3. Simplified Employee Pension (SEP)

Important Changes for 2002

Increase in limits on elective deferrals under a SEP-IRA. In general, the limit on elective deferrals made on your behalf for 2002 that represent a reduction in your salary under a SEP-IRA cannot be more than $11,000 (up from $10,500 for 2001). For more information, see What Is a Salary Reduction Arrangement, in this chapter.

Increase in overall limits on SEP-IRA contributions. For 2002, your employer can contribute to your SEP-IRA up to the lesser of 25% of your compensation or $40,000 (up from $30,000 in 2001). For more information, see What Is a Salary Reduction Arrangement, in this chapter.

Additional elective deferrals under a SEP-IRA for persons 50 and older. For contributions made after 2001, additional elective deferrals can be contributed to your salary reduction arrangement SEP-IRA if:

• You reached age 50 by the end of 2002, and
• No other elective deferrals can be made for you to the plan for the year because of limits or restrictions, such as the regular annual limit.

See What Is a Salary Reduction Arrangement, in this chapter.

Credit for salary reduction contributions. For tax years beginning after 2001, if you are an eligible individual, you may be able to claim a credit for a percentage of your qualified retirement savings contributions, such as salary reduction contributions to your SEP. To be eligible, you must be at least 18 years old as of the end of the year, and you cannot be a student or an individual for whom someone else claims a personal exemption. Also, your adjusted gross income (AGI) must be below a certain amount.

For more information, see chapter 5.

Important Changes for 2003

Increase in limits on elective deferrals under a SEP-IRA. In general, the limit on elective deferrals made on your behalf for 2003 that represent a reduction in your salary under a SEP-IRA cannot be more than $12,000 (up from $11,000 for 2002). For more information, see What Is a Salary Reduction Arrangement? in this chapter.

Additional elective deferrals under a SEP-IRA for persons 50 and older. For 2003, additional elective deferrals can be contributed to your salary reduction arrangement SEP-IRA if:

• You will be 50 or older in 2003, and
• No other elective deferrals can be made for you to the plan for the year because of limits or restrictions, such as the regular annual limit.

For 2003, the additional amount is the lesser of the following two amounts.

1. $2,000 (up from $1,000 for 2002), or
2. Your compensation for the year reduced by your other elective deferrals for the year.

For more information, see What Is a Salary Reduction Arrangement? in this chapter.

Introduction

Employers, including self-employed individuals, can set up simplified employee pension (SEP) plans. A SEP plan allows an employer to make contributions toward employees' retirement, and, if the employer is self-employed, his or her own retirement, without becoming involved in more complex retirement plans.

A self-employed individual is an employee for SEP purposes. He or she is also the employer. Even if the self-employed individual is the only qualifying employee, he or she can have an IRA under a SEP plan (SEP-IRA).

This chapter focuses on the rules affecting employees. For information on the rules affecting employers, see Publication 560.

What Is a SEP?

A simplified employee pension (SEP) is a written arrangement (a plan) that allows an employer to make deductible contributions for the benefit of participating employees. The contributions are made to individual retirement arrangements (IRAs) set up for participants in the plan. Traditional IRAs set up under a SEP plan are referred to in this publication as SEP-IRAs. For more information, see Publication 560, Retirement Plans for Small Business.

How Much Can Be Contributed on My Behalf?

The SEP rules permit an employer to contribute to each participating employee's SEP-IRA up to 25% of the employee's compensation or $40,000, whichever is less. These contributions are funded by the employer.

An employer who signs a SEP agreement does not have to make any contribution to the SEP-IRAs that are set up. But, if the employer does make contributions, the contributions must be based on a written allocation formula and must not discriminate in favor of highly compensated employees (defined in Publication 560).

Figuring the 25% Limit

For purposes of determining the 25% limit, compensation is generally limited to $200,000 for 2002, not including your employer's contribution to your SEP-IRA.

Example. Barry's nonunion employer has a SEP for its employees. Barry's compensation for 2002, before his employer's contribution to his SEP-IRA, was $120,000. Because the 25% limit is less than the $40,000 limit, Barry's employer can contribute up to $30,000 (25% × $120,000) to Barry's SEP-IRA.

Deduction Limit for a Self-Employed Person

If you are self-employed and contribute to your own SEP-IRA, special rules apply when figuring your maximum deduction for these contributions.

Determining your compensation. For purposes of the 25% limit on contributions, discussed above, your compensation is your net earnings from self-employment, defined later. Note that, for SEP purposes, your net earnings (compensation) must take into account your deduction for contributions to your own SEP-IRA. Because your deduction amount and your net earnings amount are each dependent on the other, this adjustment presents a problem. To solve this problem, you must use a reduced contribution rate to figure your maximum deduction. Make no reduction to the contribution rate for any common-law employees.

First, use either the rate table or rate worksheet to find your reduced contribution rate. Then complete the deduction worksheet to figure your deduction for contributions.

The table and the worksheets that follow apply only to self-employed individuals who have only one defined contribution plan, such as a profit-sharing plan. A SEP plan is treated as a profit-sharing plan.

Rate table for the self-employed. If your plan's contribution rate is a whole percentage (for example, 12% rather than 12 1/2%), you can use Table 3-1 to find your reduced contribution rate. Otherwise, use Worksheet 3-1 provided later.

First, find your plan contribution rate (the contribution rate stated in your plan) in Column A of the table. Then read across to the rate under Column B. Enter the rate from Column B in step 4 of Worksheet 3-2, Deduction Worksheet for Self-Employed.

Table 3-1. Rate Table for the Self-Employed

Column A If the plan contri- bution rate is: (shown as %)	Column B Your rate is: (shown as decimal)
1	.009901
2	.019608
3	.029126
4	.038462
5	.047619
6	.056604
7	.065421
8	.074074
9	.082569
10	.090909
11	.099099
12	.107143
13	.115044
14	.122807
15	.130435
16	.137931
17	.145299
18	.152542
19	.159664
20	.166667
21	.173554
22	.180328
23	.186992
24	.193548
25*	.200000*
*The deduction for annual employer contributions (other than elective deferrals) to a SEP plan, a profit-sharing plan, or a money purchase plan, cannot be more than 20% of your net earnings (figured without deducting contributions for yourself) from the business that has the plan.

Example. You are a sole proprietor with no employees. If your plan's contribution rate is 10% of a participant's compensation, your rate is 0.090909. Enter this rate in step 4 of Worksheet 3-2.

Rate worksheet for the self-employed. If your plan's contribution rate is not a whole percentage (for example, 10 1/2%), you cannot use Table 3-1. Use Worksheet 3-1, Rate Worksheet for the Self-Employed, instead.

Worksheet 3-1. Rate Worksheet for the Self-Employed

1)	Plan contribution rate as a decimal (for example, 10 1/2% would be 0.105)
2)	Rate in line 1 plus one (for example, 0.105 plus one would be 1.105)
3)	Reduced contribution rate as a decimal rounded to at least 3 decimal places . (Divide line 1 by line 2.)

Figuring your deduction. Now that you have your self-employed rate from either the rate table or rate worksheet, you can figure your maximum deduction for contributions for yourself by completing Worksheet 3-2, Deduction Worksheet for the Self-Employed.

Community property laws. If you reside in a community property state and you are married and filing a separate return, disregard community property laws for step 1 of Worksheet 3-2. Enter on step 1 the total net profit you actually earned.

Worksheet 3-2. Deduction Worksheet for the Self-Employed

Step 1
Enter your net profit from line 31, Schedule C (Form 1040); line 3, Schedule C-EZ (Form 1040); line 36, Schedule F (Form 1040); or line 15a*, Schedule K-1 (Form 1065).
*General partners should reduce this amount by the same additional expenses that were subtracted from line 15a to determine the amount shown on line 1 or 2 of Schedule SE.
Step 2
Enter your deduction for self-employment tax from line 29, Form 1040
Step 3
Net earnings from self-employment. Subtract step 2 from step 1
Step 4
Enter your rate from Table 3-1 or Worksheet 3-1
Step 5
Multiply step 3 by step 4
Step 6
Multiply $200,000 by your plan contribution rate (not the reduced rate).
Step 7
Enter the smaller of step 5 or step 6
Step 8
Contribution dollar limit	$40,000
If you made any elective deferrals, go to step 9. Otherwise, skip steps 9 through 18 and enter the smaller of step 7 or step 8 on step 19.
Step 9
Enter your allowable elective deferrals made during 2002. Do not enter more than $11,000
Step 10
Subtract step 9 from step 8
Step 11
Subtract step 9 from step 3
Step 12
Enter one-half of step 11
Step 13
Enter the smallest of steps 7, 10, or 12
Step 14
Subtract step 13 from step 3
Step 15
Enter the smaller of step 9 or step 14
If you made catch-up contributions, go to step 16. Otherwise, skip steps 16 through 18 and go to step 19.
Step 16
Subtract step 15 from step 14
Step 17
Enter your catch-up contributions, if any. Do not enter more than $1,000
Step 18
Enter the smaller of step 16 or step 17
Step 19
Add steps 13, 15, and 18. This is your maximum contribution deduction.
Next: Enter your deduction on line 31, Form 1040

  

Example. You are a sole proprietor with no employees. The terms of your plan provide that you contribute 8 1/2% (.085) of your compensation to your plan. Your net profit from line 31, Schedule C (Form 1040) is $200,000. You have no elective deferrals or catch-up contributions. Your self-employment tax deduction on line 29 of Form 1040 is $7,942. You figure your reduced contribution rate and maximum deductible contributions as shown on Filled-in Worksheet 3-1 and Filled-in Worksheet 3-2.

Filled-in Worksheet 3-1. Example of Rate Worksheet for the Self-Employed

1)	Plan contribution rate as a decimal (for example, 10 1/2% would be 0.105)	0.085
2)	Rate in line 1 plus one (for example, 0.105 plus one would be 1.105)	1.085
3)	Reduced contribution rate as a decimal rounded to at least 3 decimal places . (Divide line 1 by line 2.)	0.078

Filled-in Worksheet 3-2. Example of Deduction Worksheet for the Self-Employed

Step 1
Enter your net profit from line 31, Schedule C (Form 1040); line 3, Schedule C-EZ (Form 1040); line 36, Schedule F (Form 1040); or line 15a*, Schedule K-1 (Form 1065).	$200,000
*General partners should reduce this amount by the same additional expenses that were subtracted from line 15a to determine the amount shown on line 1 or 2 of Schedule SE.
Step 2
Enter your deduction for self-employment tax from line 29, Form 1040	7,942
Step 3
Net earnings from self-employment. Subtract step 2 from step 1	192,058
Step 4
Enter your rate from Table 3-1 or Worksheet 3-1	0.078
Step 5
Multiply step 3 by step 4	14,981
Step 6
Multiply $200,000 by your plan contribution rate (not the reduced rate).	17,000
Step 7
Enter the smaller of step 5 or step 6	14,981
Step 8
Contribution dollar limit	$40,000
If you made any elective deferrals, go to step 9. Otherwise, skip steps 9 through 18 and enter the smaller of step 7 or step 8 on step 19.
Step 9
Enter your allowable elective deferrals made during 2002. Do not enter more than $11,000
Step 10
Subtract step 9 from step 8
Step 11
Subtract step 9 from step 3
Step 12
Enter one-half of step 11
Step 13
Enter the smallest of steps 7, 10, or 12
Step 14
Subtract step 13 from step 3
Step 15
Enter the smaller of step 9 or step 14
If you made catch-up contributions, go to step 16. Otherwise, skip steps 16 through 18 and go to step 19.
Step 16
Subtract step 15 from step 14
Step 17
Enter your catch-up contributions, if any. Do not enter more than $1,000
Step 18
Enter the smaller of step 16 or step 17
Step 19
Add steps 13, 15, and 18. This is your maximum contribution deduction.	$14,981
Next: Enter your deduction on line 31, Form 1040

Net earnings from self-employment. For SEP purposes, your net earnings are your gross income from your business minus allowable deductions for that business. Allowable deductions include contributions to your employees' SEP-IRAs. You also take into account the deduction allowed for one-half of your self-employment tax, and the deduction for contributions to your own SEP-IRA.

What to include. Include the following items in your net earnings.

1. Foreign earned income and housing cost amounts.
2. If you are a partner, your distributive share of partnership income or loss (other than separately treated items such as capital gains and losses).
3. If you are a limited partner, guaranteed payments for services to or for the partnership.
4. Elective contributions or deferrals under any of the following plans.
   1. 401(k) plans.
   2. 403(b) plans (tax-sheltered annuities).
   3. SEP plans (salary reduction arrangements).
   4. Savings incentive match plans for employees (SIMPLE plans).
   5. Cafeteria plans.
   6. 457 plans (plans of state and local governments and certain tax-exempt organizations).

What not to include. Do not include the following items in your net earnings.

1. Tax-free items (or deductions related to them).
2. If you are a limited partner, distributions of income or loss.

Time Limit for Contributions

To deduct contributions for a year, the employer must make the contributions by the due date (including extensions) of the employer's return for the year.

Overall Limit - Employer With
Defined Contribution and SEP Plans

If an employer contributes to a defined contribution retirement plan (a plan under which an individual account is set up for each participant), annual additions to an account are limited to the lesser of (1) $40,000 or (2) 25% of the participant's compensation. Moreover, for purposes of these limits, contributions to more than one such plan must be added. Since a SEP is considered a defined contribution plan for purposes of these limits, employer contributions to a SEP must be added to other contributions to defined contribution plans.

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