SEPs and IRAs for 2004 Year-end Planning 23 March 2005

Greetings,

It is NOT TOO LATE for small business clients and individuals to generate a 2004 tax deduction and credit while providing retirement savings for themselves. They can establish and fund a SEP-IRA plan up until the 2004 tax return due date, with extensions (i.e., at least until April 15, 2005 for most people). A SEP works well for small- business employers, either with or without employees, because of its high contribution limit, low cost, and easy administration.

A SEP is a Simplified Employee Pension (not to be confused with a SIMPLE). Any type of business entity (corporation, LLC, partnership, sole proprietorship, etc) can set up a SEP, and there are no limits on the number of employees.

The operation of a SEP is straight-forward: Each employee sets up an IRA. The employer can make a deductible contribution to each employee's IRA each year, as long as each employee receives the same percent of compensation. The employer can change the percentage year to year, or even skip contributions, if the business needs dictate. The employer doesn't have to cover employees who are under 21, who have not worked for the employer 3 of the last 5 years, or who make less than $450 per year (2003). The plan cannot exclude employees over 70½. If your client is over 70½ and self-employed, then, he can contribute to a SEP even though he wouldn't be able to contribute to a traditional IRA.

The most an employer can contribute to an employee's SEP IRA is 25% of the employee's income, up to $41,000.

Many self-employed like the simplicity and flexibility of a SEP. A SEP allows you to make the same contribution as the more expensive and complicated 401(k) plan if income exceeds $200,000 (for both plans, you would reach the $41,000 limit). Be aware that the contribution limit for a self- employed person ends up being 20%, not 25%. A self- employed client can contribute 25% of your net income, after deducting their contribution. The math works out that this is a 20% contribution of income.

Example: You make $100,000 net earnings from self- employment, and want to make the maximum 25% contribution. You can contribute $20,000 to your SEP. $20,000 is 25% of the $80,000 you have left after deducting your $20,000 from your $100,000 income

You can find an explanation and worksheet for how to figure the amount of the SEP contribution for a self-employed person in IRS Publication 590 (2004). See below for a link for that publication.

Employees may also make their traditional IRA contributions into their SEP IRA (and they can still do this until their tax returns are due). However, they must follow the income limits for those participating in a retirement plan. The ability to deduct a traditional IRA contribution for someone participating in a retirement plan is phased out between $60,000 and $70,000 for joint filers, and between $40,000 and $50,000 for single filers.

SEPs can be very easy to set up and administer. If the SEP is your only retirement plan, you may use the IRS' Form 53 05- SEP to establish the plan rather than having the attorney draft a plan from scratch. The 5305 must be reviewed, signed and kept on record, but it is not filed with the IRS. The SEP does not require nondiscrimination testing, and the IRS also does not require annual 5500 reporting.

Finally, distribution rules from SEP plans are the same as for other traditional IRAs. Your client can take a distribution at any time, but if she is under 59 ½ she will owe a 10% penalty on premature distributions unless an exception (death, disability, equal payments, etc) applies. She must begin to take a minimum required distribution by April 1 of the calendar year after reaching age 70 ½, even if her employer is still making contributions to her account.