We previously discussed the factors small business owners should consider when choosing a retirement plan. If you haven’t already read that article, you may want to start there.

If you’re looking to learn more about the Simplified Employee Pension (SEP or SEP-IRA), then you’ve come to the right place.

We had the occasion to interview Michael Raub from New York Life Insurance Company on Tax Talk about this topic. If you haven’t watched that episode yet, here it is.

What is a SEP?

A Simplified Employee Pension (or SEP) is a defined contribution plan. With it, you make annual deductible contributions to your retirement account based on a percentage of your self-employment income or salary (if incorporated).

The SEP is a retirement plan intended for self-employed individuals and small corporate employers. SEPs are well-suited to one-owner and spousal businesses with no other employees. SEP contributions are completely discretionary, which means you or your corporation can contribute little or nothing in years when cash is tight and maximize contributions when cash is flush.

What are the contribution limits?

Like all defined contribution plans, there are contribution limits. The contributions may not exceed an annual dollar cap. In 2020, this amount was the lesser of 25% of your salary (or 20% of self-employment income) or $57,000. In future years, the ceiling might increase as the IRS indexes it
for inflation.

Advantages of a SEP

The are a few clear advantages of a SEP over other types of retirement plans available.

Advantage 1: Late contributions are permitted

You can establish a SEP as late as the extended due date of the return for which you’re making the contribution. That means if you were to receive an extension, you can establish a SEP up to October 15 of the year following the tax year for which you’re making the contribution. This has major implications for retroactive tax planning.

Advantage 2: Easy to Establish

You can establish a SEP at just about any financial institution simply by filling out IRS Form 5305-SEP. This form is fairly simple and can be completed in a matter of minutes.

Advantage 3: No Annual Information Returns Required

Many business owners are frustrated with the information returns required for some retirement plans. That’s not the case with a SEP. Once you set it up, there’s very little you have to deal with. The administration is easy and from that point it’s basically “set it and forget it”.This is a big difference from other types of plans.

Advantage 4: Discretionary Contributions

You can contribute $0 in one year and maximize your contributions in the next. For this reason, you have major flexibility. This is great for businesses with large income swings or for individuals who need total flexibility over their taxable income.

Disadvantages of a SEP

Unfortunately, there’s no perfect retirement plan. While there are several advantages to a SEP, it also comes with disadvantages.

Disadvantage 1: You may have to cover employees

In many cases, if you have employees, you will have to make SEP contributions for them at the same time you make contributions for yourself. Generally, you must contribute the same percentage of salary for your employees as you do for yourself.

You will need to consider this if your goal was to merely maximize your individual contributions. If you do not want to cover your employees, you may not be able to use a SEP.

On the other hand, if you are the only employee, this may not be a problem for you at all.

Disadvantage 2: Other plans may allow larger contributions

Depending on the structure of your business, it is possible that you would be able to contribute more under another type of plan. This depends on your salary or net income and how much you were looking to contribute.

Disadvantage 3: Borrowing is not permitted

Not everyone needs the ability to borrow from their retirement account, but if you do, the SEP may not be the right option for you. Other plans such as a 401(k) do permit borrowing.

The Verdict

Much like all of the types of retirement plans we’re going to analyze, there are situations in which this is the best plan. There are others in which it’s not. This may be the best choice for you if you do not have employees. This may also be the best choice for you if you need to make retroactive contributions.

The only way to determine the best account for you is to discuss it with a tax planning attorney.