Let SEPs Put Some Pep into Your Retirement Program
VCE Agricultural and Applied Economics: Management and Production Economics February1996
By Alex White, Dixie Watts Reaves, and David M. Kohl
In the previous issue we discussed the fundamentals of Individual Retirement Accounts (IRAs). In this issue we will discuss the basics of Simplified Employee Pension plans (SEPs), a powerful retirement tool specifically geared towards self-employed persons, including agricultural producers and small business owners. As with any investment, please consult a financial authority (certified financial planner, banker, etc.) for complete, up-to-date details concerning the tax advantages and policies associated with the investment.
Who Uses SEPs
A 1995 study of 336 agricultural producers from Virginia, Washington, Iowa, Nebraska, and Kansas, conducted by J.R. Marker and Dr. David M. Kohl of the Agricultural and Applied Economics Department at Virginia Tech, indicates that SEPs are utilized by very few farm families. Less than 10 percent of the respondents utilize SEPs. Common reasons for not using SEPs include a lack of understanding of the programs and the fact that, in many cases, the employees of the farm or business must be included in the SEP.
A SEP is an IRA-based retirement plan developed for self-employed persons and their employees. Unlike an IRA, you can establish or continue to make contributions to a SEP after you reach the age of 701/2. Any self-employed person can establish a SEP, even persons who are covered by a qualified retirement plan through another job. For example, Jennifer is an administrator for a local business, where she is covered by a qualified profit-sharing plan. Jennifer also operates a photography business on a part-time basis. She can establish a SEP to shelter a portion of her self-employment earnings.
Employee Eligibility Requirements
A SEP must include all eligible employees (including the owner) of the business. The IRS has established minimum requirements for eligibility: the employee 1) must have worked for the employer for some period of time during the past year, 2) has reached age 21, 3) has worked for the employer in at least three of the past five years, and 4) has received compensation for the year of at least $385. The employer can set eligibility requirements for their employees, as long as they conform to the IRS requirements stated above.
How to Establish a SEP
To establish a SEP the employer must develop a written plan outlining the details of the SEP. This written plan specifies eligibility requirements, contribution policy, and other administrative details. The next step is to establish IRAs (SEP-IRAs) in the name of each eligible employee and the employer. Because the IRAs are in the employee's name, the employee is responsible for overseeing the investments made with the contributions. Thus, after the employer makes the annual contribution, he/she has no fiduciary responsibilities with the IRAs. The employee has complete control over the funds in the IRA.
Tax Advantages and Contribution Limits
There are tax advantages to establishing SEPs. As with IRAs, the earnings of the account grow tax-deferred until they are withdrawn from the IRA. At that time, the funds are taxed as ordinary income without penalty as long as the employee is over age 591/2. Further, employer contributions to a SEP are a tax-deductible expense. Every dollar contributed to a SEP, up to a specified level, reduces the business's income taxes. The maximum amount an employer can contribute to his/her SEP in any year is the lesser of $22,500 or 13.04 percent of net self-employment earnings (self-employment income minus one half of self-employment taxes). These contributions are subject to self- employment taxes (FICA), but they are not subject to income taxes. For example, if Jennifer earns $30,000 this year in her part-time business, her maximum annual SEP contribution for this year is approximately $3,900 (ignoring self-employment taxes). This contribution is also a tax-deductible expense for Jennifer. If the employer is covered by another qualified retirement plan, the maximum combined annual contributions to all plans cannot exceed the lesser of $22,500 or 15 percent of earnings. For example, if Jennifer contributes $3,900 to her SEP, the maximum amount she can contribute this year to the profit-sharing plan from her full-time job is $18,600.
The maximum annual contribution an employer can make to an employee's SEP-IRA is the lesser of $22,500 or 15 percent of the employee's earned income. The amount of the contribution is included in the employee's gross income for the year. The employer's annual contribution on the employee's behalf is a tax-deductible expense for the business.
SEPs typically are not combined with other retirement plans, except for the regular IRAs. All employees and the employer are entitled to a regular IRA in addition to the SEP. Contributions to the regular IRA are limited to the lesser of 100 percent of compensation or $2,000 per year. As with IRAs, the funds invested in your SEP may or may not be guaranteed. If your funds are invested in CDs they are probably insured through FDIC or FSLIC. However, if your funds are invested in mutual funds, or stocks and bonds, those funds are not guaranteed. Thus, you may actually lose principal if you invest in non-insured instruments.
SEPs are rapidly replacing Keogh pension plans as a retirement tool for self-employed persons. The reason for this is that SEPs involve less paperwork and administrative duties than Keoghs, and SEPs tend to have lower costs to the employer than Keoghs. SEPs provide dramatic benefits for the employer and the employees by allowing substantially greater annual contributions than regular IRAs, and by allowing these annual contributions to grow tax-deferred until they are withdrawn. SEPs also provide tax advantages for the owner of the business by allowing deduction of the annual SEP-IRA contributions from the taxable income of the business.
From the employer's standpoint, the disadvantages of a SEP are similar to the disadvantages of an IRA. First, where do you get the funds for the annual contributions? Secondly, the funds in your SEP-IRA are typically inaccessible until you reach age 591/2. You can withdraw funds from the SEP-IRA before that age, but you will incur a 10 percent penalty as well as ordinary income taxes on the amount withdrawn (there are exceptions, such as death or disability). Further, you typically cannot borrow funds from your SEP, as you may be able to do from a 401(k) plan (to be discussed in the next issue).
In summary, SEPs are a very powerful retirement tool for self- employed persons. Aside from providing significant tax advantages, SEPs are capable of providing for a comfortable retirement. Remember, you must have cash flow during your retirement years. If you are planning on selling your farm or business to generate retirement income, you must consider how much income you will generate after- taxes from the sale of the business, as well as how long it will take to sell the business. Use of retirement tools such as SEPs reduces the pressure to sell or transfer the business in order to acquire living funds during your retirement years.
The next article in this series will discuss the basics of retirement plans called salary reduction plans [401(k) and 403(b) plans].
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