What Is A SEP IRA and How Does It Work

SEP-IRA Retirement Plans for Small Business

A SEP IRA, SEP stands for Simplified Employee Pension, is a type of retirement plan that can be offered by businesses that wish to be able to make company contributions to employee retirement accounts. An individual cannot open a SEP IRA unless they own their own business, in which case, the SEP IRA is still technically offered by the business to the individual.

The way a SEP-IRA works is that an employee opens an account as a SEP account. This is done by filling out the IRA custodian’s paperwork and supplying them with a form from the business, typically a 5305-SEP form from the IRS.

Once the account is opened, contributions are made directly into the employee’s SEP-IRA account by the employer as part of the payroll process. The funds are never distributed to the employee. In addition, employees may, at their own option, choose to have money deducted from their paycheck to be invested in the same SEP-IRA account.

In order to meet all the IRS requirements as a tax advantaged retirement plan, a SEP must be offered to all eligible employees. An eligible employee is any person who is at least 21 years of age, has worked for the employer for 3 of the last 5 years, and earned at least $500 in compensation for 2008, although the employer may use lower criteria if they choose to do so.

The employer may contribute up to 25% of the employee’s compensation, but not more than $49,000 in 2009. However, most SEP plans are required to contribute the same percentage to every employee. This prevents the owner from setting up a plan to primarily benefit himself and other high level employees.

The big advantage of a SEP-IRA is that unlike other retirement plans, the employer does not have to contribute to the plan every year. Thus, an employer can contribute as much as possible, but during a bad year or when money might be tight, the employer can forgo making contributions.

Generally, employees offered a SEP-IRA are not offered a 401(k) plan. But, the contributions the employee makes to the SEP plan offer the same pre-tax treatment as those made to a 401(k), so it is often a good option for those who work at smaller companies.