Understanding the intricacies of retirement plans is crucial for S corporations aiming to optimize tax advantages and provide valuable benefits to their employees. The Simplified Employee Pension (SEP) IRA offers businesses a streamlined way to contribute to employee retirement savings. This plan is particularly appealing due to its flexibility in contribution amounts and straightforward administration.
This article explores key aspects of SEP IRAs for S corporations, including eligibility criteria, coverage for shareholder-employees, and tax implications, equipping business owners with the knowledge to implement and manage this retirement strategy effectively.
Requirements for Employer Contributions
S corporations must adhere to IRS guidelines for SEP IRA contributions, which are made by the employer based on a percentage of the employee’s compensation. For 2025, the maximum contribution is the lesser of 25% of an employee’s compensation or $70,000, allowing businesses to provide significant retirement benefits.1Internal Revenue Service. 2025 Retirement Plan Limits (Notice 2024-80)
Employers must apply the same contribution percentage to all eligible employees, including shareholder-employees, ensuring equitable treatment. For instance, if an S corporation contributes 10% of compensation, this percentage must be consistently applied to every eligible employee.
Eligibility criteria require employees to be at least 21 years old, have worked for the employer in at least three of the last five years, and earn at least $750 in the current year. Employers may adopt less restrictive criteria but cannot impose stricter requirements.
Coverage for Shareholder-Employees
Shareholder-employees in S corporations must receive the same SEP IRA benefits as other employees. Compensation for shareholder-employees is typically defined as wages subject to FICA taxes, excluding distributions. This distinction follows IRS guidelines differentiating earned income from passive income.
Balancing salary and distributions is essential for optimizing SEP IRA benefits while managing tax liability. Shareholder-employees should work with financial advisors to maximize retirement savings without incurring excessive tax burdens.
Establishing the Plan
Setting up a SEP IRA involves selecting a financial institution as the trustee to hold the plan’s assets and ensure compliance with IRS regulations. Employers should compare institutions based on fees, investment options, and customer support.
Once a trustee is chosen, a formal written agreement is executed, detailing the plan’s specifics, such as contribution formulas and eligibility criteria. Employers can use Form 5305-SEP, a model agreement provided by the IRS, as long as the plan adheres to IRS guidelines.2Internal Revenue Service. SEP Fix-It Guide: SEP Plan Overview
Employers must inform eligible employees about the SEP IRA by distributing plan details, including contribution amounts. SEP IRA contributions are immediately 100% vested, so there is no vesting schedule to track.
Tax Reporting Obligations
Accurate tax reporting is critical for SEP IRAs within S corporations. Contributions should be recorded as deductible business expenses in the corporation’s financial statements, reducing taxable income.
Do not include employer SEP contributions on employees’ Forms W-2; instead, check the “Retirement plan” box in Box 13. The financial institution reports SEP IRA contributions on Form 5498.3Internal Revenue Service. Simplified Employee Pension Plan (SEP) While the SEP IRA itself does not require a separate annual tax return, distributions are reported on Form 1099-R by the financial institution.4Internal Revenue Service. Instructions for Forms 1099‑R and 5498 (2025)
Distribution Guidelines
SEP IRA distributions are treated as ordinary income and must be reported in the tax year received. Early withdrawals before age 59½ generally incur a 10% penalty in addition to regular income taxes, with limited exceptions allowed by law.
Required Minimum Distribution (RMD) rules begin at age 73. If the full RMD is not taken by the deadline, an excise tax of 25% applies, reduced to 10% if corrected within two years; RMDs use IRS life expectancy tables and the prior December 31 account balance.5Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs Consulting financial advisors can help individuals align withdrawals with retirement goals and tax strategies.