As the economy improves more small business owners find they are able to contribute to a retirement plan but are unsure what plan options are available to them. A Simplified Employee Pension (SEP) plan may be the answer to a self-employed individual’s retirement and tax planning.
Your overall financial condition, both present and future should be reviewed before establishing a retirement plan. Some factors to consider when setting up a retirement plan are: the tax savings you will achieve, your ability to make future contributions, whether you have or will have employees that must be covered under your plan, and costs for administration of the plan and filing of IRS forms.
A SEP is fairly easy to adopt and the requirements relating to participation are straightforward. Generally, completion of Form 5305-SEP “Simplified Employee Pension –Individual Retirement Accounts Contribution Agreement” is used to adopt a SEP. The form should be maintained by the business owner and a copy provided to any employee covered by the SEP, however the form is not filed with the IRS. A SEP may also be adopted with the use of a master or prototype plan sponsored by a bank or brokerage company. Unlike a traditional profit sharing plan, a SEP does not have to be adopted by the taxpayer’s year-end. A taxpayer has until the due date for filing his/her return, including extensions to adopt and fund the plan. Thus, a self-employed individual who has filed an extension of time to file their 2012 return has until October 15, 2013, to establish a SEP and make a tax-deductible contribution. A SEP contribution is not required to be made every year. For example, you may make a contribution for the 2012 tax year and decide due to a downturn in business in the 2013 tax year to forego a contribution for that year.
An IRA is set up for each participant to receive their share of the contribution. So, if a self-employed individual has no employees, an IRA is established solely for the business owner. However, if the business has employees who are eligible to participate in the plan, an IRA is established for each eligible employee.
A SEP must cover any employee who has reached age 21, has worked for the owner during at least three of the preceding five years, and has received at least $550 in current compensation. All contributions made on behalf of an employee are immediately vested and thus non-forfeitable. Many self-employed individuals with regular employees may find these requirements costly and thus look to establish a retirement plan which provides a greater barrier to participation in the plan.
The contribution limit for 2012 is 25% of compensation limited to $250,000. The contribution limit for self-employed individuals is based upon net self-employment income after the SEP contribution deduction and the employer equivalent deduction for self-employment tax. For example, assume Brandon reports $60,000 of net income on Schedule C for the tax year 2012. His self-employment tax deduction is $4,253 (one-half of his self-employment tax). If he decides to contribute at the maximum rate of 25% (effectively reduced to 20% as a result of including the deduction in the computation), his contribution deduction is determined as follows:
|Net earnings from self-employment||$60,000|
|Minus SE tax deduction||(4,253)|
|Net income for SEP funding||55,747|
|Reduced contribution percentage||.20%|
|Maximum deductible SEP contribution||
Upon the adoption of a SEP the owner must give employees notice that a SEP has been established and the requirements that an employee must meet to receive a contribution and the manner by which an employer contribution is to be allocated to employees. An annual disclosure statement showing any contribution made to the participating employee’s IRA is required. These requirements are simpler and less costly than those found in other retirement plans.
If you are a self-employed individual who wants to save for retirement and reduce your current tax liability a SEP may meet your objectives. If you would like to discuss how you may benefit from a SEP or other retirement plan, call the tax professionals at East Coast Tax Consulting Group for a retirement planning consultation.