A Simplified Employee Pension (SEP) is a special type of IRA that can be established by your employer or by you, if you are self-employed. Designed for small businesses, SEPs have many of the characteristics of qualified plans but are much simpler to establish and administer.
Any Employer Can Establish a SEP
Under a SEP, each participant has his or her own individual retirement account to which the employer contributes. The contributions are excluded from the participant's pay and are not taxable until they are distributed from the plan. If you are self-employed you may establish a SEP for yourself, even if you have no employees.
The advantage of a SEP over a regular IRA is that the contribution limits are higher. In general, the contribution can be as much as 25% of your annual compensation, up to a maximum contribution of $54,000.
The disadvantage of a SEP from an employer's standpoint is that an employer that establishes a SEP is required to make contributions on behalf of virtually all employees. Moreover, the employees must be 100% vested at all times. Those can be costly requirements for small employers whose workers often include many short-term part-time employees. In contrast, a 401(k) plan, as well as other qualified plans, can extend the period before an employee is fully vested.
A SEP is established by adopting a SEP agreement and having eligible employees establish SEP IRAs. There are three basic steps in setting up a SEP, all of which must be satisfied.
A formal written agreement must be executed. This written agreement may be satisfied by adopting an Internal Revenue Service (IRS) model SEP using Form 5305-SEP, Simplified Employee Pension - Individual Retirement Accounts Contribution Agreement. A prototype SEP that was approved by the IRS may also be used. Approved prototype SEPs are offered by banks, insurance companies, and other qualified financial institutions. Finally, an individually designed SEP may be adopted.
Each eligible employee must be given certain information about the SEP. If the SEP was established using the Form 5305-SEP, the information must include a copy of the Form 5305-SEP, its instructions, and the other information listed in the Form 5305-SEP instructions. If a prototype SEP or individually designed SEP was used, similar information must be provided.
A SEP IRA must be set up for each eligible employee. SEP IRAs can be set up with banks, insurance companies, or other qualified financial institutions. The SEP-IRA is owned and controlled by the employee and the employer sends the SEP contributions to the financial institution where the SEP IRA is maintained.