Common Questions about SEP IRA's

What is a SEP IRA?

A SEP IRA is a type of individual retirement account that has different tax rules than other types of IRA's. With a few exceptions, a SEP IRA is subject to the same rules as a Traditional IRA. One of the differences is that a SEP IRA is set up by an employer for employees, or for himself if he is self-employed. Traditional IRA's are not set up by employees. As a result, SEP IRA's have rules as to who is an eligible employee, employer contribution limits, and so forth. Self-employed individuals with no employees make up the bulk of those establishing this type of IRA, although some employers with employees do have SEP IRA's.

How does a SEP IRA work?

An employer sets up a SEP IRA for all of his eligible employees at a bank or brokerage firm, and for himself if he is self-employed. The employer then makes contributions to the employees' SEP IRA's. Employees do not make contributions to their SEP IRA's, unless they are self-employed. Because of this restriction, SEP IRA's tends to be used mainly by self-employed persons and not by employers with other employees. Contributions to SEP IRA's are the property of the employees from the moment that the money is deposited into their account, and the employer generally cannot take any of the money back.

Who is an eligible employee?

To qualify for participation in a SEP IRA, an employee must:

• Be 21 years of age
• Have worked for the employer for at least 3 of the last 5 years
• Have received at least $500 from the employer in compensation in 2007.¹

Are any employees excludable from a SEP IRA?

The following two categories of employees can be excluded from an employer's plan:

1. Employees who are covered by retirement benefits in a union agreement
2. Nonresident aliens who received only personal services compensation.²

How does an employer set up a SEP IRA?

There are three things an employer must do set up a SEP IRA plan:

1. The employer must provide a formal, written agreement that he will provide a SEP IRA for all eligible employees.
2. The employer must provide each eligible employee information about the SEP IRA plan.
3. The employer must set up a SEP IRA for each eligible employee.³

How can an employer contribute to a SEP IRA?

Only money can be contributed to a SEP IRA. Property contributions are not allowed. Employers do not have to contribute to SEP IRA's every year but when contributions are made, they must be made based on an allocation formula that is written down and does not favor highly compensated employees. If an employer does make contributions, he must contribute to each eligible employee's SEP IRA. Even if an eligible employee has quit or died during the year, the employer must make contributions to his SEP. An employer must make contributions by the due date of that year's tax return.⁴

Are there limits to contributions?

Yes, there are limits to contributions an employer can make to a SEP IRA. The contributions cannot exceed certain income limits, and contributions must be made by a certain date.

Maximum Contributions

2007 contributions cannot exceed 25% of an employee's compensation, or $45,000. For example, Susan was an eligible employee in 2007 and received a salary of $40,000. Her employer's contribution for 2007 cannot exceed $10,000, which is 25% of her salary.

There is a compensation limit to figuring contributions. Only the first $225,000 of compensation in 2007 can be considered when figuring contributions.

If an employer contributes to more than one defined contribution plan, the $45,000 limit applies to the total of all contributions to all defined contribution plans.⁵

Date Restrictions

Contributions must be made by April 15 of the year following the year for which the contribution is going to be made. For example, contributions for 2007 can be made until April 15, 2008. If April 15 happens to fall on a weekend, the next weekday following April 15 is the due date. The due date is meant to coincide with the due date for filing your federal income tax return.⁶

When can I withdraw my money from a SEP IRA?

SEP IRA's follow the Traditional IRA rules for withdrawal of funds. You can withdraw your money at any time. However, if you withdraw money before reaching age 59 ½, you will be subject to a 10% tax penalty on the money you withdraw. For example, if you withdraw $500 from your SEP when you are age 45, you will generally have to pay $50 to Uncle Sam as a tax penalty. You may not owe the 10% penalty if you qualify under the early distribution rules.⁷

What is an early distribution?

Again, the SEP IRA is subject to the distribution rules that Traditional IRA's are subject to. An early distribution is any money you withdraw from your SEP IRA before reaching age 59 ½. When you reach age 59 ½, withdrawals are automatically tax-free. Early distributions are subject to a 10% tax penalty, but if you withdraw money for any of the following situations, you will NOT owe the 10% tax:⁸

1. You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
2. The distributions are not more than the cost of your medical insurance.
3. You are disabled.
4. You are the beneficiary of a deceased IRA owner.
5. You are receiving distributions in the form of an annuity.
6. The distributions are not more than your qualified higher education expenses.
7. You use the distributions to buy, build, or rebuild a first home.
8. The distribution is due to an IRS levy of the qualified plan.
9. The distribution is a qualified reservist distribution.

How do you maintain a SEP IRA?

Employers make contributions each year to employee's SEP IRA's at their discretion, so one year your employer may make a contribution and another year he may not. Once the SEP IRA has been established, the employee is 100% vested, so all the assets in the account are his. The employer cannot take back any money that has been contributed, so there really is not any maintenance of a SEP IRA. However, there may be fees associated with the bank or broker that is custodian of the SEP IRA, so check with the financial institution where the SEP IRA is held for more information.

Can I participate a SEP IRA if I already participate in another retirement plan, such as a pension plan or profit sharing plan like 401(k)?

Yes, you can participate in a SEP IRA, but if you also contribute to another defined contribution plan like a 401(k) then the annual contribution limit includes contributions to both plans. For example, Janet received $200,000 in compensation in 2007, and she contributed $6,000 to her 401(k) plan. The annual contribution limit to a SEP is the smaller of $45,000 or 25% of compensation. 25% of Janet's compensation is $50,000, so she exceeds the limit. However, her employer cannot contribute the full $45,000 to her SEP IRA because she also contributed $6,000 to her 401(k). Janet's employer can contribute up to $39,000 to her SEP IRA in 2007, which is the $45,000 limit minus the $6,000 contribution to her 401(k).⁹

How does a SEP IRA affect my federal income tax?

Tax Consequences for the Employee

An employer's contributions to an employee's SEP are excluded from the employee's compensation, so in box 1 on an employee's W-2, contributions to a SEP are not included. For example, if the employee had $30,000 salary in 2007 and the employer contributed $500 to that employee's SEP IRA, box 1 should only show compensation to be $30,000, not $30,500. Amounts contributed to a SEP IRA are also not included when Social Security and Medicare taxes are calculated.¹⁰

Tax Consequences for the Employer

An employer can deduct contributions made to employees' SEP's from his business income. The deduction is the smaller of:

1. Total contributions, or
2. 25% of the compensation paid to employees in 2007, not exceeding $45,000 for each employee.¹¹

If the employer is self-employed and makes contributions to his own SEP, the amount he can deduct is different from the deduction for employee contributions. However, the calculation can get tricky, so we will not discuss it here, but it is based on a rate table and formula that can be found in Chapter 5 of IRS Publication 560: Retirement Plans for Small Businesses.¹²

Are there any other tax penalties that can be associated with a SEP IRA that other IRA's are not subject to?

Yes, the SEP IRA can be subject to an additional 10% excise tax if contributions are made that exceed the deduction limitations discussed in the previous answer.¹³

Do I have to withdraw money at a certain age?

Yes, you must start withdrawing money by April 1 of the year following the year in which you reach age 70½, or you will be subject to a tax penalty. Also, you must take a minimum distribution each year that is figured by a formula.¹⁴

What is a minimum distribution from a SEP IRA?

You must begin receiving distributions from your SEP IRA at age 70 ½. The minimum distribution is the amount of money that you are required to take out. It is based on a formula that divides the end of year IRA balance by a life expectancy figure found in Appendix C of IRS Publication 590 “Individual Retirement Arrangements”.¹⁵ If you do not take the minimum distribution, you may be subject to a 50% tax penalty on the amount you should have withdrawn. For example, if your minimum distribution was $1000 and you did not take it, you may have to pay Uncle Sam $500 as a penalty.¹⁶

What happens to my SEP IRA after I die?

You may designate primary and secondary beneficiaries who will inherit your SEP IRA after your death. A primary beneficiary is the person who will receive the SEP IRA after your death, usually a spouse or children. In the event that your primary beneficiary dies before you do, you can name a contingent beneficiary who will inherit the SEP IRA if the primary beneficiary is deceased.¹⁷

This article covers the basics of SEP IRA's and is meant to be an introduction to the main questions you may have about them. Use it as a starting point for learning about SEP IRA's, but since it is not meant to be a comprehensive guide, check with your financial advisor if you need further clarification about your specific situation.

References

United States Internal Revenue Service, Publication 590, Individual Retirement Arrangements (IRAs),”Traditional IRA's”, http://www.irs.gov/publications/p590/ch01.html

United States Internal Revenue Service, Publication 560, Retirement Plans for Small Businesses, “Simplified Employee Pension (SEP)”, http://www.irs.gov/publications/p560/ch02.html

United States Internal Revenue Service, Publication 15-A, Employer's Supplemental Tax Guide, “Wages and Other Compensation”, http://www.irs.gov/publications/p15a/ar02.html#d0e1238