David J. Kupstas, FSA, EA, MSEA Chief Actuary
When you first think about it, the idea of a Simplified Employee Pension (SEP) plan seems appealing. Qualified retirement plans like 401(k)s can be complicated and confusing. With a SEP, you don’t need to hire a Third Party Administrator, there are no government filing requirements, and there are fewer cumbersome rules like nondiscrimination testing. What’s not to like?
A recently updated IRS and Department of Labor publication gushes, “Looking for an easy and low-cost retirement plan? Why not consider a SEP?” Here’s one reason why not: in the retirement plan world, “Simple” and “Simplified” are often code words for “less flexible.” While SEPs do indeed provide simplicity, the tradeoff is there are stricter requirements on which employees have to be covered, how the contributions are divided up, and what kinds of investments are permitted. Many of our qualified plan clients started as SEP sponsors who were looking for a vehicle that better met their objectives.
The IRS publication has a section called “Advantages of a SEP.” Curiously, there is no section called “Disadvantages of a SEP.” Below, we will highlight a few of the SEP rules and discuss how these rules compare to those of qualified plans:
- Eligibility. An eligible employee for SEP purposes is an employee who is at least age 21 and has performed service for the employer in at least three of the last five years. All eligible employees must participate in the plan, including part-time employees, seasonal employees, and employees who die or terminate employment during the year. Some employees may be exempted, such as those whose pay is less than $600 per year. On the other hand, a qualified plan may allow employees who do not ever complete 1,000 hours of service in a year to be excluded from the plan. In addition, a qualified plan may exclude employees on some other basis, such as job title or location, even if these employees complete 1,000 hours of service per year.
- When the plan must be established. A SEP may be established as late as the due date (including extensions) of the company’s income tax return for the year you want to establish the plan. For example, if your business’ fiscal year ends on December 31 and you filed for the automatic 6-month extension, the company’s tax return for the year ending December 31, 2015 would be due on September 15, 2016, allowing you to make the initial SEP contribution no later than September 15, 2016. This is actually one advantage SEPs have over qualified plans. A qualified plan must be established prior to the end of the plan year for which it is effective, even if the contributions are not deposited until later. So an employer wanting to start a qualified plan for 2015 would have to have made that decision and acted upon it by December 31, 2015. It is now too late to establish a qualified plan for 2015. There is still time to establish a SEP for 2015, though.
- Dividing up the contributions made. Contributions for all SEP participants generally must be uniform—for example, the same percentage of compensation. Qualified plans may be designed to give different percentages of pay to different employees. For example, one individual or group may receive 20% of pay, while another group could possibly receive as little as 3% or 5% of pay. This is fine as long as a nondiscrimination test and certain other requirements are met. This might be the biggest reason an employer would prefer a qualified plan over a SEP. For an owner wanting to receive 20% of pay in a plan, having to give that same 20% to all the employees rather than 5% is a huge expense. Note that there are proposed regulations that, if finalized, could restrict these big contribution disparities. These proposed regulations will be addressed in a future article.
- Loans and certain investments. SEPs are considered Individual Retirement Accounts (IRAs) and are sometimes referred to as SEP-IRAs. IRAs do not allow participant loans. Life insurance is not permitted within a SEP-IRA, either. It may be difficult to hold certain illiquid investments such as real estate, limited partnerships, or collectibles. An IRA provider willing to trustee these assets would have to be found. There are no such restrictions in qualified plans. Loans are a popular qualified plan feature, particularly in 401(k) plans. Life insurance and illiquid investments may be held in qualified plans with little difficulty as well.
Like anything else, a business owner must weigh the pros and cons of SEPs and qualified plans. As the name suggests, SEPs are indeed simple. However, the employer needs to know what is being given up in exchange for that simplicity and whether the tradeoff is worth it.