A Simplified Employee Pension allows small businesses and self-employed individuals to contribute before-tax money on behalf of employees. Each eligible employee gets a separate SEP individual retirement account that is similar to a traditional IRA. SEP IRAs have higher contribution limits than those for traditional IRAs.
Employer SEP contributions must go into the SEP IRA, not into a traditional one. Employees can’t contribute to an SEP IRA unless they are self-employed or the business owner. You can have an SEP IRA and regular IRAs, traditional and Roth, and both types can independently receive contributions in the same year. In 2013, an employer can contribute up to $51,000 to each employee, or up to 25 percent of an employee’s salary, whichever is less. This compares with a regular IRA contribution limit of $5,500, or $6,500 if you’re 50 or older.
If you are self-employed, you can contribute your compensation to your SEP IRA, but you must perform a special calculation to figure the maximum amount. This requires you to account for the deductible portion of self-employment tax and the deduction for your SEP contributions. Internal Revenue Service Publication 560 has a rate table and worksheet to step you through the calculation. Deduct your SEP contribution on IRS Form 1040. You can also contribute to your regular IRA separately.
An employee can transfer balances between his SEP and traditional IRA at any time. An employer can’t limit an employee’s right to transfer money from an SEP to an IRA, and the employee need not end employment before making the transfer. A trustee-to-trustee transfer is tax-free. If an employee withdraws SEP money, he must contribute it to an IRA within 60 days or face taxes and possible penalties. The IRS charges a 10 percent penalty on withdrawals before age 59 1/2 that you don't roll over.
SEP and traditional IRAs have similar rules. Both require you to start taking minimum distributions beginning at age 70 1/2. However, an SEP is unique in that it allows you to contribute to employees, including yourself, who are older than this age. The two types of IRAs share the same rules governing prohibited transactions, penalty exemptions and distributions to beneficiaries. An SEP IRA cannot be a Roth account, although you can transfer SEP assets to a Roth IRA. This conversion creates taxable income.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.