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Pub. 560, Retirement Plans for Small Business 2004 Tax Year

Chapter 2 - Simplified Employee Pension (SEP)

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Table of Contents

Topics - This chapter discusses:

  • Setting up a SEP

  • How much to contribute

  • Deducting contributions

  • Salary reduction simplified employee pensions (SARSEPs)

  • Distributions (withdrawals)

  • Additional taxes

  • Reporting and disclosure requirements

Useful Items - You may want to see:

Publication

  • 590 Individual Retirement Arrangements (IRAs)

Forms (and Instructions)

  • W-2
    Wage and Tax Statement

  • 1040
    U.S. Individual Income Tax Return

  • 5305-SEP
    Simplified Employee Pension—Individual Retirement Accounts Contribution Agreement

  • 5305A-SEP
    Salary Reduction Simplified Employee Pension—Individual Retirement Accounts Contribution Agreement

A simplified employee pension (SEP) is a written plan that allows you to make contributions toward your own retirement (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. A SEP-IRA is 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 in chapter 1), 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 2004.

  
Tip
 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.

Tip
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 in chapter 1).

  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.

Credit for startup costs.   You may be able to claim a tax credit for part of the ordinary and necessary costs of starting a SEP that first became effective in 2004. For more information, see Credit for startup costs under Reminders, earlier.

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 in chapter 1). 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 2004 to a common-law employee's SEP-IRA cannot exceed the lesser of 25% of the employee's compensation or $41,000 ($42,000 for 2005). Compensation generally does not include your contributions to the SEP.

Example.

Your employee, Mary Plant, earned $21,000 for 2004. The maximum contribution you can make to her SEP-IRA is $5,250 (25% 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 $205,000 when figuring your contribution limit for that employee. However, $41,000 is the maximum contribution for an eligible employee. (The annual compensation limit of $205,000 increases to $210,000 for 2005.)

More than one plan.   If you contribute to a defined contribution plan (defined in chapter 4), annual additions to an account are limited to the lesser of $41,000 or 100% 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 2004 that exceed the lesser of the following amounts.

  • 25% of the employee's compensation (or, for you, 20% of your net earnings from self-employment).

  • $41,000.

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 Contributions for Participants

The most you can deduct for your contributions (other than elective deferrals) for participants is the lesser of the following amounts.

  1. Your contributions (including any excess contributions carryover).

  2. 25% of the compensation (limited to $205,000 per participant) paid to the participants during 2004 from the business that has the plan, not to exceed $41,000 per participant.

In 2005, the $205,000 and $41,000 amounts in (2) above increase to $210,000 and $42,000.

Caution
Compensation in (2) above includes elective deferrals (explained, later, under Salary Reduction Simplified Employee Pension (SARSEP)). Elective deferrals are no longer subject to this deduction limit. However, the combined deduction for a participant's elective deferrals and other SEP contributions cannot exceed $41,000.

Your SEP document may limit contributions to lower amounts because of elective deferrals.

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 in chapter 1), 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 chapter 5. Then figure your maximum deduction by using the Deduction Worksheet for Self-Employed in chapter 5.

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 in chapter 4 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 under Qualification Rules in chapter 4. For information about the special deduction limits, see Deduction limit for multiple plans under Employer Deduction in chapter 4.

SEP and defined contribution plan.   If you also contribute to a qualified defined contribution plan, you must reduce the 25% deduction limit for that plan by the allowable deduction for contributions to the SEP-IRAs of those participating in both the SEP plan and the defined contribution 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 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 Employer Deduction in chapter 4 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 Employer Deduction in chapter 4.

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 2004 on your tax return for your tax year ending June 30, 2005.

Where To Deduct Contributions

Deduct the contributions you make for your common-law employees on your tax return. For example, sole proprietors deduct them on Schedule C (Form 1040), Profit or Loss From Business, or Schedule F (Form 1040), Profit or Loss From Farming, partnerships deduct them on Form 1065, U.S. Return of Partnership Income, and corporations deduct them on Form 1120, U.S. Corporation Income Tax Return, Form 1120-A, U.S. Corporation Short-Form Income Tax Return, or Form 1120S, U.S. Income Tax Return for an S Corporation.

Sole proprietors and partners deduct contributions for themselves on line 32 of Form 1040, U.S. Individual Income Tax Return. (If you are a partner, contributions for yourself are shown on the Schedule K-1 (Form 1065), Partner's Share of Income, Credits, Deductions, etc., you get from the partnership.)

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.

Caution
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 chapter 3.

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 to make elective deferrals.

  • You have 25 or fewer employees who were eligible to participate in the 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 non-highly compensated employees eligible to participate. A highly compensated employee is defined in chapter 1.

Deferral percentage.   The deferral percentage for an employee for a year is figured as follows.
  The elective employer contributions
(excluding certain catch-up contributions)
paid to the SEP for the employee for the year 		 
  The employee's compensation
(limited to $205,000) 		 

Tip
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.

Employee compensation.   For figuring the deferral percentage, 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 in chapter 1. Elective deferrals under the SARSEP are included in figuring your employees' deferral percentage even though they are not included in the income of your employees for income tax purposes.

Compensation of self-employed individuals.   If you are self-employed, compensation is your net earnings from self-employment as defined in chapter 1.

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

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.

Limit on Elective Deferrals

The most a participant can choose to defer for calendar year 2004 is the lesser of the following amounts.

  1. 25% of the participant's compensation (limited to $205,000 of the participant's compensation).

  2. $13,000.

In 2005, the compensation limit in (1) of $205,000 increases to $210,000. The amount in (2) increases to $14,000.

The $13,000 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.

Catch-up contributions.   A SARSEP can permit participants who are age 50 or over at the end of the calendar year to also make catch-up contributions. The catch-up contribution limit for 2004 is $3,000 ($4,000 for 2005). Elective deferrals are not treated as catch-up contributions for 2004 until they exceed the elective deferral limit (the lesser of 25% of compensation or $13,000), the SARSEP ADP test limit discussed earlier, or the plan limit (if any). However, the catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts.

  • The catch-up contribution limit.

  • The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.

  Catch-up contributions are not subject to the elective deferral limit (the lesser of 25% of compensation or $13,000).

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 exceed the lesser of 25% of the employee's compensation or $41,000 ($42,000 for 2005). The same rule applies to contributions you make to your own SEP-IRA. See Contribution Limits, earlier.

Figuring the elective deferral.   For figuring the 25% limit on elective deferrals, compensation does not include SEP contributions, including elective deferrals or other amounts deferred in certain employee benefit plans.

Tax Treatment of Deferrals

Elective deferrals are no longer subject to the deduction limits discussed earlier under Deducting Contributions. However, the combined deduction for a participant's elective deferrals and other SEP contributions cannot exceed $41,000.

Elective deferrals that are not more than the limits discussed earlier under Limit on Elective Deferrals 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 2004, excess deferrals are the elective deferrals for the year that are more than the $13,000 limit discussed earlier. For a participant who is eligible to make catch-up contributions, excess deferrals are the elective deferrals that are more than $16,000. 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 Elective Deferrals (401(k) Plans) in chapter 4.

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 2½ 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 12. Mark the “Retirement plan” checkbox in box 13. 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 in chapter 4.

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.

Reporting and Disclosure Requirements

If you set up a SEP using Form 5305-SEP, 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. You must also give them notice of any excess contributions. For details about other information you must give them, see the instructions for Form 5305-SEP or 5305A-SEP (for a salary reduction SEP).

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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