In a word, simplicity. SEP (Simplified Employee Pension) IRAs are a low-hassle way for small business owners to obtain tax-advantaged savings for themselves and to contribute for their employees as well. They can be ideal for businesses with fewer than 10 employees, especially when compared with more complex plans such as 401(k) plans. They also offer higher contribution limits than Traditional IRAs, perhaps up to ten times more.
SEP IRA advantages for small companies:
"Contributions are generally tax-deductible to the business. There's also a tax credit aimed at encouraging small employers to start plans."
— Judith Anderson, Senior Vice President, Retirement & Personal Wealth Solutions at Bank of America
- Low maintenance. With little paperwork and low start-up costs, SEP IRAs allow you to contribute for you and your employees and these contributions are generally tax-deductible to the business.
- The ability to contribute generously. The maximum contribution limit for 2020 is $57,000 ($56,000 for 2019) or 25% of your employees' eligible compensation (20% of your net earnings if contributing to your own account as sole proprietor), whichever is less. Contributions can only be made by you as the employer — employees cannot make salary deferral contributions to a SEP IRA — and are generally tax-deductible. Depending upon your circumstances, you may be able to contribute significantly more to a SEP IRA than to a Traditional IRA.
- Adjustable contributions and employee requirements. SEP IRAs offer the flexibility to contribute more when business is strong and cut back when things are tighter. When it comes to deciding which employees are eligible, you can adhere to the IRS's standard requirements or set your own less restrictive rules.
- It helps your workers plan for the long-term. SEP plans offer a wide range of possible investments, and employees can generally transfer or roll over funds to and from a SEP IRA into or from other retirement accounts, consolidating their savings.
- Potential tax benefits. A newly expanded tax credit of up to $5,000 is aimed at small business owners who want to help their employees prepare for retirement, but who may have hesitated due to the perceived expense. The credit (previously capped at $500 annually for three years) kicks in when you establish a workplace retirement plan, and there's an additional new $500 annual credit for up to 3 years if the plan includes automatic enrollment (even if the feature was added after the plan was adopted). The act also includes provisions intended to make it easier, from an administrative standpoint, for small businesses to offer 401(k) plans to their employees.
So what are the limitations of SEP IRAs?
- Only you as the employer (and not your employees) may contribute for yourself and your eligible employees to the plan.
- Participants don't have the option of taking loans from their SEP IRA accounts.
- SEP IRAs have no catch-up provision enabling older participants to contribute more.
Could my company outgrow a SEP IRA?
As your company and staff grow, and your revenue potentially becomes more predictable, you might want to
consider offering a company 401(k) plan. Though these come with greater fees and administrative requirements, 401(k)s can offer some advantages:
- Participants can contribute directly to their own retirement savings through salary deductions — up to $19,500 in 2020, plus an additional $6,500 in catch-up contributions for those 50 and older at any time during the calendar year.
- Participants may generally elect pre-tax or post-tax (Roth) contributions, depending on their situation and preferences.
- Participants may take loans or hardship withdrawals from their savings, if offered under the plan.
When Should I Consider a Company 401(k)?
As your company grows and your revenue becomes more predictable, it may be time to consider the significant advantages a 401(k) can offer your employees. Here are a few.
Employees can:
Contribute
directly from their
pay — up to
$19,500 in 2020
Elect
pre-tax
or post-tax (Roth)
contributions Footnote 1
Take out
loans or hardship
withdrawal
from their savings Footnote 1
Footnote 1 if allowed under the plan
Caption: Graphic illustrating the advantages a company 401(k) can offer the employees of a small business that has shown growth and begun to establish a more predictable revenue stream. Employees can contribute directly to their 401(k) from their paycheck, elect pre-tax salary deferrals and may be able to make post-tax contributions and take out loans or a hardship withdrawal from their savings.
In the end, understanding your choices can help you find the approach that helps your valued workers prepare for retirement, while also giving you and your company the opportunity for a healthy financial future.