SEP IRA contribution rules are designed to give the maximum benefit to a very small business, typically with only a few employees. The employer and owner must fund all employee accounts to the same percentage as his or her own. This percentage is as high as 25 percent of an annual salary. This high cost is designed for self-employed individuals or those running family businesses. If this describes your business, consider an SEP IRA and learn about the many formulas used to determine your contributions.
Most small business IRAs have relatively-low contribution limits. For example, in 2011, the SIMPLE IRA is capped at $10,500 per employee. With the SEP option, you can far exceed this barrier. The annual maximum is $46,000. The maximum compensation that can be used to calculate a contribution limit is $230,000 annually. Further, a business owner can choose whether to treat his own income as net income to the business or as a salary paid to him by the business. This is very favorable for an individual freelancer whose salary equals the business's income on a given year.
There are three main formulas to compute contributions. The first and most basic is pro-rata. In this formula, the same percentage is used for every employee at the company, each receiving the same portion distribution regardless of salary. For example, a 10 percent rate would net a $10,000 contribution for an employee earning $100,000 and a $5,000 contribution for an employee earning $50,000. An employer can also elect the flat-dollar formula where every employee receives the same amount, regardless of salary. In this example, both the $100,000 earner and the $50,000 earner would receive the same amount each year to their SEP IRA. Social security integration is an option to progressively reward higher earners. Higher-paid employees would receive a larger percentage of contribution. The employer uses a formula to determine how much all employees will receive combined. Then, dollars are allocated out of that communal retirement pot with the highest amounts going to the highest earners.
Choosing a Formula
When choosing a formula for your business, set your priorities. Are you looking to reward everyone equally? Are you looking to give your higher earners more benefits? Are you simply looking for a formula that is easy to manage? Once you know your priorities, you can then move forward in choosing which option is best for you. The most important thing to know is you must choose your formula by your tax filing deadline. At this point, all employer contributions must be fully vested. Some employers will choose to wait until the end of the year to vest contributions while others will do so periodically throughout the year. Whatever your model, it must be applied consistently and finished by your tax filing deadline. You will only need to fill out one form annually for your SEP IRA. You will also have to notify your employees of the plan and contribution formula you chose in order to make the process transparent to them.