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SEPs
As a small-business owner, you may decide that a retirement plan is a good way to recruit and retain employees. You may also want to set up a retirement account for yourself. This educator aims to explain some of the major retirement-plan options available to you and your business.
The simplest retirement plan available is a
Simplified Employee Pension (SEP) plan. A SEP plan requires the least amount of paperwork and offers important benefits to you and your employees. A SEP plan must be in writing and offered to all eligible employees. In most cases, the IRS requires you to document the plan by completing Form 5305-SEP.
With a SEP plan, you open an individual retirement account (IRA) for each eligible employee and make contributions to the accounts. Employees are not allowed to contribute to their SEP-IRAs. The employer is responsible for funding all amounts. Because individual retirement accounts are the investment vehicle, SEP plans are also called SEP-IRA plans. You can establish a SEP-IRA plan up to the date that you file your income tax return for the current year.
Your contributions to employee SEP-IRAs grow tax-deferred the way other qualified retirement accounts do. Similarly, IRS rules for regular and Roth IRAs govern the taking of distributions from SEP-IRAs.
Employees pay an early-withdrawal penalty if they take distributions before they are eligible. In most cases, early distributions are those made before the employee reaches age 59-1/2. SEP-IRAs cannot be designated as Roth IRAs and contributions to a SEP-IRA do not count toward the annual contribution limits of Roth IRAs.
As the employer responsible for contributing to a SEP-IRA plan, you are allowed to deduct the amount of contributions from taxable income. Deductions may be restricted in some cases. The self-employed rate on net earnings governs the amount of contributions to a SEP-IRA plan that you can deduct. For additional information, see IRS Pub. 560.
If you are self-employed, you can also contribute to your own SEP-IRA. You may want to understand what the IRS calls net earnings from self-employment, which determines the amount you can contribute to your own SEP-IRA. The IRS considers you self-employed if you are either a sole proprietor or partner.
Generally, you can contribute up to the lesser of 25% of annual compensation or $45,000 in 2007 to the SEP-IRA of each common-law employee. Contributions made to a SEP-IRA are not included in compensation. (If your retirement plan includes a salary-reduction plan, you may be subject to different limits. See IRS Pub. 560 for more information.)
For 2007, the maximum compensation amount for calculating allowable contributions is $225,000. This amount is indexed from time to time to changes in inflation. As a result, the most you can contribute in 2007 to a SEP-IRA (including your own SEP-IRA) is $45,000.
However, you may choose to sponsor another defined-contribution retirement plan for your employees. In that case, you and the employee can contribute up to the lesser amount of 100% of compensation $44,000, in aggregate, in 2006. For example, if an employee makes $150,000, the most you can contribute in 2006 to her SEP-IRA only, based on the 25% threshold of annual compensation is $37,500 ($150,000*.25).
If, in addition to the SEP-IRA, the employee also has a 401(k) plan, for example, the employee may contribute an additional $6,500 ($44,000 - $37,500), in aggregate.
If you contribute more than the allowable amount to a SEP-IRA, you will be taxed on the amount of excess contributions. The IRS allows you to carry over excess contributions to subsequent years.
Predecessors of SEP-IRAs are called SARSEP plans. SARSEP plans are SEP plans created before 1997 and include a salary-reduction plan. With a salary-reduction plan, an employee authorizes his employer to deposit a portion of pretax salary in a tax-advantaged account.
An employer is allowed to maintain a SARSEP plan if it meets certain conditions. These conditions require that at least half its employees use the salary-reduction plan and that the company had 25 or fewer employees that were eligible to use a SEP-IRA with the employer at any time in the preceding year.
Contribution limits to a SARSEP in 2007 is the lesser of $15,500 or 100% of annual compensation (subject to the same 2007 limit of $225,000). For those who will be age 50 or older during 2007, the contribution limit is the lesser of $20,500 or 100% of annual compensation. SARSEPs are subject to the same contribution limits (called elective deferrals) that govern 401(k) plans and other defined-contribution plans. The Economic Growth and Tax Relief Reconciliation Act authorized increases in elective deferrals.
In addition to the tax-deductible features and low administrative costs, SEP-IRA plans provide employees with immediate vesting and a choice of investment options. You need to weigh the benefits of these features with the restriction on employee contributions. Nonetheless, SEP-IRA plans remain a popular retirement plan for small businesses.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Next Topic: SIMPLEs
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