Hans Kasper, MS-CPA, PS

Simplified Employee Pensions - SEP IRA

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A simplified employee pension (SEP) is a type of retirement plan under which an employer makes contributions to IRAs of employees.  For 2005, annual contributions by an employer to a SEP are excluded from the employee's gross income to the extent that the contributions do not exceed the lesser of: (1) 25% of the participant's compensation ($210,000 maximum for 2005) or (2) $42,000.  For 2006, the $210,000 limit is increased to $220,000 and the $42,000 limit is increased to $44,000.  If the employer exceeds the annual limit on contributions, the employee is generally taxed on the amount of the excess contribution.  In the case of a SEP established by an unincorporated employer, the “compensation” of a self-employed participant (partner or proprietor) is “earned income”. 

In order to deduct its SEP contributions for a particular year, the employer must make the contributions by the due date (including extensions) of its tax return for that tax year.  The contributions are made to the SEP-IRAs that have been established by, or for, each eligible employee.

Example :   J.  B.  Books, Inc.  is a calendar year corporation.  A few years ago, the corporation established a SEP plan for its eligible employees.  Its contributions to the separate SEP-IRAs for 2005, must generally be made by the due date of its tax return (i.e., March 15, 2006).  However, if it has requested a six-month filing extension, the contributions may be made up to September 15, 2006.

Although the employer's deduction cannot exceed 25% of the employee's compensation (not in excess of $210,000 for 2005, any excess can be carried over and deducted (subject to the percentage limitation for the carryover year) in later years.  In addition, when an employer maintains another type of defined contribution plan, the contributions to a SEP must be taken into account when determining compliance with the annual limit imposed on deductible contributions to the plans. 

Nondiscriminatory employer contributions under a SEP must be made for each employee who: (1) has reached age 21; (2) has performed services for the employer during at least three of the immediately preceding five years; and (3) received at least a specific dollar amount of compensation from the employer for the year ($450 for 2005 and 2006). 

Employee Contributions.  Employees may make contributions to their SEP-IRA that are independent of their employer's contributions.  However, the employee's total contributions to a SEP-IRA, a traditional IRA, and/or a Roth IRA are subject to a yearly maximum ($4,000 for 2005 or $4,500 if catch-up contributions are allowable).  As with traditional IRAs, the employee's gross income and filing status determines whether the employee's contribution to the SEP-IRA is deductible.

Establishing a SEP-IRA.  Most employers are able to establish a SEP plan by completing a Form 5305-SEP, Simplified Employee Pension —Individual Retirement Accounts Contribution Agreement.  The form is not filed with the IRS.  Instead, it is retained by the employer as evidence that a SEP plan has been established.  All eligible employees must be given a copy of the Form 5305-SEP.  Certain employers should not use Form 5305-SEP (e.g., employers that are currently maintaining another qualified plan, or use the services of leased employees).  An employer may establish a SEP-IRA for a particular year as late as the due date, including extensions, for the income tax return for that year.

Distributions.  Distributions from a SEP are taxed under the rules that apply to distributions from an IRA.

Top-Heavy SEP.  If a SEP is top heavy, each participant who is not a key employee must be provided with a contribution that is not less than three percent of his compensation.  If the rate for the key employee receiving the largest contribution is less than three percent, the contribution rate for that employee is used to determine the minimum contribution for non-key employees. 

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This page was last updated on 05/13/2010


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