Most employers who want to avoid the administration costs of a 401(k), deliberate between the traditional (or Roth IRA), SIMPLE plan, or a SEP IRA. The SEP IRA is usually appealing because it allows for contributions up to $56,000 annually. Compare this with the traditional IRA or Roth limits up to $6,000 – $7,000 a year, or the SIMPLE maximization of $13,000. However, many states, including Oregon, are requiring retirement plans for their employees. Usually, the primary decision of which retirement account to use is based on if you have employees in the business, and whether you need to offer then plan and contribute for them?

Employer Contribution

First, keep in mind, the money contributed to a SEP IRA is an “employer contribution.” In other words, the money comes from the company, and is set at a maximum of 25% of the employee’s wage. A business owner as the only employee who makes $100,000 that year, can have the company contribute $25,000 to the SEP IRA. For business owners without employees, it doesn’t make a difference whether the payment into a SEP IRA is from the company’s account or from a personal account as its all effectively their money in the end!

However, once the owner has employees, he is required to offer the same SEP IRA and employer contribution to the employees that the owner offers to themself. For example, an S-Corporation with a W-2 of $100,000, and one employee, who has a W-2 of $40,000. The company would contribute $25,000 to the owner’s SEP IRA account (if doing the 25% max rate) and would also contribute $10,000 to the employee’s SEP IRA. While the business owner may be excited about contributing $25,000 their own SEP IRA from company’s funds, they are probably less excited about contributing $10,000 to an employee’s SEP IRA account from the company’s funds. This is why eligibility becomes an important deciding factor in determining whether to establish a SEP IRA.

Employee Eligibility Rules Provide Flexibility

Owner’s will note they only need to offer the SEP IRA to “eligible employees,” and they can make employees “ineligible” if they have not worked for the company for 3 years out of the prior 5 years. Consequently, employees who have not worked for the company for at least 3 years, do not need to receive an offer of the SEP IRA to them. Owner’s can also restrict eligibility if an employee has not yet turned 21. This 3 year employee eligibility rule under a SEP IRA is far more restrictive than the 1 year employee eligibility rule that applies when using a 401K or Solo 401K upon hiring employees.

Keep in mind owner’s are subject to the same eligibility rules. So, if this is a new company, then the strategy of offering the plan to yourself while restricting others doesn’t work so well. But, as is usually the case, if you have worked the business for years before having an employee, then you can set the work year requirement to make yourself eligible while setting it out up to 3 years for any employees.

If an employee has worked 3 out of the prior 5 years and is now eligible, the business owner can decide to cease the SEP IRA plan (and their own contributions), and can instead move to a 401(k) or other more common retirement plan structure where the company is not required to offer such a generous employer contribution. For more information or to continue the discussion, please reach out to your CPA at Isler CPA Business Advisors.