Simplified Employee Pension (SEP) plans are, practically, another “spin-off” of the Traditional IRA and a significant source of income at retirement by allowing employers to set aside money in retirement accounts for themselves and their employees.

A business of any size, and even self-employed, can establish a SEP. It is a written plan that allows you to make contributions toward your own retirement and your employees' retirement without getting involved in a more complex qualified plan.

Under a SEP, you make contributions to a traditional individual retirement arrangement (SEP-IRA) set up by or for each eligible employee. A SEP-IRA is owned and controlled by the employee, and contributions are made to the financial institution where the SEP-IRA is maintained.

An eligible employee to participate in the plan is an individual who meets all the following requirements.

1. Has reached age 21.
   
   
2. Has worked for you in at least 3 of the last 5 years.
   
   
3. Has received at least $600 in compensation from you in 2018. This amount remains unchanged in 2019.

You can use less restrictive participation requirements than those listed, but not more restrictive ones.

Some employees can be excluded from coverage under a SEP.

• Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by the employees' union and you.
  
  
• Nonresident alien employees who have received no U.S. source wages, salaries, or other personal services compensation from you.

There are three basic steps in setting up a SEP.

1. You must execute a formal written agreement to provide benefits to all eligible employees.
   
   
2. You must give each eligible employee certain information about the SEP.
   
   
3. A SEP-IRA must be set up by or for each eligible employee.

Many financial institutions can help you set up a SEP. You must execute a formal written agreement to provide benefits to all eligible employees. You can satisfy the written agreement requirement by adopting an IRS model SEP using Form 5305- SEP, Simplified Employee Pension—IndividualRetirement Accounts Contribution Agreement.

If you adopt an IRS model SEP using Form 5305-SEP, no prior IRS approval or determination letter is required. Also, using Form 5305-SEP will usually relieve you from filing annual retirement plan information returns with the IRS and the Department of Labor.

You must give each eligible employee a copy of Form 5305-SEP, its instructions, and the other information listed in the Form 5305-SEP instructions. An IRS model SEP isn't considered adopted until you give each employee this information.

A SEP-IRA must be set up by or for each eligible employee. SEP-IRAs can be set up with banks, insurance companies, or other qualified financial institutions. You send SEP contributions to the financial institution where the SEP-IRA is maintained.

You can set up a SEP for any year as late as the due date (including extensions) of your income tax return for that year.

You may be able to claim a tax credit for part of the ordinary and necessary costs of starting a SEP that first became effective in 2018.

The SEP rules permit you to contribute a limited amount of money each year to each employee's SEP-IRA. If you are self-employed, you can contribute to your own SEP-IRA.

Contributions must be in the form of money (cash, check, or money order), you can't contribute property. However, participants may be able to transfer or roll over certain property from one retirement plan to another.

Contributions are immediately 100% vested, which means the employee may withdraw the amount immediately after it is deposited into his/her SEP IRA.

You don't have to make contributions every year. But if you make contributions, they must be based on a written allocation formula and must not discriminate in favor of highly compensated employees.

When you contribute, you must contribute to the SEP-IRAs of all participants who actually performed personal services during the year for which the contributions are made, including employees who die or terminate employment before the contributions are made.

Employer contributions to a SEP-IRA will not affect the amount an individual can contribute to a Roth or traditional IRA.

Unlike regular contributions to a traditional IRA, contributions under a SEP can be made to participants over age 701⁄2. At the same time, a SEP plan does not allow catch-up contributions and additional contributions by people older than 50.

If you are permitted to make traditional IRA contributions to your SEP-IRA account, you may be able to make catch-up IRA contributions.

If you are self-employed, you can also make contributions under the SEP for yourself even if you are over 701⁄2. Participants age 701⁄2 or over must take required minimum distributions.

To deduct contributions for a year, you must make the contributions by the due date (including extensions) of your tax return for the year.

Employer and employees contribution limits:

• You may contribute up to 25% of the employee's total compensation or a maximum of $55,000 for the 2018 tax year and $56,000 for the 2019 tax year, whichever is less.
  
  
• If you're self-employed, your contributions are generally limited to 20% of your net income.
  
  
• Contributions are deductible and aren't required every year.
  
  
• Contributions must be the same for employers and employees up to the specified limit.
  
  
• Employees may be able to make traditional IRA contributions to the SEP-IRA of up to $6,000 ($7,000 for employees age 50 or older) for 2019 tax year.
  
  
• This amount is the total contribution allowed by the IRS that employees can make to all their IRAs (SEP, traditional, or Roth) each year.

Because a SEP-IRA is a traditional IRA, you may be able to make regular, annual IRA contributions to this IRA, rather than opening a separate IRA account. However, any dollars you contribute to the SEP-IRA will reduce the amount you can contribute to other IRAs, including Roth IRAs, for the year.

Excess contributions are included in the employee's income for the year and are treated as contributions by the employee to his or her SEP-IRA.

Generally, you can deduct the contributions you make each year to each employee's SEP-IRA. If you are self-employed, you can deduct the contributions you make each year to your own SEP-IRA.

The most you can deduct for your contributions to your or your employee's SEP- IRA is the lesser of the following amounts.

1. Your contributions (including any excess contributions carryover).
   
   
2. 25% of the compensation (limited to $275,000 per participant) paid to the participants during 2018 from the business that has the plan, not to exceed $55,000 per participant.

In 2019, the amounts in (2) above increase to $280,000 and $56,000, respectively.

If you contribute to your own SEP-IRA, you must make a special computation to figure your maximum deduction for these contributions. When figuring the deduction for contributions made to your own SEP-IRA, compensation is your net earnings from self-employment, which takes into account the deduction for the deductible part of your self-employment tax, and the deduction for contributions to your own SEP-IRA.

If you made SEP contributions that are more than the deduction limit (nondeductible contributions), you can carry over and deduct the difference in later years. However, the carryover, when combined with the contribution for the later year, is subject to the deduction limit for that year.

You can deduct the contributions you make for your common-law employees on your tax return. For example, sole proprietors deduct them on Schedule C (Form 1040) or Schedule F (Form 1040), Profit or Loss From Farming; partnerships deduct them on Form 1065, U.S. Return of Partnership Income; and corporations deduct them on Form 1120, U.S. Corporation Income Tax Return, or Form 1120S, U.S. Income Tax Return for an S Corporation.

Sole proprietors and partners deduct contributions for themselves on line 28 of Schedule 1 (Form 1040). Remember that sole proprietors and partners cannot deduct as a business expense contributions made to a SEP for themselves, only those made for their common-law employees.

Beginning at age 70-1/2, required minimum distributions (RMDs) must be taken annually. As with a Traditional IRA, withdrawals from a SEP IRA will be added to your income and taxed accordingly. SEP IRA distributions are meant to occur at retirement age when you're ideally in a lower tax bracket.

Early withdrawals will face a 10% extra tax if the withdrawer is younger than 59-1/2.

If you do not take any distributions, or if the distributions are not large enough, you may have to pay a 50% excise tax on the amount not distributed as required.

The biggest mistake you can make with a SEP plan or any other pension plan, is not to contact a professional advisor to make sure you comply with the tax law if you want to set up any retirement plan that is tax-advantaged, and, of course, keep up with our newsletters for regular updates on topics of general interest.