SEP IRA Rules: The 5 Critical Rules For Business Owners


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At Emparion, we are of course known for our cash balance plans and defined benefit plans. But many clients come to us asking questions about SEP IRA rules. So we think it makes sense to clear up some of the confusion.

Our goal is always to provide strategic retirement advice so you can find the best retirement plan for you and your business. We see so many clients that start with SEP plans and then progress to more advanced retirement structures.

What is a SEP IRA?

Simplified Employee Pension Plan or SEP IRA is a retirement solution for small business owners and self-employed professionals planning to save for retirement. SEP IRAs come with comparatively higher contribution limits in comparison to traditional IRAs.

5 Essential SEP IRA Rules

Rule 1: Who can open a SEP IRA?

One of the most critical SEP IRA rules is about who can and who cannot open a SEP IRA. You can open a SEP IRA only if you’re self-employed, earn freelance income, employ others, or own a business.

You’ll have to open and contribute to individual SEP IRAs for qualified employees. We’ll talk about these qualifications below.

Rule 2: Who can contribute to a SEP IRA?

According to the current rules, the employer is responsible for making contributions to the SEP-IRA of each employee. The current SEP IRA contribution limits allow you to contribute up to:

  • 25% of compensation, or
  • $57,000 for 2020.
Financial planning puzzle piece

In case you end up making excess contributions to an employee’s SEP IRA, it will be included in his or her gross annual income.

The only way employees can contribute to a SEP IRA is if the plan permits non-SEP contributions, allowing them to make regular IRA contributions up to the maximum contribution limits.

If you’re self-employed, the IRS provides a deduction worksheet and rate table for all the calculations.

Pro Tip: There are no annual contribution requirements for SEP IRAs, which gives you the flexibility to increase or reduce contributions in proportion to your income.

Rule 3: How to choose plan participants for SEP IRA?

Since you are planning to set up a SEP IRA for your business, it’s critical to consider the cost of the plan, including contributions, setup, and maintenance, before opening one.

The IRS has set apart eligibility requirements for qualified employees. An employee qualifies for a SEP IRA if he or she is:

  • 21 years or older;
  • Has worked for your company for at least 3 out of the past 5 years;
  • Has received annual compensation of $600 or above.

The IRS also provides a list of excludable employees in Publication 560. When establishing a SEP IRA, you can exclude employees if:

  • They’re covered by a union agreement under which, the union and you bargained the retirement benefits; or
  • They’re nonresident aliens with no source of income in the U.S.
Taxes written on hanging tags

Additionally, you can exclude employees who do not meet the eligibility criteria for age, employment history, and compensation.

Rule 4: Mandatory Distributions from SEP IRAs

The IRS requires you to take mandatory distributions from your SEP IRA once you reach the age of 70½. You can use the IRS worksheet to identify the required minimum distributions for your account.

If you fail to take required distributions, you may end up paying up to 50% excise tax on the amount not distributed as per the guidelines.

Rule 5: What is the last date to contribute to a SEP IRA?

You must make the contributions for a year by the tax-filing deadline, including any extensions. You can use Form 5498 to report the contributions made to the SEP-IRA.

Why cash balance plans are an excellent alternative for SEP IRAs

SEPs are great plans for sole proprietors as long as you are looking to get a contribution range of maybe $10,000 to $30,000 annually. But what if you are looking to get $100,000 plus into a plan? Then a SEP is not a good choice.

Call us a bit biased, but we consider cash balance plans a better solution. This is a result of their higher contribution limits, the ability to combine them with a 401k plan (401k Cash Balance Plan Combo), and their easy portability.

mega rules

For small business owners and self-employed professionals nearing retirement, cash balance plans offer the best way to boost their retirement contributions. Maximum contribution limits are around $300,000, depending on age.

Who should opt for a SEP?

If you’re an owner-only business, self-employed professional, or operate with fewer employees, a SEP IRA plan is a decent choice. These plans do not have strict reporting requirements and are cheaper to manage. Additionally, you do not have to make compulsory annual contributions to the plan.

Bottom Line

Retirement isn’t perhaps what most of the small business owners pay much attention to. They have their business, cash flow, and assets to fall back on. However, a recent survey from Paychex falls in the face of such beliefs, revealing that nearly 39% of small business owners aren’t confident about retiring before 65. Another 30% are only somewhat sure about their financial capability when it comes to retirement.

If you’re a small business owner feeling anxious about your retirement, establishing and contributing to a SEP-IRA can relieve you of these tensions. We have put together this post to discuss some of the essential SEP IRA rules that you must be aware of before opening an account.

Planning for retirement is one of the best financial decisions you can take for yourself and your employees. Choose a plan that maximizes the benefits for your entire team. Ideally, you should go with a retirement vehicle that fulfills your financial objectives while providing maximum tax benefits and savings.

Paul Sundin

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