SEPs vs. IRAs: How They are Similar, How They are Different

Small-business consultant Barbara Weltman recently reminded her readers about SEP plans for business owners (SEP stands for simplified employee pension). The basis of her article was that these retirement plans are sometimes treated like an IRA (individual retirement arrangement), sometimes not when it comes to tax law.

Since we have clients who own their own businesses and open self-directed SEPs to save for retirement, we thought it was a good idea to share Ms. Weltman’s insights about these retirement plans. The timing is good as taxpayers head into the final laps before the 2015 tax filing and contribution deadlines.

A key takeaway is to understand that a SEP is not the same as a qualified retirement plan, which may have more leeway regarding some of the pointers listed below, depending on how the qualified plan is set up. Also, depending on the account holder’s particular situation or needs, some of these issues can be viewed as either favorable or not so favorable. We are sharing them here for informational purposes only; as always, it is best to consult your tax professional or trusted adviser regarding any of these as they may apply to you.

Some ways in which the IRS treats a simplified employee pension plan like an IRA are:

• Participants may NOT borrow from a SEP; this is a prohibited transaction that will cause the account to lose its tax advantages. Funds that are borrowed from a SEP are immediately taxable as income and there are penalties.
• You must start taking your required minimum distribution (RMD) starting at age 70-1/2, even if you own less than five percent of the business and are still working (this differs from qualified plans).
• Transfer of funds in the case of divorce is not a taxable event for the transferring spouse (as long as that transfer to a former spouse is “incident to divorce.”).
• The penalty exceptions for early distributions (taken before age 59-1/2) also apply to SEPs. You can read about these penalty exceptions on the IRS website.
• Assets held in a SEP are not protected to the same extent from creditors’ claims as those in a qualified retirement plan (which are covered by a provision in the Employee Retirement Income Security Act of 1974). This concerns assets that are not involved in bankruptcy. Your state laws may provide different protection so that’s worth checking out.
• That said, under the federal Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, an unlimited amount of assets in SEPs are shielded in case of bankruptcy; this is in contrast to IRAs, which shielded up to a $1 million limit of assets (adjusted for inflation).
• You may continue to make contributions to a SEP after reaching age 70-1/2 and enjoy the tax deduction for these contributions (remember you must start taking your RMD after reaching this age).
• Qualified charitable distributions (QCDs) cannot be used for SEPs; IRA owners age 70-1/2 are permitted to make tax-free transfers directly to public charities, up to $100,000 a year.

There are plenty of good reasons for owners of small businesses to open a self-directed SEP and even to offer these plans to your employees. At Next Generation Trust Services, we make it easy with our SEP Starter Kit. And of course, if you self-direct this retirement plan, you’ll be able to include many different types of assets beyond stocks, bonds and mutual funds to build your retirement wealth. But as we always say at Next Generation, do your research and fully understand your retirement plan and assets!

We hope this information has provided some insights into the potential pros and cons of a self-directed SEP. If you have any questions about SEP IRAs or any other type of retirement plan that can be self-directed, contact our helpful professionals at (888) 857-8058 or Info@NextGenerationTrust.com.