Taxation of SEP Distributions

When an individual receives a distribution from a SEP-IRA, he or she must pay federal income tax on the proceeds in the year the payment is received. If the proceeds are paid out in a lump sum, the tax must be paid on the entire amount in one year. Averaging is not available for SEP-IRA lump-sum distributions.

If a distribution is taken before the employee reaches age 59½, the amount withdrawn is subject to ordinary income tax and a 10% penalty tax unless the amount—

• was paid due to death or disability;
• is part of a series of substantially equal periodic payments which have been calculated based on life expectancy;
• is used to pay unreimbursed medical expenses in excess of 7.5% of adjusted gross income;
• is used to purchase health insurance for an unemployed individual;
• is used for qualified higher education expenses; or
• is used within 120 days to pay the acquisition costs of a first-time home buyer.

Qualified reservist distributions. The additional 10% tax on early distributions does not apply to a qualified reservist distribution. A qualified reservist distribution is a distribution from an IRA or an elective deferral account made after September 11, 2001, and before January 1, 2008, to a military reservist or a member of the National Guard who has been called to active duty for at least 180 days or for an indefinite period. All or part of a qualified reservist distribution can be recontributed to an IRA.

An individual must begin receiving payments of a minimum required amount from a SEP-IRA by April 1 of the year following the calendar year in which he or she reaches age 70½ (not the later of 70½ or year of retirement as with qualified retirement plans). If this does not happen, a 50% penalty tax is imposed on the amount that should have been paid out but which was not for the year. If it can be proven that the failure to make the minimum distribution was due to reasonable error, the IRS may waive the excise tax (see IRS Form 5329 for further information). Contributions must continue for those who work past age 70½, even though distribution has begun.

Review of SEP Advantages

• minimal paperwork and bookkeeping
• flexibility regarding employer's decision to contribute each year
• tax-deductible contributions for the employer
• contributions not currently taxable to the employee
• tax-deferred accumulation of funds.

Review of SEP Disadvantages

• virtually all employees, including part-time employees, must be covered under the plan, which could be quite costly
• employees are fully vested immediately, which means the employer has no protection from high turnover
• protection of SEP assets from creditors is not as great as under a qualified retirement plan subject to ERISA
• employer flexibility with regard to contributions could be detrimental to employees in that a lack of commitment would prevent the plan from providing the retirement security originally intended.