As qualified retirement plans go, a SEP, which stands for Simplified Employee Pension, has a lot going for it. You can save substantial sums and take large deductions for contributions, assuming your earnings are high. You don’t have to file any annual information returns with the Department of Labor as you do for profit-sharing plans and 401(k)s. And you can set up and fund the plans as late as the extended due date of your return. But just because a SEP looks and feels like an IRA, the tax law doesn’t treat it as such in some respects.
Here’s a rundown of when SEPs are treated like IRAs, and when they’re not. Whether they’re treated like IRAs may be favorable or unfavorable, depending upon the issue involved.
Like an IRA
Borrowing. A qualified retirement plan can allow a participant to borrow from his or her account (assuming the plan permits it), a SEP cannot allow this. In this respect, a SEP is like an IRA. Borrowing from a SEP is a prohibited transaction that causes the account to lose its tax-exempt status. Transaction: If you borrow from a SEP, all of the funds in the account become immediately taxable to you. There are also penalties. This is unfavorable.
Delayed RMDs. Required minimum distributions (RMDs) from a qualified plan that normally must begin at age 70½ can be postponed until retirement for a participant who is not a more-than-5% owner of the business. This rule does not apply to SEPs. Distributions must commence after this age regardless of whether a participant owning 5% or less is still employed. This is unfavorable.
Divorce. In the case of divorce, in order to transfer funds from a qualified plan to an ex-spouse without tax cost to the participant, there must be a court-issued qualified domestic relations order (QDRO). However, a SEP is treated like an IRA for transfers related to divorce. As long as a transfer to a former spouse is “incident to divorce,” the owner (transferor-spouse) isn’t taxed. This is favorable.
Early distributions. Distributions from a qualified retirement plan before age 59½ escape penalty in limited circumstances. There are many more penalty exceptions for IRAs; these apply as well to SEPs (see the IRS chart on penalty exceptions). For example, there’s no penalty for early withdrawals to pay qualified higher education expenses or first-time homebuyer costs. This is favorable.
Asset protection not involving bankruptcy. Assets held in a qualified retirement plan enjoy maximum protection against the claims of creditors because there’s an anti-alienation provision in the Employee Retirement Income Security Act of 1974 (ERISA). However, this provision does not apply to assets in an SEP. (State laws may provide different protection.) This is unfavorable.
Not like an IRA
Age limit. Contributions to traditional IRAs are barred once the owner attains age 70 ½. However, there is no age restriction for making contributions to SEPs. Of course, RMDs must commence at this age, but the account may continue to grow faster than distributions are taken. And for an owner contributing to a SEP, the tax deduction for the contribution is valuable. This is favorable.
Qualified charitable distributions (QCDs). IRA owners age 70 ½ can make tax-free transfers directly to public charities up to $100,000 annually. These transfers can include RMDs, effectively making them tax free. However, QCDs cannot be used for SEPs. Distributions from employer-sponsored retirement plans, including SEPs, are not eligible for this tax rule. This is unfavorable.
Bankruptcy protection. Under the federal Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, an unlimited amount of assets in SEPs are shielded in case of bankruptcy, in contrast to a $1 million limit (adjusted for inflation) of assets in IRAs. This is favorable.
Bottom line
There are many retirement plan options for small business owners. If you don’t have one for your business and are considering a SEP, be aware of how it is similar to or different from an IRA. And if you’re looking at your 2015 profits and don’t have a plan in place, it’s not too late to make tax deductible contributions that will reduce your 2015 taxes. You’ll have to contribute to employees’ accounts, but the tax deduction combined with employee loyalty for offering this fringe benefit may be well worth the cost.
