On December 29, 2022, President Biden signed into law the Securing a Strong Retirement Act, known as the “SECURE Act 2.0.” This legislation includes provisions from the House of Representative’s initial version of the SECURE Act 2 and two Senate bills – the EARN Act and the RISE & SHINE Act. SECURE Act 2.0 covers over 90 provisions related to retirement accounts in over 400 pages. It follows the original SECURE Act and has been met with overwhelmingly positive feedback in the retirement and tax industry. Several provisions in the Act have received quite a bit of media attention, such as increasing the RMD age to 73. However, numerous other provisions in the bill will have a real impact on retirement savers, such as the new Roth employer contribution options for SEP IRAs.
- The SEP IRA is a popular retirement plan among small business owners
- SECURE Act 2.0 contains provisions related to the SEP that could make it even more popular
- You can now make employer contributions to an after-tax Roth account
What is a SEP IRA?
A Simplified Employee Pension (SEP) is a profit-sharing plan that allows any business to establish for the benefit of its employees. In 2023, the maximum one can contribute to a SEP IRA is $66,000. As a profit-sharing plan, a sole proprietor or single-member LLC can make a maximum contribution of 20% of each eligible employee’s compensation up to the limit. Whereas, in the case of a corporation or partnership, the maximum contribution percentage is 25% of each eligible employee’s W-2, or guaranteed payment in the case of a partnership.
An eligible employee for a SEP IRA is an individual (including a self-employed individual) who meets all the following requirements:
- Has reached the age 21
- Has worked for the employer in at least 3 of the last five years
- Received at least $750 in compensation for 2023
SEP IRA Contributions Tax Rules Pre-2023
A SEP IRA can generally receive only employer contributions and generally cannot allow for employee elective deferrals like a 401(k) plan. SEP IRA employer contributions must be made to a traditional (pretax) IRA; a Roth IRA cannot be used. The contributions are made by the employer to the employee and vest immediately. Therefore, the employer receives an income tax deduction for the SEP IRA contribution. In the case of the employee that receives the employer profit-sharing contribution, any SEP IRA distribution taken after the age of 59 ½ would only be subject to ordinary income tax.
SEP IRA Contributions Tax Rules For 2023 & Beyond – Hello Roth
Thanks to Section 601 of SECURE Act 2.0, starting on January 1, 2023, SEP IRA employer profit-sharing contributions can now be designated as a Roth IRA. Note that the IRS has not yet set forth rules on the procedures for the employee to elect to have the SEP contribution treated as a Roth. The provision states that the employee must elect for the contributions made by the employer to be treated as made to a Roth IRA. It also appears that an employer would not be required to offer the Roth election.
One wrinkle to electing to receive employer Roth contributions is that SEP IRA participants should be aware that an election to receive contributions in Roth will trigger current taxation, even though they are employer contributions. Any designated Roth contribution made by the employer on the employee’s behalf is required to be included in the employee’s taxable wages as reported on Form W-2. Just like pretax contributions, which are tax-deductible to the employer, SEP Roth IRA contributions would be tax-deductible. In addition, any non-elective designated Roth contributions made by the employer are required to be fully vested.
In essence, the SEP Roth IRA contribution option will allow the employee to have the chance to elect when they wish to pay the tax on the funds – on grant or upon distribution. Another way to look at the SEP Roth IRA option is to think of it as a Roth conversion, without the actual conversion taking place. The amount of the SEP IRA Roth contribution would be subject to tax just like a conversion.
One other issue that needs to be addressed by the IRS in connection with Section 601, is will a SEP Roth IRA contribution impact the amount of Roth IRA contributions that are available to the employee to be made individually. There is a thought based on how the provision is drafted the SEP IRA Roth employer contribution will reduce the amount that may be made by an individual to a separate Roth IRA for that year. This language does not impact the traditional IRA contribution limits. However, it is unclear whether this what the intent of the provision. We can expect the IRS to address this and other issues raised herein in the coming months.
Additionally, there are several unresolved questions involving SEP IRA Roth contributions that the IRS will need to address at some point:
- How will the income from the SEP Roth IRA contribution be reported? On a W-2 or 1099?
- Will the SEP Roth IRA contribution be subject to FICA/Medicare taxes?
- Will the option be available for 2022 contributions made in 2023?
Section 601 of SECURE Act 2.0 allowing SEP IRA employer contributions to be made in Roth provides employees greater control over the tax treatment of their funds. The fact that Roth employer contributions provided to the employee would be taxable will likely make the option somewhat unpopular. Nevertheless, the provision is worth understanding as the benefits of a Roth retirement plan are superior. All qualified distributions from a Roth are tax-free. Who likes paying taxes? Generally, you’re better off paying them before you contribute rather than at the time of distribution since the earnings generated by your investments are also tax-free. It’s up to you, and your particular situation, to decide whether or not you wish to make Roth contributions to your SEP.