Simplified Employee Pension (SEP)

A simplified employee pension (SEP) is a written plan that allows you to make contributions toward your own (if you are self-employed) and your employees' retirement without getting involved in a more complex qualified plan.

Under a SEP, you make the contributions to a traditional individual retirement arrangement (called a SEP-IRA) set up by or for each eligible employee. SEP-IRAs are owned and controlled by the employee, and you make contributions to the financial institution where the SEP-IRA is maintained.

SEP-IRAs are set up for, at a minimum, each eligible employee (defined later). A SEP-IRA may have to be set up for a leased employee (defined earlier under Definitions You Need To Know), but does not need to be set up for excludable employees (defined later).

Eligible employee. An eligible employee is an individual who meets all the following requirements.

• Has reached age 21.
• Has worked for you in at least 3 of the last 5 years.
• Has received at least $450 in compensation from you for 2000.

You can use less restrictive participation requirements than those listed, but not more restrictive ones.

Excludable employees. The following employees can be excluded from coverage under a SEP.

• Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by the employees' union and you.
• Nonresident alien employees who have received no U.S. source wages, salaries, or other personal services compensation from you. For more information about nonresident aliens, see Publication 519, U.S. Tax Guide for Aliens.

Setting Up a SEP

There are three basic steps in setting up a SEP.

1. You must execute a formal written agreement to provide benefits to all eligible employees.
2. You must give each eligible employee certain information about the SEP.
3. A SEP-IRA must be set up by or for each eligible employee.

Many financial institutions will help you set up a SEP.

Formal written agreement. You must execute a formal written agreement to provide benefits to all eligible employees under a SEP. You can satisfy the written agreement requirement by adopting an IRS model SEP using Form 5305-SEP. However, see When not to use Form 5305-SEP, later.

If you adopt an IRS model SEP using Form 5305-SEP, no prior IRS approval or determination letter is required. Keep the original form. Do not file it with the IRS. Also, using Form 5305-SEP will usually relieve you from filing annual retirement plan information returns with the IRS and the Department of Labor. See the Form 5305-SEP instructions for details.

When not to use Form 5305-SEP. You cannot use Form 5305-SEP if any of the following apply.

1. You currently maintain any other qualified retirement plan. This does not prevent you from maintaining another SEP.
2. You have any eligible employees for whom IRAs have not been set up.
3. You use the services of leased employees (as described earlier under Definitions You Need to Know).
4. You are a member of any of the following unless all eligible employees of all the members of these groups, trades, or businesses participate under the SEP.
   1. An affiliated service group described in section 414(m).
   2. A controlled group of corporations described in section 414(b).
   3. Trades or businesses under common control described in section 414(c).
5. You do not pay the cost of the SEP contributions.

Information you must give to employees. You must give each eligible employee a copy of Form 5305-SEP, its instructions, and the other information listed in the Form 5305-SEP instructions. An IRS model SEP is not considered adopted until you give each employee this information.

Setting up the employee's SEP-IRA. A SEP-IRA must be set up by or for each eligible employee. SEP-IRAs can be set up with banks, insurance companies, or other qualified financial institutions. You send SEP contributions to the financial institution where the SEP-IRA is maintained.

Deadline for setting up a SEP. You can set up a SEP for a year as late as the due date (including extensions) of your income tax return for that year.

How Much Can I Contribute?

The SEP rules permit you to contribute a limited amount of money each year to each employee's SEP-IRA. If you are self-employed, you can contribute to your own SEP-IRA. Contributions must be in the form of money (cash, check, or money order). You cannot contribute property. However, participants may be able to transfer or roll over certain property from one retirement plan to another. See Publication 590 for more information about rollovers.

You do not have to make contributions every year. But if you make contributions, they must be based on a written allocation formula and must not discriminate in favor of highly compensated employees (defined earlier under Definitions You Need To Know). When you contribute, you must contribute to the SEP-IRAs of all participants who actually performed personal services during the year for which the contributions are made, even employees who die or terminate employment before the contributions are made.

The contributions you make under a SEP are treated as if made to a qualified pension, stock bonus, profit-sharing, or annuity plan. Consequently, contributions are deductible within limits, as discussed later, and generally are not taxable to the plan participants.

A SEP-IRA cannot be designated as a Roth IRA. Employer contributions to a SEP-IRA will not affect the amount an individual can contribute to a Roth IRA.

Time limit for making contributions. To deduct contributions for a year, you must make the contributions by the due date (including extensions) of your tax return for the year.

Contribution Limits

Contributions you make for a year to a common-law employee's SEP-IRA cannot exceed the lesser of 15% of the employee's compensation or $30,000. Compensation generally does not include your contributions to the SEP. However, if you have a salary reduction arrangement, see Employee compensation under Salary Reduction Simplified Employee Pension (SARSEP), later.

Example. Your employee, Mary Plant, earned $21,000 for the year. The maximum contribution you can make to her SEP-IRA is $3,150 (15% x $21,000).

Contributions for yourself. The annual limits on your contributions to a common-law employee's SEP-IRA also apply to contributions you make to your own SEP-IRA. However, special rules apply when figuring your maximum deductible contribution. See Deduction Limit for Self-Employed Individuals, later.

Annual compensation limit. You cannot consider the part of an employee's compensation over $170,000 when figuring your contribution limit for that employee. Therefore, $25,500 is the maximum contribution for an eligible employee whose compensation is $170,000 or more.

More than one plan. If you contribute to a defined contribution plan (defined later under Qualified Plans), annual additions to an account are limited to the lesser of $30,000 or 25% of the participant's compensation. When you figure this limit, you must add your contributions to all defined contribution plans. Because a SEP is considered a defined contribution plan for this limit, your contributions to a SEP must be added to your contributions to other defined contribution plans.

Tax treatment of excess contributions. Excess contributions are your contributions to an employee's SEP-IRA (or to your own SEP-IRA) for a year that exceed the lesser of the following amounts.

• 15% of the employee's compensation (or, for you, 13.0435% of your net earnings from self-employment).
• $30,000.

Excess contributions are included in the employee's income for the year and are treated as contributions by the employee to his or her SEP-IRA. For more information on employee tax treatment of excess contributions, see chapter 4 in Publication 590.

Reporting on Form W-2. Do not include SEP contributions on your employee's Form W-2 unless contributions were made under a salary reduction arrangement (discussed later).

Deducting Contributions

Generally, you can deduct the contributions you make each year to each employee's SEP-IRA. If you are self-employed, you can deduct the contributions you make each year to your own SEP-IRA.

Deduction Limit for Your Contributions on Behalf of Employees

The most you can deduct for your contributions for participants is the lesser of the following amounts.

• Your contributions (including any elective deferrals and excess contributions
  carryover).
• 15% of the compensation (limited to $170,000 per participant) paid to them during the year from the business that has the plan.

Deduction Limit for Self-Employed Individuals

If you contribute to your own SEP-IRA, you must make a special computation to figure your maximum deduction for these contributions. When figuring the deduction for contributions made to your own SEP-IRA, compensation is your net earnings from self-employment (defined under Definitions You Need To Know), which takes into account both the following deductions.

• The deduction for one-half of your self-employment tax.
• The deduction for contributions to your own SEP-IRA.

The deduction for contributions to your own SEP-IRA and your net earnings depend on each other. For this reason, you determine the deduction for contributions to your own SEP-IRA indirectly by reducing the contribution rate called for in your plan. To do this, use the Rate Table for Self-Employed or the Rate Worksheet for Self-Employed, whichever is appropriate for your plan's contribution rate, in the Appendix. Then figure your maximum deduction by using the Deduction Worksheet for Self-Employed in the Appendix.

Deduction Limits for Multiple Plans

For the deduction limits, treat all your qualified defined contribution plans as a single plan and all your qualified defined benefit plans as a single plan. See Kinds of Plans, later, under Qualified Plans for the definitions of defined contribution plans and defined benefit plans. If you have both kinds of plans, a SEP is treated as a separate profit-sharing (defined contribution) plan. A qualified plan is a plan that meets the requirements discussed later under Qualification Rules. For information about the special deduction limits, see Deduction limit for multiple plans under Qualified Plans, later.

SEP and profit-sharing plan. If you also contribute to a qualified profit-sharing plan, you must reduce the 15% deduction limit for that profit-sharing plan by the allowable deduction for contributions to the SEP-IRAs of those participating in both the SEP plan and the profit-sharing plan.

Carryover of Excess SEP Contributions

If you made SEP contributions that are more than the deduction limit (nondeductible contributions), you can carry over and deduct the difference in later years. However, the contributions carryover, when combined with the contribution for the later year, is subject to the deduction limit for that year. If you also contributed to a defined benefit plan or defined contribution plan, see Carryover of Excess Contributions under Qualified Plans, later, for the carryover limit.

Excise tax. If you made nondeductible (excess) contributions to a SEP, you may be subject to a 10% excise tax. For information about the excise tax, see Excise Tax for Nondeductible (Excess) Contributions under Qualified Plans, later.

When To Deduct Contributions

When you can deduct contributions made for a year depends on the tax year on which the SEP is maintained.

• If the SEP is maintained on a calendar year basis, you deduct contributions made for a year on your tax return for the year with or within which the calendar year ends.
• If you file your tax return and maintain the SEP using a fiscal year or short tax year, you deduct contributions made for a year on your tax return for that year.

Example. You are a fiscal year taxpayer whose tax year ends June 30. You maintain a SEP on a calendar year basis. You deduct SEP contributions made for calendar year 2000 on your tax return for your tax year ending June 30, 2001.

Where To Deduct Contributions

Deduct contributions for yourself on line 29 of Form 1040. You deduct contributions for your employees on Schedule C (Form 1040), on Schedule F (Form 1040), on Form 1065, on Form 1120, U.S. Corporation Income Tax Return, on Form 1120-A, U.S. Corporation Short-Form Income Tax Return, or on Form 1120S, U.S. Income Tax Return for an S Corporation, whichever applies to you.

If you are a partner, the partnership passes its deduction to you for the contributions it made for you. The partnership will report these contributions on Schedule K-1 (Form 1065). You deduct the contributions on line 29 of Form 1040.

Salary Reduction Simplified Employee Pension (SARSEP)

A SARSEP is a SEP set up before 1997 that includes a salary reduction arrangement. (See the Caution, next). Under a SARSEP, your employees can choose to have you contribute part of their pay to their SEP-IRAs rather than receive it in cash. This contribution is called an "elective deferral" because employees choose (elect) to set aside the money, and they defer the tax on the money until it is distributed to them.

You are not allowed to set up a SARSEP after 1996. However, participants (including employees hired after 1996) in a SARSEP set up before 1997 can continue to have you contribute part of their pay to the plan. If you are interested in setting up a retirement plan that includes a salary reduction arrangement, see SIMPLE Plans, later.

Who can have a SARSEP? A SARSEP set up before 1997 is available to you and your eligible employees only if all the following requirements are met.

• At least 50% of your employees eligible to participate choose the salary reduction arrangement.
• You have 25 or fewer employees who were eligible to participate in the SEP (or would have been eligible to participate if you had maintained a SEP) at any time during the preceding year.
• The elective deferrals of your highly compensated employees meet the SARSEP ADP test.

SARSEP ADP test. Under the SARSEP ADP test, the amount deferred each year by each eligible highly compensated employee as a percentage of pay (the deferral percentage) cannot be more than 125% of the average deferral percentage (ADP) of all nonhighly compensated employees eligible to participate. A highly compensated employee is defined earlier under Definitions You Need To Know.

Deferral percentage. The deferral percentage for an employee for a year is figured as follows.

The deferral percentage

The instructions for Form 5305A-SEP have a worksheet you can use to determine whether the elective deferrals of your highly compensated employees meet the SARSEP ADP test.

Who cannot have a SARSEP? A state or local government, any of its political subdivisions, agencies, or instrumentalities, or a tax-exempt organization cannot have a SEP that includes a salary reduction arrangement.

Limit on Elective Deferrals

The most a participant can choose to defer for calendar year 2000 is the lesser of the following amounts.

• 15% of the participant's compensation (limited to $170,000 of the participant's compensation).
• $10,500.

The $10,500 limit applies to the total elective deferrals the employee makes for the year to a SEP and any of the following.

• Cash or deferred arrangement (section 401(k) plan).
• Salary reduction arrangement under a tax-sheltered annuity plan (section 403(b) plan).
• SIMPLE IRA plan.

Overall limit on SEP contributions. If you also make nonelective contributions to a SEP-IRA, the total of the nonelective and elective contributions to that SEP-IRA cannot be more than the lesser of 15% of the employee's compensation or $30,000. The same rule applies to contributions you make to your own SEP-IRA. See Contribution Limits, earlier.

Employee compensation. For figuring the elective deferral, compensation is generally the amount you pay to the employee for the year. Compensation includes the elective deferral and other amounts deferred in certain employee benefit plans. See Compensation, earlier under Definitions You Need To Know. These amounts are included in figuring your employees' total contributions even though they are not included in the income of your employees for income tax purposes.

You can choose not to treat the deferral as compensation, as discussed later.

To figure the deferral, multiply the employee's compensation by the deferral contribution rate. However, you must always use the reduced rate method to determine the maximum deductible contribution (13.0435% of unreduced compensation). This is the same method you use to figure your deduction for contributions you make to your own SEP-IRA.

Example 1. Jim's SARSEP calls for a deferral contribution rate of 10% of his salary. Jim's salary for the year is $30,000 (before reduction for the deferral). You multiply Jim's salary by 10% to get his deferral of $3,000. Your maximum deduction for elective deferrals and any nonelective contributions would be $3,913.05 ($30,000 x .130435).

On Jim's Form W-2, you show his total wages as $27,000 ($30,000 - $3,000). Social security wages and Medicare wages will each be $30,000. Jim will report $27,000 as wages on his individual income tax return.

Choice not to treat deferrals as compensation. You can choose not to treat elective deferrals (and other amounts deferred in certain employee benefit plans) for a year as compensation under your SARSEP. You can use this method for calculating deferral percentages for the SARSEP ADP test defined earlier.

The deferral and the compensation (minus the deferral) depend on each other. For this reason, you figure the deferral indirectly by reducing the contribution rate for deferrals called for under the salary reduction arrangement. This method is the same one you use to figure your deduction for contributions you make to your own SEP-IRA. You must also use the reduced rate method to determine the maximum deductible contribution (13.0435% of unreduced compensation).

To figure the deferral, use either the rate table or rate worksheet in the Appendix. Use the rate table if the deferral contribution rate called for under the SARSEP equals a whole percentage. Otherwise, use the rate worksheet. When using the rate table, first locate the deferral contribution rate in Column A. Then read across to find the reduced rate in Column B. Multiply the reduced rate by your employee's compensation to get the deferral.

Example 2. The facts are the same as in Example 1 except you chose not to treat deferrals as compensation under the arrangement. To figure the deferral, you multiply Jim's salary of $30,000 by 0.090909 (the reduced rate equivalent of 10%) to get the deferral of $2,727.27. Your maximum deduction for elective deferrals and any nonelective contributions would be $3,913.05 ($30,000 x .130435).

On Jim's Form W-2, you show his total wages as $27,272.73 ($30,000 - $2,727.27). Social security wages and Medicare wages will each be $30,000. Jim will report $27,272.73 as wages on his individual income tax return.

Alternative definitions of compensation. In addition to the general definition of compensation under Definitions You Need To Know and the choice described in the preceding paragraphs, you can use any definition of compensation that meets all the following conditions.

• It is reasonable.
• It is not designed to favor highly compensated employees.
• It provides that the average percentage of total compensation used for highly compensated employees as a group for the year is not more than minimally higher than the average percentage of total compensation used for all other employees as a group.

Compensation of self-employed individuals. If you are self-employed, compensation is your net earnings from self-employment as defined earlier under Definitions You Need To Know.

To figure the deferral, you must use a reduced rate instead of the deferral contribution rate called for under the SARSEP. Use either the rate table or rate worksheet in the Appendix to get the reduced rate. Then use the deduction worksheet to figure the deferral.

Compensation does not include tax-free items (or deductions related to them) other than foreign earned income and housing cost amounts.

Compensation of disabled participant. You may be able to choose to use special rules to determine compensation for a participant who is permanently and totally disabled. Under these rules, compensation means the compensation the participant would have received if paid at the rate paid immediately before becoming permanently and totally disabled. See Internal Revenue Code section 415(c)(3)(C) for details.

Tax Treatment of Deferrals

You can deduct your deferrals that, when added to your other SEP contributions, are not more than the limits under Deducting Contributions, earlier.

Elective deferrals that are not more than the limit discussed earlier are excluded from your employees' wages subject to federal income tax in the year of deferral. However, these deferrals are included in wages for social security, Medicare, and federal unemployment (FUTA) tax.

Excess deferrals. For 2000, excess deferrals are the elective deferrals for the year that are more than the $10,500 limit discussed earlier. The treatment of excess deferrals made under a SARSEP is similar to the treatment of excess deferrals made under a qualified plan. See Treatment of Excess Deferrals under Qualified Plans, later.

Excess SEP contributions. Excess SEP contributions are elective deferrals of highly compensated employees that are more than the amount permitted under the SARSEP ADP test. You must notify your highly compensated employees within 2 1/2 months after the end of the plan year of their excess SEP contributions. If you do not notify them within this time period, you must pay a 10% tax on the excess. For an explanation of the notification requirements, see Revenue Procedure 91-44 in Cumulative Bulletin 1991-2. If you adopted a SARSEP using Form 5305A-SEP, the notification requirements are explained in the instructions for that form.

Reporting on Form W-2. Do not include elective deferrals in the "Wages, tips, other compensation" box of Form W-2. You must, however, include them in the "Social security wages" and "Medicare wages and tips" boxes. You must also include them in box 13. Mark the "Deferred compensation" checkbox in box 15. For more information, see the Form W-2 instructions.

Distributions (Withdrawals)

As an employer, you cannot prohibit distributions from a SEP-IRA. Also, you cannot make your contributions on the condition that any part of them must be kept in the account.

Distributions are subject to IRA rules. For information about IRA rules, including the tax treatment of distributions, rollovers, required distributions, and income tax withholding, see Publication 590.

Additional Taxes

The tax advantages of using SEP-IRAs for retirement savings can be offset by additional taxes. There are additional taxes for all the following actions.

• Making excess contributions.
• Making early withdrawals.
• Not making required withdrawals.

For information about these taxes, see chapter 1 in Publication 590. Also, a SEP-IRA may be disqualified, or an excise tax may apply, if the account is involved in a prohibited transaction, discussed next.

Prohibited transaction. If an employee improperly uses his or her SEP-IRA, such as by borrowing money from it, the employee has engaged in a prohibited transaction. In that case, the SEP-IRA will no longer qualify as an IRA. For a list of prohibited transactions, see Prohibited Transactions under Qualified Plans, later.

Effects on employee. If a SEP-IRA is disqualified because of a prohibited transaction, the assets in the account will be treated as having been distributed to the employee on the first day of the year in which the transaction occurred. The employee must include in income the fair market value of the assets (on the first day of the year) that is more than any cost basis in the account. Also, the employee may have to pay the additional tax for making early withdrawals. For more information, see Taxes on Prohibited Transactions under Qualified Plans, later.

Reporting and Disclosure Requirements

If you set up a SEP using Form 5305-SEP or Form 5305A-SEP (for a SARSEP), you must give your eligible employees certain information about the SEP when you set it up. See Setting Up a SEP, earlier. Also, you must give your eligible employees a statement each year showing any contributions to their SEP-IRAs. If you set up a salary reduction SEP, you must also give them notice of any excess contributions. For details about other information you must give them, see the instructions for either of these forms.

Even if you did not use Form 5305-SEP or Form 5305A-SEP to set up your SEP, you must give your employees information similar to that described above. For more information, see the instructions for either Form 5305-SEP or Form 5305A-SEP.

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