Previously I've discussed how much money a small-business owner needs to retire. For many readers this is a wake-up call; retirement planning really can’t wait. The next decision small-business owners need to make is which types of accounts to choose to hold their retirement savings. The options are many. And you even have some choices that aren’t available to the average consumer, such as the Simplified Employee Pension (SEP) plan.
What Is a SEP?
An SEP is setup by a business for the benefit of its employees. (The size of the business doesn’t matter; if you are the only employee you can still setup a SEP.) It is a tax-deferred individual retirement account. This means that you do not pay income taxes on the gains you make while investing the money. You instead pay income taxes when you withdraw the money for use during retirement. Just like other qualified retirement accounts, SEP funds cannot be withdrawn before age 50½ otherwise you will have to pay a 10 percent penalty and treat the distribution like ordinary income increasing your tax liability for the year. In addition to deferring income taxes on investment gains, SEPs have the added benefit of reducing your company’s current taxable income as contributions into an SEP are considered tax deductible.
Unlike other retirement accounts where both the employer and the employee contribute money, an SEP only allows employer contributions—employees cannot deposit money into an SEP. The employer contributions must be uniform for all employees. The typical formula is a percentage of each employee’s salary. So if you plan to contribute 10 percent of your salary into an SEP, you must contribute 10 percent of each employee’s salary into their respective SEPs. The contribution limit for 2012 is 25 percent of salary up to a maximum of $50,000 per employee.
If you pay yourself $200,000 per year, then you can contribute the maximum $50,000 into an SEP, but then you would have to make an equivalent 25 percent contribution for each of your employees that qualify. The IRS requires that participating employees work at least three out of the last five years for your company and earn between $550 and $250,000 for the year.
Flexibility and Easy Set Up
Many business owners that use SEPs see them as a profit-sharing plan for themselves and their employees. While SEPs require equitable contributions to participating employees, the amount can vary from year to year similar to a profit-sharing plan. When your company is doing very well, you may want to contribute the maximum 25 percent of salary. But in lean years you may want to adjust that down to 5 percent or even 0 percent if you have losses. SEPs give you this flexibility which makes them ideal for companies that operate in cyclical sectors, startups or for businesses that otherwise experience tremendous variability in profitability from year to year.
Easy Setup and Flexibility
The investment options and administrative process of an SEP are fairly similar to those of a typical 401(k) plan. The plan administrator (the financial company you hire to manage this for you) will offer a series of investment funds from which you and your employees can build a balanced investment portfolio according to each person’s risk tolerance and financial goals.
The SEP plan is relatively easy to setup with low administrative cost and very few regulatory restrictions. You can set one up by filling IRS form 5305-SEP. It is important to note that for self-employed individuals SEPs can be a little more complex and it is always recommended to work with a tax accountant and understand the IRS code that directs this type of plan.
Read Mike Periu's expert financial advice for small-business owners here.