Simplified Employee Pension Benefits

A simplified employee pension, or SEP, is the simplest, most efficient, and least expensive way for a small business to establish a pension plan for its owners and employees.

What is a SEP? SEPs are essentially individual retirement accounts (IRAs) in that they still act in many respects like pension plans but are much easier and less expensive to administer.

While the "S" in "SEP" stands for "simplified," if you have employees, the process of creating and administering a SEP is not all that simple. If you're interested in establishing a retirement plan, you must consult your financial and legal advisors about how to create and administer the plan. This discussion is designed to acquaint you with some of the major steps in creating and administering a SEP.

A sample SEP is available in the Business Tools area.

Who should set up a SEP? If you fall into one of these categories, you should consider setting up a SEP:

• persons who are regularly employed by a company but who "moonlight" for themselves as independent contractors (In fact, that's why some commentators have referred to SEPs as a "moonlighter's retirement plan.")
• sole proprietors who have no employees — for these folks, establishing a SEP is as simple as walking into a bank or brokerage firm and setting up an IRA account (Just tell them that you want a SEP-IRA.)
• any business that won't know its financial condition until tax time (because SEPs are the only type of employer-sponsored retirement plans that can be established after the employer's tax year has ended, and where contribution amounts can be determined after you see what your profits will be for the year)
• persons or companies providing financial services who might want to use a SEP to provide clients with combined plan and investment services (one-stop shopping for retirement plan and investment services is attractive to busy clients)

Who shouldn't set up a SEP? You should stay away from SEPs if you:

• want to set up a retirement plan that gives you a lot of flexibility; in allowing employers to set up SEPs, Congress traded off flexibility for lower costs and fewer administrative burdens
• foresee wanting to contribute in a given year more than the limit Congress has placed on annual SEP contributions, the lesser of 25 percent of compensation up to $255,000 or $51,000 for 2013 (the lesser of 25 percent of $250,000 or $50,000 for 2012; these amounts may be adjusted annually).
• have high income and you don't want to be limited by the rules that base allowable SEP contributions on compensation

Setting up a SEP. To set up a SEP, you need to take three steps, in the following order:

1. Determine your contributions allocation formula.
2. Establish IRAs for all your eligible employees.
3. Complete IRS Form 5305-SEP (or create your own document with similar information in it), and sign and date it.

If you decide to create a SEP, make joining it a condition of employment for all employees. Otherwise, an employee who chooses not to participate could create adverse tax consequences for those who do participate.

Administration. There are also many administrative issues involved in offering a SEP, including:

• providing employees with information about the SEP
• keeping track of limits on contributions
• knowing who can participate in a SEP
• understanding the rules related to vesting in a SEP