According to the Small Business Administration, there were more than 30 million small businesses in the United States in 2018, and they employed nearly half (47.5%) of all workers.1 The collective role these enterprises play in the economy is truly mind-bending. What may be even more difficult to wrap your head around is the scale of the opportunity it may present for financial professionals.
In particular, financial professionals who help small business owner clients understand their retirement plan options may be in the best position to make the most of these circumstances.
According to research conducted by The Pew Charitable Trust, only 53% of businesses with five to 250 employees offer a retirement plan. Interestingly, 37% of those who do not offer a plan cited cost, and 22% indicated a lack of organizational resources as the primary reasons.2
Controlling costs and optimizing resources are top of mind for almost every small business owner. And retirement plans come with inherent complexities. The good news, however, is that the IRS provides a few relatively straightforward solutions that may allow business owners to offer a retirement plan without the expense and administrative burden typically associated with many qualified plans. One such option is the Simplified Employee Pension (SEP) IRA.
The first step in establishing a SEP IRA is choosing a financial institution to act as a trustee of the SEP IRA accounts for each participant. A written agreement for the SEP IRA must be created and kept on record as a plan document. Many business owners will use the IRS’s model plan document – Form 5305 SEP. In some instances, a prototype or individually designed document must be used.
Proper notification then has to be made to each participant regarding the plan’s creation, requirements for receiving an allocation, and the basis on which the employer contribution will be allocated.3 The last step is setting up the SEP IRA account by or for each eligible participant at a qualified financial institution such as an insurance company or bank. The financial institution will provide statements each subsequent year and whenever a contribution is made. SEP IRAs can be established all the way up to the business’s tax filing deadline (including extensions).
Contributions to SEP IRAs cannot exceed the lesser of 25% of compensation or $56,000 for 2019 (up from $55,000 in 2018). For business owners and self-employed individuals, the compensation figure is determined by calculating adjusted net earnings, which is the net of revenue and expenses minus half of self-employment tax.
Employees are not able to make contributions to their own IRAs as a part of the SEP established by their employer. However, if the SEP permits, the IRS allows employees to make traditional IRA contributions to the same IRA being used for the SEP plan. Normal traditional IRA rules still apply in this instance.
While employers have discretion over the amount and frequency of the contributions they make to the SEP, the nondiscrimination rules employers must follow are strict and must be adhered to closely. Essentially, employers much contribute the same percentage of salary to each eligible employee’s account, including their own.
For example, an employer may decide to make a 10% contribution of employees’ salary one year and then, depending on business performance and other prevailing factors, make a 15% contribution the next year. In each year, the employer would be able to make the same 10% and 15% contributions to his or her own SEP IRA within the stated guidelines, respectively. Catch-up contributions for SEP IRA participants who are 50 and older are not allowed. IRS Publication 590-A is the best resource for more detailed explanations of SEP IRA contribution rules.
SEP IRAs follow the same distribution rules as traditional IRAs. When money is taken out, it is taxed as ordinary income in the year in which it is received. Distributions are optional when the SEP IRA account holder is between the ages of 59½ and 70½. Unless an exception is met, distributions taken prior to when the account owner is 59½ are subject to a 10% penalty in addition to regular taxes.
Required minimum distribution (RMD) rules must also be followed. Beginning no later than April 1 following the year in which a SEP IRA owner reaches age 70½, he or she must begin taking distributions. The RMD amount is based on the end-of-year (December 31) account value from the previous year and the account holder’s life expectancy. Either the IRS Uniform (Table III) or the IRS Join Life and Last Survivor (Table II) is used to determine the life expectancy factor. In some cases, if a participant is working past age 70½, it is possible he or she has to take distributions pursuant to RMD rules, while still receiving employer contributions into the plan. The full list of rules regarding IRA distributions can be found in IRS Publication 590-B.
Investment flexibility is one of the biggest advantages of SEP IRAs. Here again, SEP IRAs follow the same rules as traditional IRAs. Account holders have the opportunity to work closely with their financial professionals to take advantage of the array of investment options available in the marketplace. This typically enables participants and financial professionals to design and implement an investment strategy that meets the unique investment objectives of each SEP IRA owner.
The tax-deferred nature of SEP IRA accounts also make them ideal platforms for creating an optimal asset mix relative to the client’s overall portfolio and exploring options related to retirement income.
The bottom line
A developed proficiency in SEP IRA rules can create tremendous opportunities for financial professionals who are looking for ways to help self-employed and small business owner clients. Many financial professionals and their small business owner clients often discover that SEP IRA’s can be a great fit for a growing business because they’re flexible and easier to manage than they may have initially thought. SEP IRA rules should still be followed closely because noncompliance can lead to costly penalties and time-consuming correction processes.
Neither Transamerica nor its agents or representatives may provide medical, tax, investment or legal advice. Anyone to whom this material is promoted, marketed, or recommended should consult with and rely on their own independent tax and legal advisors and financial professional regarding their particular situation and the concepts presented herein.