The SEP-IRA is a nice plan but very few people self-direct this type of plan. I am sure that it is because most people are enticed by many of the benefits of the 401(k) plan….a Solo 401(k) or multi-participant 401(k). Remember that the SEP-IRA is…still an IRA. Therefore, while it has some wonderful features, it is part of the IRA family and is limited to some of the same limitations (e.g., no loan provisions) as an other IRA.
Simplified Employee Pension (SEP-IRA)— Believe it or not, many people believe that the SEP-IRA actually has the moniker of a “Self-Employed Pension” because so many self-employed individuals utilize this type of plan. However, the correct terminology for the SEP-IRA is a Simplified Employee Pension. It fits the name as the SEP-IRA is intended to be simpler in establishment, operation and administration than the 401(k) plan. And, there is some truth in that, especially for a multi-participant 401(k) plan.
The IRS identifies characteristics of a SEP-IRA to include:
- Available to any size business
- Easily established by adopting Form 5305-SEP, a SEP prototype or an individually designed plan document
- If Form 5305-SEP is used, cannot have any other retirement plan (except another SEP)
- No filing requirement for the employer
- Only the employer contributes
- To traditional IRAs (SEP-IRAs) set up for each eligible employee
- Employee is always 100% vested in (or, has ownership of) all SEP-IRA money
Why Might an Employer Elect a SEP-IRA?
Probably the SEP-IRAs most friendly feature is the relative ease of establishment and administration. While the plan requires a written document to establish, many traditional SEP-IRA custodians have these documents in place for their clients. The SEP-IRA has nearly the same contributions maximum limits of the 401(k). SEPs have many of the characteristics of qualified plans but are much simpler to establish and administer. There are no annual reports that must be filed by the employer for the plan.
The SEP-IRA can be established for any business…self-employed or with participants. Contributions are based on a percentage (up to 25%) of the participant’s income up to a maximum of $52,000. The contributions go directly into a separate IRA account for the participant. All contributions are made by the employer and the participant is able to choose their investments offered by the plan.
Individuals may ask why they shouldn’t set up a self-directed SEP-IRA if, generally speaking, it may be easier to establish such a plan. compared to others (e.g. 401(k)). And, keeping in mind that a self-employed individual would only be responsible for compliance to the plan for themselves, and not other participants.
Well, for a self-employed individual, the establishment, operation and reporting requirements for a Solo 401(k) are minimal. And, one still has the benefits of a 401(k) plan over the SEP-IRA. But, beyond the benefits of the Solo 401(k), are there disadvantages of the SEP-IRA?
First, the business owner will need to make equitable contributions for almost all employees of the business. And, it doesn’t matter if the employer is concerned about employee turnover…all employees are 100% vested immediately. That can certainly rankle an employer if they have continual turnover in employee retention. A 401(k) plan, in contrast, can legally limit (to a degree) when employees enter the plan and can establish a vesting schedule for employees. This is not the case with the SEP-IRA.