SEP IRAs

How a SEP-IRA Works

Simplified Employee Pension

The Basics: A SEP provides an employer with a simplified way to make contributions to an employee’s individual retirement account or individual retirement annuity.

• Employer contributions are made directly to SEP-IRAs set up for each employee with a bank, insurance company or other qualified financial institution.
• Employer contributions are tax deductible. See IRC Sec. 404(h).
• Contributions are not taxed currently to the employee. See IRC Sec. 402(h).
• Earnings accumulate income tax-deferred. See IRC Sec. 501(a).

How Much Will There Be at Retirement?

This will depend upon three factors.

1. The frequency and amount of contributions,
2. The number of years until retirement, and
3. The investment return.

The risk of poor investment returns rests upon the employee. However, if the investment results are favorable, the participant will have a larger fund at retirement age.

The following table 4 illustrates the amount to which annual deposits of $10,000 will accumulate at various growth rates for various periods.

Top-Heavy Plans

If more than 60% of the plan assets are allocated to key employees5, then the employer must contribute at least as much for non-key participants as it does for key employees. This requirement applies only to a contribution of up to the first 3% of includable compensation (higher in some instances).

Additional Considerations

Annual Contribution:

No annual contribution is required. If a contribution is made and IRS Form 5305-SEP is used as the plan document, the allocation must be the same percentage for each eligible employee. Allocation formulas that favor older employees may not be used. If integration with Social Security is desired, a custom plan or prototype document must be used.

Individual limits:

The allocations of excludable emplyer contributions to a participant’s account may not exceed the lesser of 25% of compensation or $44,000. For the self-employed, these maximum values are 20% and $44,000. For 2006, the maximum amount of compensation that may be considered in this calculation is $220,000.

Time of contribution:

Contributions can be made until the due date (plus extensions) of the employer’s return.

Vesting:

Vesting must always be 100%

Who may participate:

Any employee who is at least 21 years old and has performed service in at least three of the last five calendar years must be permitted to participate under the SEP unless his or her total compensation is less than $450 6 for the year.

Investment of plan assets:

Plan assets can be invested in most equity products or debt instruments by may not be invested in life insurance, “hard” assets or collectibles. (Except for U.S. gold and silver coins.) Participants direct the funds contributed on their behalf.

Withdrawals:

Participants may withdraw or cash out at any time. However, withdrawals are included in taxable income in the year received. Withdrawals prior to age 591/2 are subject to an additional 10% penalty tax. Exceptions to the 10% penalty apply if a distribution is made because of the participant’s death or disability, or if a distribution is made as a series of substantially-equal periodic payments over the life expectancy of the SEP owner, or joint life expectancies of the owner and a designated beneficiary. Once the periodic payment format is chosen, it may not be modified without penalty before the later of five years, or the participant reaches age 591/2. An additional exception to the 10% penalty applies for distributions made to pay medical expenses in excess of 7.5% of adjusted gross income. In certain cases, distributions to unemployed individuals for payment of health insurance premiums, or withdrawals made to pay certain firt-time homebuyer or educational expenses, may also avoid the penalty.7

Advantages to Employer

• Contributions are tax deductible.
• Contributions and costs are very flexible.
• Reporting is very minimal – no IRS or Dept. of Labor forms.
• The plan is easy to understand by the employees.
• The plan is easy to set up by merely completing IRS Model Form 5305-SEP 8, or the funding institution’s plan.
• There is little or no administrative expense.

Advantages to Employees

• Annual contributions are not taxed currently to the participant.
• Earnings on the account are not currently taxed.
• Participants have the right to direct investments.
• Participants may also have a traditional, deductible IRA (subject to certain income level limitations based on filing status), a traditional, nondeductible IRA, or a Roth IRA.
• Funds can be withdrawn at any time; e.g., in the event of an emergency suc as death or disability. Distributions are includable in taxable income in the year received. A 10% penalty tax may also apply if the participant is under age 591/2 when a distribution is received.9
• Federal bankruptcy law provides significant protection from creditors to participant accounts or accrued benefits in tax-exempt retirement plans. In traditional and Roth IRAs, generally, up to $1,000,000 is protected. However, funds in a SEP IRA are protected without any dollar limitation.

Disadvantages to Employer

• Contributions must be made for part-tiome and seasonal employees.
• Employees can withdraw the funds as fast as they are put into the account.
• Employees are always 100% vested – there are no forfeitures to reduce employer contributions.
• Employees control investments.
• Allocation methods that reduce employer costs may not be used; employee costs can be high compared to other types of plans. However, some plan documents used by investment bednors permit integration with social security, which will reduce employer contributions to some extent.

Disadvantages to Employees

• There is no guarantee as to future benefits.
• Investment risks rest on the participant.
• There is no assurance as t the frequency and amount of employer contributions.
• Special lump-sum tax treatment of distributions is not available.
• There are no forfeitures to be reallocated.
• Life insurance funding is not available.

Securities offered through
Ogilvie Security Advisors, Corp.
900 N. Michigan Avenue Suite 1860, Chicago, IL 60611
(312) 335-5476
Member NASD/SIPC