At Emparion, we are all about the efficient tax structuring of retirement plans including SEP IRAs. That’s all we do.
Many of our clients have S-Corps and want to get $20k to $40k into a SEP. That can work well.
But did you know you could save thousands using a cash balance plan rather than a SEP? Take a look at saving $9,475 with a cash balance plan below.
But first things first. Let’s take a close look at contribution rules for an S Corp SEP IRA.2021 Quick Navigation
- Can an S Corp have a SEP IRA?
- S-Corp Rules
- Why is a cash balance plan often a better option than a SEP?
- How is SEP IRA contribution calculated for an S Corp?
- SEP Contribution Table
- How do SEP IRAs compare to other plans?
- How much can an S Corp contribute to a SEP IRA?
- SEP IRA for S-Corp: Bottom Line
Can an S Corp have a SEP IRA?
A Simplified Employee Pension (SEP) IRA is a retirement solution crafted explicitly for self-employed professionals, small business owners, and owner-only businesses. They also work very well if you earn freelance income.
It is a tax-deferred retirement account that allows plan sponsors to contribute up to $57,000 to their retirement plan and that of their qualified employees.
S Corps are the bread and butter business for most small business owners. I often recommend for business owners looking to make lower retirement contributions that a SEP IRA might be the best option. This is because of plan simplicity and the ability to open up and fund the plan just before the S Corp deadline.
S Corps are certainly allowed to have a SEP IRA. They are actually allowed for sole proprietors, C Corps and partnerships as well. But the rules work a little differently for each.
Let’s take a look through some of the rules and requirements specific to SEPs.
- Eligibility for SEP IRA: To open a SEP IRA, you must have some business income and you must have a W2 paid to you by the corporation.
- SEP IRA contribution deadline: The final deadline to set up and contribute to a SEP IRA is the same as your tax-filing deadline, including any extensions.
- Required minimum distributions (RMDs): The IRS requires you to take minimum distributions starting at age 72. You can calculate your required minimum distribution using the worksheet provided by the IRS.
If you want to make after-tax contributions you are out of luck. The IRS doesn’t allow Roth contributions under a SEP IRA. Depending on your eligibility, you may be able to contribute to a Roth IRA separately.
Why is a cash balance plan often a better option than a SEP?
So let’s take a hypothetical business owner who is looking to make a contribution of $25,000 into a retirement plan. The table below spells out the actual savings of $9,475 with the cash balance plan option.
Take a look at the following table and then we will discuss the specifics below:
Based on the table, you can see this is really a payroll tax play. A SEP will allow you to get a contribution of 25% of your W2. But for a cash balance plan, your contribution will often be as high as 100% of W2.
So a W2 of $25,000 will get you the same contribution as a W2 of $100,000.
A 100% contribution is not an option for everyone. But if you are 50 years of age or older, this can usually work. You will also get a funding range each year so you can get a little more or less in depending on the income for the year.
The payroll tax savings of $11,475 ($15,300 less $3,825) is a big savings. But, of course, make sure that your wage is reasonable. Your accountant should have some insight.
But don’t forget the cost of a cash balance plan. Most custodians like Vanguard, Schwab and Fidelity won’t charge you an annual fee for having a SEP. There really is not much administration to do because you do not have to file Form 5500.
But a cash balance plan requires actuary review and approval. This will run you $2,000 or so annually. Final cost depends on the plan administrator and structure. But you get the point, these plans are a little more expensive to maintain.
The results are clear cut. You can save a lot with a cash balance plan compared to a SEP IRA, even considering a modest contribution like the one above.
How is SEP IRA contribution calculated for an S Corp?
Let’s now start to get into the specifics. The first step is to determine eligibility. Specifically, employee eligibility can be the biggest challenge.
Your employee qualifies for a SEP IRA if:
- He or she is at least 21 years old;
- Has worked with your firm for at least 3 out of the last 5 years;
- Has earned more than $600 during a calendar year.
You do not establish a SEP IRA for an employee if:
- The employee is covered under a union agreement that includes retirement benefits bargained by the union with your firm;
- The employee is a nonresident alien with no US wages or other compensation from your firm.
How much can an S Corp contribute to a SEP IRA?
The contribution limits are straightforward. You can contribute up to $66,000 or 25% of your annual compensation, whichever is less. If you have eligible employees, you must make the same percentage contributions to their account as well.
The owner is not allowed, for example, to make a 25% contribution for himself and then only make a 10% contribution for eligible employees.
SEP Contribution Table for S Corp
How do SEP IRAs compare to other plans?
Most of our client conversations start with the same question: What is a SEP IRA account? Is it right for us? How can we open one?
SEP IRAs are suitable for employers or self-employed professionals who intend to make low to moderate contributions ($10,000 to $50,000) to their retirement plan. But they do not combine will with solo cash balance plans.
If you’re a high-income professional, such as a physician with your practice or a highly-paid consultant, or firm with critical employees, SEP IRA may not serve the purpose.
We often suggest cash balance plans to high earners and business owners who want to maximize their retirement savings while saving hundreds of thousands of dollars in taxable income.
We create defined benefit plans, such as cash balance plans, that allow plan sponsors to contribute anywhere between $100,000 to $500,000 (with our 401k cash balance combo structure) annually to a plan.
Pros of SEP IRA
If this is not the first time you are wondering what is a SEP IRA account, you’ve probably heard about the benefits of a SEP-IRA over other retirement plans. Let us find out why SEP IRAs are popular.
- Flexibility: As an employer, you’re not required to contribute every year, giving higher flexibility during difficult times.
- Large contributions: In comparison to traditional IRAs, SEP IRAs allow high contributions ($57,000 for SEP IRA Vs. $6,000 + $1,000 for IRA).
- Easy setup and maintenance: SEP IRAs are easy to set up and manage in comparison to other plans. You have limited filing obligations, making it easier to manage the plan.
Cons of SEP IRA
- No catch-up contributions: Unlike traditional IRAs and 401ks, you will not be able to make catch-up contributions when you reach age 50.
- Same percentage contributions for employees: You will have to make similar percentage contributions to the SEP IRAs of qualified employees, making the plan somewhat expensive.
- No Roth contributions: There is no such thing as a Roth SEP IRA. If you intend to make post-tax contributions, a SEP IRA may not be the best option.
SEP IRA for S-Corp: Bottom Line
However, the first thing that we often hear from small business owners or other clients is not about our defined benefit plans, but more like “What is a SEP IRA account.” We have decided to explain everything about SEP IRAs in this post and then compare it with other retirement solutions available in the market.
One of the best ways to ensure a prosperous retired life is to start contributing to your retirement plan as early as possible. If you’re a freelancer or just starting a business, do not ignore the importance of long-term capital growth.
Also, it is critical to evaluate your financial goals periodically. Instead of sticking with a single plan, upgrade your retirement strategy to maximize your contributions through cash balance plans, defined benefit plans, or other creative retirement solutions.
5 Keys Steps to a SEP IRA S-Corp Contribution
- Determine if a SEP IRA is best for your business. SEPs are elective plans and very flexible. They just don’t allow very large contributions. If you want larger contributions consider a cash balance plan or defined benefit plan.
- Calculate owner contribution. This calculation is pretty straightforward. You can go as high as 25% of your W2.
- Calculate employee contribution. The employee contribution can be a little more complex. In addition to compensation, you need to consider years of service.
- Finalize custodian paperwork. Depending on if you are setting up a new plan or funding an existing one, make sure that the funding paperwork is in line.
- Make contribution before due date. Remember to contribute the funds up to the date the tax return is filed. This includes extension periods.
As a retirement solution provider for small to mid-sized businesses, we come across business owners who are genuinely worried about their retirement preparedness and that of their employees.
Our team at Emparion relieves them of their anxiety by providing custom-defined benefit plans, such as cash balance plans, along with a financial roadmap for all the critical life milestones.