This blog will address some issues that I was made aware of a few weeks ago when I had dinner with a family that also happen to be good friends of mine. Without getting into too much detail I am appalled on many levels with what happened to my friends. First for those of you who are not aware I am one course shy of completing a Master’s of Science in Financial Planning and I am also a licensed life insurance agent in the state of Tennessee. First I will explain what has me so upset about this situation then I will explain the solution for those of you who may be in a similar situation.
First my friends are naturalized US citizen who own their own business. They have a wonderful family and work as hard as anyone I know for their livelihoods. Now I know for a fact I am outraged at their insurance agent who took complete advantage of their good and trusting nature. This agent sold them a whole life insurance policy that had a monthly premium that was well into four digits for the two of them. They were sold this policy with the intention of using it for their retirement as they really have no need for additional life insurance. This agent told them the accumulated cash value would be theirs tax free when they needed the money. They did not however explain that this is their money and is considered a loan against the death benefit that is due with interest when they do in fact die. The agent sold them this policy as a retirement asset and not as life insurance. If the agent did have my friend’s interest at heart they could at least have sold them an annuity that is actually a retirement asset and not a whole life policy. The second aspect that I am not certain of but suspect with a high degree of certainty is that they do employ a CPA to help with their tax situation. It amazes me that the CPA never mentioned what the rest of the blog will be about and that is Simplified Employee Pension (SEP) plans. It amazes me that these people who have people such as my friends trust them are not providing good services and advice. These professionals should have their client’s best interests in mind and not their own.
A SEP is simply a retirement plan established by employers and individuals who own their own businesses. The plans are IRA based in nature with more liberal contribution guidelines and act similar to other business’s 401(k) plans. In the case of a SEP the employer is able to make tax-deductible contributions for the employee. In these instances the employer is able to receive a tax deduction for the contributions made to all eligible employees. So in the case of my friends they could have made contributions to a SEP plan for their retirement while lowering the taxes owed by their business. A win-win situation that any CPA should have been aware of if they had their client’s best interest at heart.
Now the contributions to a SEP plan are not taxed at the time of the contribution to the employee but any accumulated value including all earnings will be taxed as ordinary income when they make withdrawals after age 59 ½. As I stated earlier a SEP plan is an IRA based plan and these funds have to be placed in a Traditional IRA for the employee. Some firms require the IRA to be designated as a SEP IRA; however it is in the basics a Traditional IRA and is treated as such.
The following people may establish a SEP IRA and they include owners of sole-proprietorships, partnerships, corporations and non-profit organizations with one or more employees including the owner who in theory could be the only employee. Employees may not establish SEP IRA’s unless they are in fact the owner of the business. In the event your employer wishes to contribute to a SEP IRA it is the responsibility of the employee to first establish the Traditional IRA that the funds will be deposited into. SEP IRA’s are relatively easy to administer compared to other qualified plans with lower fees as a general rule. Also unlike a qualified plan SEP IRA’s are discretionary and the employer decides if a contribution will be made in any particular year provided it is done fairly and equally to all eligible employees.
In order for an employer to establish a SEP IRA there are three criteria that need to be met. First it must be a formal written agreement to provide the benefit to all eligible employees. The second step is for the employer to provide each eligible employee information about the SEP and the guidelines of the plan. The third is for the employer to ensure that a SEP is established for each eligible employee. Failure to do any one of these three things could negate the SEP’s tax advantages for the employer. In order for an employee to be eligible they must meet the following conditions: be at least 21 years old, earn at least $550 for the year, and has worked for the employer for 3 of the previous 5 years. Those three requirement are recommended and any employer may elect to set their own set of requirements that ensures it does not disqualify themselves. About the only limitation on earnings is that an individual cannot be part of the SEP if they earn over $255,000 a year. For the current year, SEP IRA’s are limited to 25% of the employee’s salary or pay up to a maximum of $51,000 which is indexed. For any questions it is best to consult a tax planner, financial planner, or a competent CPA.
In order to calculate how much an employee will receive the employer has a few options at their discretion. First is the pro-rata method which gives all eligible employees the same percentage of their salary as everyone else. The second is a flat-dollar formula which is simply everyone receives the same dollar amount regardless of their salary or pay. And the third is Social Security Integration where higher wage earners may receive higher SEP contributions. In this method the employer assigns a percentage of the accumulated total of the employee’s compensation. Using a special formula the employer allocates a percentage to each eligible employee. This method must follow regulatory requirements or the SEP may be disqualified.
As the SEP IRA is a Traditional IRA those rules generally apply to the SEP account. One main difference is that an employee may make a withdrawal to pay for medical insurance for themselves, their spouse, and their dependents under the following conditions: the individual has lost their job, they have received unemployment compensations for at least 12 consecutive weeks, they receive the distribution in the year or following year they received unemployment compensations, and they receive the distribution within 6o days of being re-employed. Withdrawals may also be made penalty free in the event of disability provided they can provide proof that they are not able to be gainfully employed. There are special withdrawal stipulations for beneficiaries so check with a specialist in the event you inherit a SEP IRA. If the owner has qualified higher education expenses the SEP IRA may be used for those qualified costs as are first time homebuyers. When taking out an early withdrawal it is always advisable to check with a qualified professional.
As you can now see, it was a great dis-service that the life insurance agent and CPA did to my friends. With a little knowledge the life insurance agent could have sold them an annuity for their retirement years that would have made much more sense than a whole life policy. Many people view annuities as a bad financial tool but used properly they can be very advantageous to someone in their retirement years. And if the agent really had their best interests in mind they would have referred them to a financial planner. As for their CPA he should have recommended that they establish a SEP IRA for themselves years ago to accomplish two things. One they would be saving a substantial amount for their retirement and two they would have lowered the income taxes they would have owed from their business. A true win-win for my friends. I cannot stress this enough but you should always know and trust the financial experts with whom you do business with. And always use one that takes the time to fully explain any products they sell or services they offer. Do not assume that they are ethical and are looking out for your best interests and not their own.
