on 25% of your compensation (or 20% of self-employment income).

The IRS allows excess SEP contributions to be withdrawn without penalty by the due date of the tax return (including extensions), but are included in gross income. 

If want to set up a defined benefit plan and you have already have funded your SEP, make sure you reach out to us. We can help you determine if you have a model SEP or a non-model SEP. 

Depending on when the defined benefit plan was established, there is a chance the SEP contribution can be disbursed back to you as an error correction without having a tax problem.

Paul Sundin

Get a FREE 30 Minute Consultation

Reach out to us today and we'll show you our favorite strategies! We can show you how to structure a plan for maximum tax benefit and provide you with a custom plan design.

Leave a Comment