SEP IRA or Profit Sharing Plan? Five Small Business Considerations

Want to provide a retirement plan for your employees? You have some great alternatives. Here’s how to choose between a SEP IRA and a profit sharing plan.
5 min read
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Key Takeaways

  • There are several things to consider when choosing between a SEP IRA and a profit sharing plan
  • A SEP IRA is often the most simple and flexible alternative
  • Profit sharing plans typically give you more control over employee accounts

As a business owner, you know it’s important to attract and keep talented team members. One way to do that is to offer a retirement plan. While some business owners might want employees to contribute to the plan for themselves, you might not want to spend the time, hassle, and expense from having to make monthly (or more frequent) contributions to the plan coordinated with your payroll - like you would have with a 401(k) or SIMPLE IRA. The good news is there are other alternatives such as a SEP IRA or a profit sharing plan.

These choices are very similar and both allow you to offer retirement benefits to your employees, plus set aside money for your own retirement. As the business owner, you will make all the contributions to the plan and get the appropriate tax deductions. But it is important to keep in mind that each alternative has its pros and cons. Here are five things to consider when deciding between a SEP IRA and a profit sharing plan.

Which Employees Will You Cover?

The first thing to consider is which employees you want to cover, assuming you have employees. Either plan can be an effective option for sole proprietors, LLCs, and those with a side gig. If you don't have employees feel free to skip ahead to to the next section. If you do have employees in your business, any of them who meet the eligibility requirements in your plan will be covered, meaning in years where you make a contribution for yourself, you must make contributions for these eligible employees too.

SEP IRA employee eligibility requirements are not as flexible if you have long-term employees. With profit sharing, you have a little more leeway.

In general for a SEP IRA, you must cover any employee who has worked for you in at least three of the last five years. Whether an employee is full-time, part-time, seasonal help, or only works one day; so long as they earn at least $600 for the current year, they are eligible for the SEP IRA contribution.

A profit sharing plan, though, does not necessarily cover some part-time workers. If someone hasn’t worked at least 1,000 hours for you in a year, including them is not mandatory. But if they do work at least 1,000 hours in a year then they do get credit for a year of service. The maximum number of years you can require is two years, but if you want a vesting schedule on plan contributions then the maximum requirement is one year for plan eligibility. It’s also possible to make other rules limiting employee participation in a profit sharing plan. 

Contribution Amount

Next, it’s important to understand how to handle contributions. After all, as an employer, you’re probably hoping to make your own contributions to the plan in addition to those for your employees. Maximum contributions in both plans are 25% of compensation up to $55,000 per person for 2018. And remember all contributions come from the business.

The general rule with a SEP IRA is that your contribution percentage (not a dollar amount) for each employee should equal what you put in for yourself. If you contribute 10 percent of your income to your own account, you will also put 10 percent of your employees’ pay into each of their accounts.

Profit sharing plans allow an employer more flexibility. In addition to everyone in the plan receiving the same contribution percentage, some plans allow an age-weighted formula to give older workers a larger percentage than younger workers. As a business owner, you’re typically among the oldest workers in your company, so it’s one way to add a little extra to your retirement account. And you will need to make sure your specific profit sharing plan document allows this age-weighted formula and that you hire a third party administrator to make sure your contribution still meets IRS guidelines each year.

Of course if you have no employees then either plan will let you contribute the maximum of 25% up to $55,000 for 2018. Make sure to try our handy Small Business Contribution Calculator to model different contribution levels — whether you have employees or not.

Flexibility and Commitment

This is where the SEP IRA really shines. It’s the most flexible and least commitment-heavy plan for business owners. Whether you have employees or not, it’s possible to have a SEP for one year, make the contributions, and then never contribute again. You can also change contribution amounts from year to year.

A profit sharing plan, on the other hand, requires more solid commitments. The IRS encourages you to contribute to the plan about two out of every five years. It’s not codified, but it is a rule of thumb if a business is considered an ongoing entity.

Both of these plans are fairly easy to set up. However, you can set up a SEP IRA for the previous year through the tax filing deadline — including extensions. So, if you decide in 2019 that you could use a tax benefit for tax year 2018, you have until April 15 to retroactively set up a SEP IRA and contribute for yourself and your employees. And if you file an extension, you could do so as late as October 15.

While you can make profit sharing contributions for a previous year through the tax filing deadline, you can’t set up a new plan after the calendar year ends. For 2018, you’d have to set up the plan by December 31.

TD Ameritrade does not provide tax advice. Clients should consult with a tax advisor with regard to their specific tax circumstances.

Potential Complexity

What forms do you fill out, and how do you maintain the plan? Complexity of administration can be a real issue with employee retirement plans. Let’s explore some key differences in the set up process for both plans.

Once you set up a SEP IRA, and you’ve figured out what to contribute, the heavy lifting is finished. There’s no special tax paperwork, and ongoing administration is fairly simple. Your chosen vendor takes care of things from there. For example, if you select TD Ameritrade, we’d report contributions and distributions with the IRS. Once you put money in the accounts and take the tax deduction, you’re pretty much done with the administration.

Profit sharing plans can sometimes be a little more complex. You’re required to file an annual Form 5500 with the IRS. If your plan is small and doesn’t come with a lot of requirements, you may choose a simpler option. You could handle it yourself, hire a firm specializing in plan administration, or get help from an accountant. The more complexity you add to the plan, like age-weighted contributions and vesting schedules, the more complicated (and expensive) your tax filing and administration could become.

Carefully consider this aspect of plan administration to make sure the benefits outweigh the costs.

Control and Responsibility

Finally, when choosing between a SEP IRA and a profit sharing plan, consider the issues of control and responsibility. 

With a SEP, as soon as you contribute to your employees’ accounts, they can invest or withdraw like any other IRA, subject to the same benefits and penalties. Additionally, with the SEP IRA, you can’t enforce a vesting schedule or require that employees work on the last day of the year to get a contribution. On the other hand, you’re not responsible for how they invest the money and you aren’t required to provide specific investment options.

Profit sharing plans offer the employer a little more control over employee access. You can impose a minimum number of hours or years an employee must work for you before participating, and you can set up a vesting schedule to limit how they withdraw the money. However, with this control comes greater responsibility. You’ve got a fiduciary responsibility to provide a broad range of investment options that work well for employees. If you don’t want to take on this task, you will need to hire an administrator or advisor who invests according to fiduciary principles.

Additionally, you can set a profit sharing plan to allow loans, and you can loan yourself money from your own account and use the capital. This is one of the main reasons business owners may choose a profit sharing plan. Before selecting this route, though, it’s important to determine whether this feature makes sense for your unique financial situation.

In the end, whether you choose a SEP IRA or a profit sharing plan depends on your goals and priorities as a small business owner and employer. Carefully weigh the options and consult your tax advsior before choosing.


Key Takeaways

  • There are several things to consider when choosing between a SEP IRA and a profit sharing plan
  • A SEP IRA is often the most simple and flexible alternative
  • Profit sharing plans typically give you more control over employee accounts

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