Small business owners who want to save funds for retirement have the option of contributing to a Keogh or SEP IRA plan. Both of these options offer tax deductions on contributions and deferred tax on earnings from these accounts, and any withdrawals made after age 59 ½ are taxed as regular income.
In spite of these similarities, SEP IRAs and Keogh plans are not exactly the same. It is important to differentiate between these two retirement plans to avoid any confusion and select the one that best suits your goals.
What are Keogh Plans and How Do They Work?
Unincorporated businesses and self-employed persons can choose to open a Keogh plan, and there are two main types of Keogh plans from which to choose:
- Defined Benefit Keogh Plan – The defined benefit package allows account holders to choose an annual pension plan they want and then deducts the required amounts to reach the set goal. One key aspect about this type of Keogh plan is that the account holder solely funds it.
- Defined Contribution Keogh Plan – A defined contribution Keogh plan has two variations, namely profit sharing and money-purchase. The former version is much like an SEP plan with limits on contribution amounts and caps on the maximum funds you can save. As for the latter Keogh plan, it allows you to choose and commit to a percentage of income you will contribute each year.
Keogh plans require you to prepare a formal written plan and file regular reports. For most people, all the paperwork involved makes these plans seem more complex and less desirable than SEP IRAs.
What is an SEP IRA and How Does it Work?
The acronym SEP stands for Simplified Employee Pension, and these retirement plans are indeed simplified, requiring only a single page document called Form 5305-SEP that is available from the IRS.
An SEP IRA allows small business owners with one or more employees, as well as individuals with a freelance income, to save for retirement with pre-tax dollars. In other words, contributions are not taxable until one starts taking withdrawals. With SEP IRAs, those employed cannot contribute funds to the plan. Instead, the business owner or employer makes all the contributions on the behalf of employees.
Who can Participate in SEP IRA?
Anyone who is self-employed is eligible for an SEP IRA. In addition, this plan is open to employees aged 21 and above who have worked for a company for the last five years and earned at least $550 in the current year.
SEP IRA Contribution Limits
Funding an SEP IRA is not a mandatory requirement. As an employer, you have the discretion to contribute funds in a given year. If you choose to do so, you must deposit contributions by the due date, including extensions, of filing your tax returns.
Self-employed persons are not allowed to deduct overdue SEP plan contributions on that year’s return. If you did not request an extension and missed to deposit funds to employee SEP IRAs by the due date of filing your tax return, those overdue contributions may be deducted when filing the following year’s return.
The contributions you make for each employee on a defined SEP IRA plan cannot go beyond 25% of compensation or the annual cap of $55,000 for tax year 2018 (this is subject to cost of living adjustments for subsequent years, and was $54,000 in 2017). In 2018, employees with compensation that exceeds $275,000 ($270,000 in 2017) are exempt from this rule since that figure is the maximum cap.
The same rules for employee SEP IRA contribution limits apply when it comes to how much you can contribute to your own account. Employer contributions are not taxable to the employees and any excess contributions made are included in the employee’s gross income. Excess employee contributions that remain in a SEP IRA are subject to a 6% tax deduction while the employer may incur an additional 10% excise tax. However, employees can avoid the 6% tax deduction by withdrawing any excess SEP IRA contributions before their federal tax return deadline passes.
Keep in mind that your tax benefits may be lost if your SEP plan fails to meet Internal Revenue Code statutory requirements. If you have made some mistakes with excess employee SEP IRA contributions, it is wise to seek advice from a tax professional regarding what corrective measures to take. Tax benefits may be retained if you follow one of the correction programs that are recommended by the IRS.