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The 2 Parts of a SEP IRA: You Can't Have One Without the Other

SEP IRA rules
An issue we recently discussed with a financial advisor highlighted the rule that there are two separate parts to a SEP (Simplified Employee Pension) plan. If both parts of the SEP are not executed, then severe tax consequences can result to both the employer and any eligible employees.

A SEP is an employer retirement plan that uses an IRA to receive the contributions. The employer voluntarily makes SEP contributions to the IRAs of its eligible employees, much like a profit-sharing plan.

The first part of a SEP is the SEP plan document that the employer must fill out. The employer must fill out a SEP document, which describes the SEP plan features and eligibility rules. The employer then has to give a copy of this completed document to each eligible employee. Often, employers use IRS Form 5305-SEP as the employer document.

The second part of a SEP agreement is the IRA that receives the employer SEP contributions. Every employee who is eligible to participate in the SEP, including the business owner, must open an IRA to receive the SEP contributions. The SEP contributions can be made into either the employee’s traditional IRA or a SEP IRA. A SEP IRA really is a traditional IRA except for the fact that the only money in it is SEP money. The IRS doesn’t require SEP funds to be kept in a separate SEP IRA, but many financial institutions do this as a policy. As far as IRS is concerned, either way is fine, so check with your financial institution. Note that SEP contributions cannot be made into a Roth IRA or to a SIMPLE IRA.

In one case, an employer who was a sole proprietor was making SEP contributions for himself for the last few years into his SEP IRA. But he is now hiring some employees and wanted to know if they had to be covered in his company’s SEP. The financial advisor asked him what eligibility elections he made on the employer SEP agreement (e.g., IRS Form 5305-SEP). His response was that he never filled out an employer SEP agreement. Apparently, he just went to a financial institution and opened a SEP IRA without ever filling out an employer SEP document.

The bad news is that those contributions he’s been making for the last few years are not SEP contributions, and thus could not be deducted as SEP contributions on his tax returns. They’re considered regular IRA contributions, which likely are excess contributions if they exceed the IRA limit (e.g., $5,500 for 2013 for someone under age 50). Excess IRA contributions are generally subject to a 6% penalty tax too. No employer SEP document means no SEP. What a mess!

He likely can’t blame the financial institution either. While some financial institutions ask to see a copy of the employer SEP document, they are under no duty to do so. It was his responsibility to fill out the first part of the SEP agreement (the employer level document). Now he needs to hire a tax expert to represent him and see if the IRS will allow him to fix the problem.

The IRS has a program where SEP errors can potentially be fixed. Under the IRS Employee Plans Compliance Resolution System (EPCRS), certain mistakes can be fixed and disqualification of the SEP can be avoided. Under EPCRS, if the IRS allows him to fix the problem, they can assess penalties for his failure to fill out the employer SEP document.

Business owners should realize that only opening up a SEP IRA is not enough to establish a SEP plan for their business. Both parts are needed (the employer SEP document and the IRA).


- By Joe Cicchinelli and Jared Trexler

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