SEP IRA Rules and Regulations
SEP IRA rules can be read in detail in IRS Pub 560. In this section I have compiled some of the most basic rules for SEP IRA plans that people often have most questions on. READ ALL THE WAY BELOW ON HOW TO ESTABLISH A SEP IRA.
SEP IRA Rules on Plan formation
I am always asked when can an employer establish and contribute to a SEP plan. The answer is whenever the employer’s tax return is due. If an employer files an extension, its SEP contribution deadline also extends automatically.
All employees are eligible to participate as long as they are at the minimum 21 years old, have worked for the employer for three of the past five year and have earned a minimum of $500 in salary for the tax year. That said, the eligibility criteria may be a bit more lenient, however it cannot be more stringent or limiting than the above.
Tax Treatment of Funds Upon Withdrawal
Funds withdrawn from a SEP account are taxed at ordinary income tax rates. One must be 59 and a half years old to qualify for deductions. This is no different than a Traditional IRA plan. All contributions to a SEP plan are deductible in the tax year contributed, consequently benefiting the employer/contributor in form of a tax deduction.
SEP IRA Rules on dispensing
There is no difference in the SEP IRA rules for dispensing compared to a Traditional IRA plan. The Traditional IRA plan dispensing rules state that one must take out distributions ultimately at some point. This is called the mandatory withdrawal or dispensing age. Funds that are take out before one’s eligibility date are taxed and penalized quite heavily. This is one thing you DO NOT want to do!
The eligible dispensing age is 59 and a half, which is typically at or near retirement age for many. Distributions prior to this point are penalized by 10%. Not to mention the owner pays taxes based on their current ordinary income tax rate. Distributions after the eligibility age of 59 and a half are taxed, but not penalized.
Another point before moving forward on the 10% penalty; this does not pertain to amounts that are not taxable. For example, distributions for roll over purposes that are re-deposited into another retirement plan or account within 60 days of receipt are not unprotected to any penalties.
There are also other instances where the IRS sometimes can waive the hefty 10% penalty if and when early distributions are used for specific purposes. Let’s look at each one of these in detail:
Medical Expense and Insurance
The law provides some leniency if you are in a situation where you have unreimbursed medical expenses that go beyond 7.5% of your AGI or modificated gross income in the year of the SEP IRA dispensing. This is a big assistance because the government understands that medical expenses can add up to a meaningful amount. They understand that you may need to tap into your IRA in the event of unforeseen emergencies.
Similarly, the law provides leniency in the event you use your SEP IRA dispensing amounts to pay for medical insurance for yourself and your dependents. For you to assistance from the penalty free distributions, you must have lost your employment and have received unemployment benefits for at the minimum a consecutive period of 12 weeks. The dispensing from your SEP IRA account must occur in the same year or the following year from when you received the unemployment compensation. Finally, if you become employed again, you cannot take SEP IRA dispensing past 60 days of your employment.
A lot to look out for, but do understand why the rules are stringent. The law is providing you with a tax efficient saving means, and it wants to ensure that people do not abuse this privilege.
buy of Home
If you are purchasing your first home, the law allows for leniency in that it allows you to take SEP IRA distributions without paying any penalties on the funds. If you were to take a dispensing for this purpose, you must use the money on qualified home acquisition costs, all of which must occur within 120 days of you receiving the SEP IRA dispensing.
However, this amount may not increase $10,000. So you cannot liquidate your complete SEP IRA account and pay cash for your first home buy. This amount is a lifetime limit. But if you are married, you each get to take $10,000 for a total of $20,000. That can be a nice down payment on your first home.
Why is the dispensing penalty free? The Government has always favored home ownership – the so called American Dream. Just like it gives you some tax advantages in form of the mortgage deduction, it gives you some leniency by not penalizing your early SEP dispensing if used to pay for qualified expenses as part of your first home buy.
If you don’t make to or become disabled before age 59 and a half, which is the eligibility age from when you can start taking SEP distributions, your assets are distributed to your beneficiaries. These distributions are not penalized due to their character.
Disability is defined as a physical or mental condition that prevents one from being productive. In legal terms they say “engaging in substantial gainful activities”. The disability has to be attested to by a licensed physician and proof must be provided to assistance from the penalty free dispensing. A disability must be long-lasting in character for one to assistance from the penalty free beneficiary dispensing.
Qualified Higher Education Expenses
The law also provides some leniency if you want to pursue higher education, or want to put your dependents by higher education. The Government knows that education pays off in the long term in form of qualified citizens who are able to contribute back to society. Higher education expenses include class tuition, books, fees, school supplies and any equipment needed as part of the education such as a laptop of tool for someone attending vocational school.
You or your dependents may attend most educational institutions such as colleges, universities and vocational tech schools. There are other institutions that fall under the Department of Education which qualify in addition. When in doubt, ask the institution directly.
Owing the IRS
If you owe the IRS any money for in any case reason, they can come after you and levy against a IRA account. When they do this, it automatically triggers a dispensing. So while you are obligated to pay the tax on the dispensing, you don’t have to pay any penalties because this is a non voluntary dispensing. That said, you don’t want to be in a situation where the IRS is running after you. Bad move!
Required Minimum Distributions Rules
As I mentioned above, you cannot keep accumulating money in your IRA without withdrawing it at some point. The concept of Required Minimum dispensing, or RMD, requires you to start taking money out at age 70 and a half, eleven years after the eligibility age of 59 and a half. At the RMD age however, you may elect to spread the complete balance of your IRA account or a certain amount each year. The dispensing is required to occur in the year you reach the RMD age. In addition, it must occur (or funds must be distributed) by April 1st of the year after the year you hit the RMD age.
Because most IRA accounts are held with reputable custodians or trustees, these companies / firms are often on top of their game. They will calculate what the RMD amount is for you and will send you automatic notifications so you don’t forget!
This is very important to understand. Why? Because if you do not take the RMD by your due date, you will be penalized by 50%! No that is not a typo. Half your wealth will disappear before your eyes. The Government calls this the excess accumulation penalty. Absolutely brutal!
When must the excess accumulation penalty be paid? First of all I hope you never fall in a situation where you have to. But IF you have to confront the IRS’s wrath, the penalty is due when you file your tax return. But in fairness to the IRS, many who write to them requesting the penalty be removed because of oversight are often granted their wishes. Be genuine in your approach and request if you ever find yourself in this situation.
How to Establish a SEP IRA?
Alright, enough about SEP IRA rules and more on how to truly open an account; There are three basic steps an employer must follow when setting up a SEP IRA.
1) Sign an agreement to provide a SEP IRA to all employees
2) Communicate the information to all employees
3) Ensure an account is established for each employee
Let’s go over each of these SEP IRA rules in detail together:
You first need to sign an agreement suggesting that you will provide a SEP IRA contribution option for all eligible employees. You must do this by the date your tax return is due. If you will extend your tax return filing date, use the latter date as the due date for this letter. You will have to wait a complete year if you miss this deadline.
Most, if not all, financial institutions will have a SEP IRA form you can fill out when starting one. If you’d like to use your own form, Google IRS form Form 5305-SEP which will walk you by what a SEP IRA set up form should look like. There are exceptions in terms of not being able to use the 5305 IRS form. Read up on this on the IRS website. The best course may be just to ask your financial institution for a form that they have for their clients. These forms are often preapproved by the IRS.
Once the agreement has been established, you (as an employer) must communicate the eligibility requirements to your employees in addition as the rules of the SEP IRA plan. The IRS recommends providing employees with some sort of written communication to signify having communicated the information. A detailed summary plan description is provided by many employers since the intent of this step is to truly educate your employees about what the plan is and what it method for them.
Once communicated, it is YOUR responsibility as the employer to ensure each eligible employee has a SEP IRA account established and that they receive the SEP IRA contributions you make to the plan. The IRS can easily disqualify your complete plan if you don’t execute this step properly.
While you must be careful in execution, setting up a SEP IRA plan is not very difficult or time consuming. As you can see, the time of action is straightforward. All that is needed from you is diligence and care in execution.
Read more about SEP IRA Contribution Limits, or how to maximize benefits from your SEP IRA Contribution here.
I hope you found this information helpful. All the best to you.