Why a SEP IRA is a Great Starter Option for Small Businesses

When it comes to setting up a qualified retirement plan, business owners have several options. For business owners who devote their lives to building a business, doing nothing at all is not an option. To forego the time value of accumulating capital for retirement as well as the current tax savings from contributing to a qualified plan could risk their financial security. To start with, it may be important to keep it simple, which is why many small business owners start out with a SEP IRA.

When a SEP IRA may be the Best Option

The majority of small business owners are "solopreneurs," typically starting out with no employees but with plans to hire some as their business grows. The first employees they hire may or may not be full-time, but they are usually lower paid than the business owner. With a SEP, which stands for "simplified employee pension," a business owner can easily establish a plan that is simple and inexpensive to administer while providing significant retirement savings and tax reduction opportunities. As with a traditional IRA, contributions to a SEP IRA are tax-deductible, and the savings grow tax deferred.

With a SEP IRA, the employer makes contributions on behalf of employees, which some small business owners may view negatively. However, contributions are not mandatory. The employer does not have to make employee contributions in any given year, but that precludes the employer from making a contribution for himself.

Employers can exclude employees who have yet to reach age 21 and have not worked for the employer in at least three of the last five years. Also, employees must earn at least $600 during the year to be eligible for a contribution.

When implemented effectively, employers can use the potential for SEP contributions as an incentive to boost productivity. Higher productivity leads to higher profits, which are used to make SEP IRA contributions.

How a SEP IRA Works

To establish a SEP IRA, all an employer needs to do is complete IRS form 5305-SEP and formally inform employees of the plan. There is no need to administer the plan because employees set up their own self-directed IRA, which they manage. The employer has until the April 15 tax filing deadline to contribute for the prior year.

For the tax year 2020, contributions are limited to the lesser of

1. 25% of the employee’s compensation or
2. $57,000

There is no catch-up provision for employees age 50 or older.

SEP IRA is a Great Starter Option

The SEP IRA is an ideal "starter" employer-sponsored qualified plan for small business owners who do not plan on hiring more than a few employees. However, when the business takes off, and the need to staff up increases, a SEP IRA can become more expensive than other plan options, such as a SIMPLE IRA. A SEP IRA does allow for the largest tax-deductible contribution ($57,000 in 2019) by the employer. So, if the business keeps growing its profits, the business owner may benefit more from a SEP IRA.