SEP IRA Rules

For many small businesses and self-employed persons, SEP IRAs offer an easy entry point into tax-deferred retirement planning. SEP IRA rules govern contributions, distributions, eligibility, and structuring of these plans and outline the tax benefits for both employers and employees. SEP IRA plans are attractive to employees because they are completely employer funded and tax deferred, thus providing a solid basis for retirement.

Contributions


SEP IRA rules for employers limit the annual contribution to 25% of the employee’s salary for small businesses and 20% for unincorporated companies. Contributions are not mandatory; companies can contribute in one year and make no contribution in the next. As a result, contributions to SEP accounts are sometimes used as profit sharing methods or incentives for outstanding overall performance. Under the SEP IRA rules for employers, all employees over the age of 21 years who have been with the company for three of the last five years and who earn $450 or more must be included in the SEP plan and be eligible for company contributions. Additionally, the percentage of salary selected as a contribution level must be the same for all employees, including the owner and CEO of the company. The SEP IRA rules for self employed individuals are similar, with contributions limited to 20% of the adjusted net profit, or about 18.6% of the net profit of the business.

Distributions


SEP IRA distributions follow the same rules as those set forth for traditional IRA accounts. Distributions that take place before the account holder is 59 and 1/2 years of age generally incur significant tax penalties of 10% over and above normal taxation rates; exceptions exist for the purchase of the account holder’s first home, certain unreimbursed medical expenses, and qualifying educational costs including tuition, books, and room and board. For distributions, SEP IRA rules for self employed participants are the same as those for participants covered by a sponsoring employer.


Eligibility


The SEP IRA rules for employers state that the choice to make SEP contributions in any given year is discretionary. However, if such contributions are made, the employer must make contributions to all employees who meet certain criteria. The criteria are:
  • The employee must be 21 years of age or older
  • The employee must have been employed by the company for three of the last five years
  • The employee must make over $450 in the current fiscal year
The percentage contributed must be the same across the board; that is, the percentage paid into an employee’s account must be the same as that of all other employees including the most highly-ranked managers within the company.

SEP IRA accounts are structured like traditional IRAs and are subject to most of the same rules and regulations. For most smaller employers, SEP IRAs can provide a valuable way of attracting new employees and keep the current ones happy; they can even provide an added incentive for higher performance levels when used as profit sharing mechanisms. Overall, SEP IRAs are a solid addition to the employee benefit portfolio of small businesses.
Tim Ord
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