It may not be too late to get a tax deduction for the 2015 tax year. If you had self-employment income in 2015, you may still be eligible to establish and fund a Simplified Employee Pension plan (SEP). The income can be based on a 1099 or W-2 and can come from working as a sole proprietor or through a partnership, LLC, or corporation.
What is an SEP?
Some retirement plans require participants to defer salary during the calendar year in order to take a deduction during that tax year, including the Simple IRA and the 401(k). However, an SEP can be established and funded up through the tax return due date (including extensions) for the year in which you want to establish the plan. So you have up to the Oct. 15 extension to establish and fund an SEP for the prior year.
An SEP is a flexible plan that has no mandatory employer contributions, no form 5500 filings or discrimination testing, and few administrative costs. An SEP is easily established using prototype plan documents that are readily available at most mutual fund companies or brokers. Once the plan is established, the only requirements are for the employer to notify employees about the plan's eligibility requirements and how contributions will be allocated.
What are the contribution limits?
An SEP is 100% employer-funded. No employee deferrals are allowed. Contributions are limited to 25% of an employee's taxable compensation, up to a maximum contribution of $53,000 for 2015. However, there is a separate calculation, which adjusts income for self-employment taxes paid, that must be completed to determine the correct contribution for business owners who pay self-employment tax. The IRS has more information on how to calculate your allowable contribution.
If you had W-2 income from another employer and participated in that employer's retirement plan, you may still be eligible to fund an SEP. However, you do need to aggregate all defined-contribution plan additions -- both employee deferrals and employer contributions -- and be sure to stay within the total limit of $53,000 or 100% of compensation.
Who can participate?
Employees must be automatically included in the plan if they've reached age 21, worked in the business for at least three of the past five years, and earned at least $600 during the tax year. However, an employer can use less restrictive eligibility requirements if desired. Once eligible, individual IRA accounts are set up for each employee, and employer contributions are immediately vested. Employer contributions can be made incrementally during the year and/or as a lump sum.
It is the account owner's responsibility to make any investment decisions, so the employer has no fiduciary responsibilities. Loans are not permitted in an SEP, but an in-service withdrawal is allowed. Distributions are taxed as ordinary income in the year they're received, and they may be subject to an additional 10% penalty if the participant is under age 59-1/2. As with IRAs, required minimum distributions must begin by age 70-1/2.
The bottom line
An SEP is easy to set up and allows for last-minute funding, but there are definitely issues to weigh, including the goal of the employer, number of employees, and the employees' compensation. If the employer's goal is to benefit all employees equally, then an SEP may work. However, if the employer's goal is to maximize their individual contributions, then putting in 25% of each eligible employee's compensation can become expensive.
Generally, an SEP is a good choice if a business has few employees, or if the majority of plan participants are equally compensated long-term employees or business partners. In other situations, a different employer-sponsored retirement plan, such as a SIMPLE IRA or 401(k) that allows for employee deferrals and limited employer matches, or a profit-sharing plan with a vesting schedule, may be a better choice.
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