Choosing the right type of retirement savings plan can be a complicated decision for any employer, but the ramifications of the decision are magnified for the small business employer who is also choosing the plan that will provide for his or her own retirement security.
Some small business owners may have started out with a simplified employee pension (SEP, also known as a SEP IRA) for administrative convenience and simplicity, but circumstances change — meaning that the SEP IRA that was implemented years ago may no longer be the best plan for accomplishing the business owner’s current goals.
Fortunately, the small business client who opted for a SEP IRA is not locked into that decision, and if the right set of circumstances exists, that client may actually be able to maximize the business’ retirement savings by switching to a 401(k).
SEP IRA Basics
Contrary to what many business owners believe, any employer can establish a SEP IRA as long as that employer does not maintain any other retirement plan — there is no maximum number of employees, as is the case with SIMPLE IRAs. SEP IRAs are retirement savings accounts that only provide for employer contributions (employee contributions are not permitted).
As the name suggests, SEP IRAs are relatively simple to establish. The IRS has created prototype documents that can be used to form a SEP IRA, although individually designed plans are permitted. A primary advantage to these plans is that there is no filing requirement for the employer beyond using the Form 5305-SEP to create the plan.
Importantly, while no contributions are required each year, if the employer contributes any amount to a SEP IRA during any given year, contributions to the accounts of all employees who have performed services for the employer during that year become mandatory (certain employees who are under 21, earn less than $600 during the year or have not worked for the employer for three of the five preceding years may be excluded from participation).
Contributions must be uniform for all participants (limited to the lesser of $54,000 in 2017 or 25% of compensation) and, as with a 401(K), are deductible by the employer and excluded from employees’ income.
The SEP IRA contribution rules can have their advantages, particularly in the case of small employers with cyclical business structures who wish to contribute to employees’ retirement savings. The employer sponsoring a SEP can contribute more in good years, and nothing at all in other years, which is a reason for many business owners to choose a SEP when they are just starting out in business.
SEP IRA vs. 401(k): To Convert or Not to Convert
While a SEP IRA may be attractive to small business owners who wish to provide retirement benefits to employees but are just entering the business, these same owners may consider converting to a more traditional 401(k) as the business becomes more established. The business owner is not obligated to notify the IRS upon termination of the SEP (the financial institution administering the SEP should be notified), and the participants have the choice of taking a SEP distribution or rolling the funds into the new plan (or an individually established traditional IRA).
Employers who have grown substantially and wish to allow employees to contribute to their own retirement savings may wish to convert to a traditional 401(k) plan (which would allow the employee to make the decision whether to contribute up to $18,000 in pre-tax contributions, or $24,000 if the employee is at least 50). Further, employers who have experienced growth in their business may find that the obligation to contribute to each employee’s SEP IRA (if they wish to contribute anything to their own accounts) is no longer viable.
401(k) plans also offer the employer more flexibility in deciding whether to exclude a certain group of employees (for example, employees who have never worked more than 1,000 hours in a year for the employer may be excluded). 401(k) plans offer the employer more control over employee withdrawals by permitting rules that only allow employee withdrawals under certain circumstances (generally, upon attainment of a certain age, death, disability or in the event of a financial hardship).
With a SEP, the employee can withdraw funds at any time (a 10 percent penalty applies if the employee is under age 59 ½) and the employer has no ability to prevent these withdrawals.
For many other employers, the possibility of offering a Roth feature may make a 401(k) more attractive (SEP IRAs do not allow the employer to establish a Roth). Participant loans from SEP IRAs are also impermissible, while a 401(k) plan document can be written to permit participant loans up to certain limits.
The primary disadvantage of the 401(k) plan is, of course, the expense of administering the plan. The plan must file Form 5500 each year and is required to conduct testing to ensure that it complies with the applicable nondiscrimination rules.
Converting a SEP IRA to a 401(k) can be advantageous for many small business owners because of the relative flexibility of the 401(k) structure—however, these advantages must be weighed with the expense and added complexity of the IRS reporting requirements a 401(k) carries.
See previous coverage of transitioning between retirement plans in Advisor’s Journal.
For in-depth analysis of the rules governing SEPs, see Advisor’s Main Library.