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Retirement Perspectives

SEP IRAs can help self-employed individuals and small businesses save more for retirement while reducing taxable income.

SEP [Simplified Employment Pension] IRAs, which were designed to provide self-employed individuals and small-business owners with the ability to save for retirement on a tax-deferred basis, may appeal to business owners who want to help their employees save, but do not want the cost or administrative and fiduciary responsibilities to assist with a qualified plan. Instead, SEP IRAs are low-cost, easy to establish and maintain, and allow the business owner to make discretionary contributions, based on the fortunes of the business. For business owners, the contributions they make to their own and to each eligible employee’s SEP IRA account generally are tax-deductible.

More important, sole proprietors and small-business owners who missed the deadline to set up a qualified retirement plan for the 2017 tax year still have time to establish a SEP IRA and claim the tax deduction for the 2017 tax season.

Establishing a SEP IRA
Any employer, including self-employed individuals, can establish a SEP. While the employee owns and controls the SEP IRA, workers are not permitted to contribute their own money to their SEPs. However, employer contributions can be commingled with workers’ traditional IRA accounts, but not with Roth IRAs or SIMPLE IRAs. SEP IRAs can be converted to Roth IRAs at any time.

Receiving a SEP allocation does not affect the amount an individual can contribute to a traditional or Roth IRA, although the investor may be not be able to realize a tax deduction as he/she could with a contribution to a traditional IRA. In other words, receiving a SEP contribution could prevent an investor from making a deduction contribution to a traditional IRA, whereas, Roth IRA contributions are always made on an aftertax basis. 

Because employees establish their own accounts, they have the flexibility to choose from a diverse universe of investment options offered by the IRA custodian. Employees are not restricted to a set menu of investments typically selected by their employer, as would be the case with a qualified plan.

Deadlines
SEP IRAs can be established and funded as late as the business's tax-filing deadline plus extension. For example, sole proprietors have at least until April 15 to establish a SEP IRA for 2017, and as late as October 15, 2018, if they are on extension.

Contributions
SEPs are funded solely with employer discretionary contributions. Contribution limits are generous, allowing an owner to shelter and potentially deduct 25% of compensation or $54,000 (whichever is less) in 2017. There is a slight increase to $55,000 for 2018. The percentage is reduced to 20% for business owners who are self-employed. Although SEP contributions are discretionary, they must be based on a written allocation formula, and every employee must get the same rate of contribution. Further, all contributions must be fully vested upon receipt. Employers are not permitted to defer any of their compensation.

As previously mentioned, receiving a SEP allocation does not affect traditional/Roth IRA limits. In other words, having a SEP IRA does not preclude the ability to fully fund a separate traditional or Roth IRA assuming eligibility has been satisfied.

Tip: All SEP contributions must be deposited into a traditional IRA established by the employee. SEP contributions cannot be contributed to a Roth or SIMPLE IRA.

Employer Liability
Unlike employers who offer qualified plans, such as 401(k)s, businesses that offer SEPs have reduced oversight and fiduciary obligations because SEPs are generally not subject to the fiduciary standards of the Employee Retirement Income Security Act (ERISA).

Reporting
Employers simply report SEP contributions on a business’s tax return. For individual participants, the IRA custodian reports SEP IRA contributions on IRS Form 5498 and distributions on IRS Form 1099-R. Keep in mind that the custodians report contributions in the year they are received. If an employer makes a 2017 contribution in 2018, the amounts reported by employees on their individual returns may not coincide with the employer’s filing. Employers are advised to keep their own records of SEP contributions.

Setup
Establishing a SEP IRA is straightforward. In most cases, the employer completes IRS Form 5305-SEP, while eligible employees establish their own individual SEP IRA. Employees generally are eligible to participate if they are at least 21, worked for the business in three of the last five years, and earned at least $600 for the year.

Employer Eligibility
Virtually any type and size of employer can establish a SEP IRA, including corporations, partnerships, self-employed, LLCs, and nonprofit organizations. If an employer establishes a SEP by using Form 5305-SEP, IRS requires that the SEP be the only retirement plan offered by the business.

Tip: Take caution when you and/or certain family members own a related business, as SEPs are subject to controlled-group rules. If you or family members own a controlling interest in another business, employees of that other business may need to be included in the SEP, assuming eligibility rules are satisfied.

Employee Notification
The business owner is required to make certain notifications to the employees within a reasonable time after the plan is established. Among other things, the employer must notify employees that a retirement plan has been established, what the eligibility rules are, and how the SEP contribution will be calculated and allocated.

Tip: These requirements, assuming you establish your SEP using IRS Form 5305-SEP, can be satisfied with a copy of Form 5305.

Rollovers
When it comes to rollovers, SEP IRAs, like traditional IRAs, are versatile. A SEP IRA account can be transferred to another SEP IRA at any time. Moreover, an individual can roll over a 401(k), 403(b), or governmental 457(b) into a SEP IRA, and vice-versa.

Converting to a Roth IRA
A SEP IRA can be converted into a Roth IRA, subject to the same rules as a conversion from a traditional IRA. As with a traditional IRA conversion, the amount of the SEP conversion is subject to federal and state taxation, but not to the 10% early-withdrawal penalty.

Tip:  Effective January 1, 2018, The Tax Cuts and Jobs Act repealed ability to recharaceterize Roth conversions. Therefore, a conversion to a Roth IRA is irrevocable.

Required Minimum Distributions
As with traditional IRAs, SEP IRA account owners are required to take a minimum distribution the year they turn age 70½. The required minimum distribution (RMD) rules permit the initial minimum distribution to be deferred until April 1 of the following year. Delaying an RMD requires the account owner to take two RMDs the following year.

Tip: An individual 70½ or older is eligible to participate in a SEP, assuming eligibility requirements have been satisfied. However, the individual also must take minimum distributions.

Caveats to Consider
The immediate vesting of SEP IRAs means employees can withdraw the contributions immediately for any reason. It also removes a potential retention tool from employers who cannot set a future date for vesting.

Unlike qualified plans, SEPs, like all IRAs, do not have a loan feature.

The mandated employee eligibility requirements mean that employees who work as little as one day in a year are qualified to participate. This can prove burdensome, especially to businesses that routinely hire part-time or seasonal employees.

While SEP IRAs offer some attractive features, including ease of use and cost-effectiveness, business owners are urged to consult with their tax professionals to make sure that a SEP is the right choice for the business owner’s particular situation. It should be noted that businesses that fund SEPs now may roll over the balance to a qualified plan that is established later, if that is the preference.

A SEP IRA can be a powerful tool in helping sole proprietors and employees of small businesses build their retirement savings. As with traditional IRAs, contributions to SEP IRAs, and the earnings they realize, are tax deferred until withdrawal. SEPs retain the distribution rules that apply to traditional IRAs. Of course, with opportunity comes responsibility, and with SEPs individuals are given sole responsibility for deciding how to manage their retirement account. Financial professionals are well positioned to both advise employers on establishing SEP IRAs and workers on how best to manage them.

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A Simplified Employee Pension plan, commonly known as a SEP IRA, is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP IRA plan for your business, you and any eligible employees establish your own separate SEP IRA; employer contributions are then made into each eligible employee’s SEP IRA.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

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