Chapter 24: simplified employee pension (SEP).
A simplified employee pension (SEP) is an employer-sponsored plan under which plan contributions are made to the participating employee's IRA. Tax-deferred contribution levels for SEPs are generally significantly higher than the maximum contribution limit for traditional IRAs (see Chapter 5). A SEP provides for employer contributions only, except for salary reduction SEPs (SAR-SEPs), which had to be adopted before 1997.
SEPs are easy to adopt and generally simple to administer, while providing employees with the tax-deferred retirement savings benefits of a qualified plan. However, qualified plans potentially can provide higher contribution levels. Annual SEP contributions are effectively limited to the lesser of 25% of compensation or $49,000 (in 2009). (1)
WHEN IS IT INDICATED?
1. When the employer is looking for an alternative to a qualified profit sharing plan that is easier and less expensive to install and administer. For very small employers, a SEP is one of the simplest types of tax-deferred employee retirement plans available. For larger employers (more than about 10 employees), the cost of installing and administering a qualified plan can be spread over enough employees that the advantages of a SEP are less significant.
2. When an employer wants to install a tax-deferred plan and it is too late to adopt a qualified plan for the year in question. (Qualified plans must be adopted before the end of the year in which they are to be effective. SEPs can be adopted as late as the tax return filing date for the year in which they are to be effective.)
3. When an employer who adopted a SAR-SEP prior to 1997 wants to continue to operate a simplified plan funded through employee salary reductions (before-tax contributions). While such plans may not be adopted after 1996, plans in existence before 1997 may continue to operate and add new participants. (See "Tax Implications," below for more details.) Employers wishing to adopt a simplified plan that is funded through employee salary reductions should consider a SIMPLE IRA plan (see Chapter 23).
1. A SEP can be adopted by completing IRS Form 5305SEP, found at: http://pro.nuco.com/booksupplements/ TTEB, rather than by the complex procedure required for qualified plans (described in Chapter 10). However, if the employer adopts a master or prototype qualified plan, the installation costs and complexity may not actually be much greater than that for a SEP, even though the documentation is more voluminous.
2. A SEP can be adopted at any time up to the tax return filing date for the year, including extensions. For example, if an incorporated employer uses the calendar year, the tax return filing date for the year 2009 is March 15, 2010, with extensions possible to September 15, 2010. Therefore, a SEP could be adopted for 2009 as late as September 15, 2010.
3. Benefits of a SEP are totally portable for employees, since funding consists entirely of IRAs for each employee and employees are always 100 percent vested in their benefits. Employees own and control their SEP/IRA accounts, even after they terminate employment with the original employer.
4. A SEP provides as much or more flexibility in the timing of contributions as a qualified profit sharing plan. The employer is free, at its discretion, to make no contribution to the plan in any given year.
5. Individual IRA accounts allow participants to benefit from good investment results (however, participants also assume the risk of bad investment results).
6. A SAR-SEP that was adopted before 1997 can be funded through salary reductions by employees, if the conditions described under "Tax Implications," below, are met.
1. Employees cannot rely upon a SEP to provide an adequate retirement benefit. First, benefits are not significant unless the employer makes substantial, regular contributions to the SEP. Such regular contributions are not a requirement for a SEP. Furthermore, employees who enter the plan at older ages have only a limited number of years remaining prior to retirement to build up their SEP accounts.
2. Annual contributions may be restricted to lesser amounts than would be available in a qualified plan. Although SEPs are subject to the same Section 415 limit as a defined contribution plan (i.e., the lesser of (a) 100% of compensation or (b) $49,000 (in 2009 as indexed), the deduction and exclusion amounts may be lower than they would be for a qualified plan, as explained below.
3. Distributions from SEPs are not eligible for special averaging available for certain qualified plan distributions (see Chapter 8).
1. An employer may deduct contributions to a SEP, up to 25% of the total payroll of all employees covered under the plan, if the contributions are made under a written formula that meets various requirements of the Internal Revenue Code. (2)
2. The major SEP coverage requirements are: (3)
* A SEP must cover all employees who are at least 21 years of age and who have worked for the employer during 3 out of the preceding 5 calendar years. Part-time employment counts in determining years of service.
* Contributions need not be made on behalf of employees whose compensation for the calendar year was less than $550 (as indexed for 2009).
* The plan can exclude employees who are members of collective bargaining units if retirement benefits have been the subject of good-faith bargaining. Nonresident aliens can also be excluded.
See Figure 24.1 for a comparison of small business retirement plan options.
3. The employer need not contribute any particular amount to a SEP or make any contribution at all. The "recurring and substantial contributions" requirement applicable to qualified profit sharing plans (as discussed in Chapter 17) has no effect on SEPs, so SEP contributions are more flexible than those to a qualified plan. An employer can freely omit any year's contribution to a SEP without any concern about adverse tax consequences.
4. The employer contribution, if made, must be allocated to plan participants under a written formula that does not discriminate in favor of highly compensated employees. The definition of "highly compensated" is that used for most employee benefit purposes, as discussed in Chapter 7. SEP formulas usually provide allocations as a uniform percentage of total compensation of each employee. In the allocation formula, only the first $245,000 (as indexed for 2009) of each employee's compensation can be taken into account. SEP allocation formulas can be integrated with Social Security under the integration rules applicable to qualified defined contribution plans (discussed in Chapter 7).
5. Partners and proprietors can be covered under the SEP of an unincorporated employer, as well as regular employees. As discussed in Chapter 22 (relating to HR 10 plans), for a partner or proprietor, "earned income" is used in place of compensation in computing SEP contributions.
6. Salary Reduction SEP (SAR-SEP): While new SARSEPs may not be adopted after 1996, an employer who has 25 or fewer eligible employees and who adopted a salary reduction SEP (i.e., one funded through employee salary reductions) prior to 1997 may continue to operate the plan and may add new participants (up to the 25-employee limit). Under a salary reduction plan, employees have an election to receive cash or have amounts contributed to the SEP. The arrangement works similarly to a Section 401(k) salary reduction arrangement described in Chapter 20. The rules with respect to the exclusion for SEPs also apply to SAR-SEPs, but the picture is a little more complex for SAR-SEPs. The definition of "compensation" for purposes of the SEP provisions does not include elective deferrals. As a result, the "25% of compensation" limit will produce a smaller total than in the case, for example, of a 401(k) plan, where "compensation" may include elective deferrals. (4)
Salary reductions are subject to an annual limit. The employee must add together each year all elective deferrals to (1) salary reduction SEPs, (2) Section 401(k) plans (see Chapter 20), (3) SIMPLE IRAs (see Chapter 23) and (4) Section 403(b) tax deferred annuity plans (see Chapter 25). All elective deferrals from all employer plans that cover the employee must be aggregated. The total must not exceed $16,500 (as indexed for 2009). (5)
In addition to the foregoing salary reductions, employees who have reached age 50 during the plan year are generally eligible to make "catch-up" contributions. For salary reduction SEPs, the elective deferral limit is increased by $5,500 (as indexed for 2009) for catch-up contributions. (6)
Note that the above limits are higher than those applicable to SIMPLE IRAs and SIMPLE 401(k) plans (see Chapter 20 and Chapter 23), so employers with grandfathered salary reduction SEPs may wish to continue them.
An employer cannot use a salary reduction SEP unless 50 percent or more of the employees eligible to participate elect to make SEP contributions. In addition, rules similar to the "actual deferral percentage" (ADP) test apply to a salary reduction SEP. (7) Under the ADP rules for SAR-SEPs, the deferral percentage for each highly compensated eligible employee who participates must be no more than 1.25 times the ADP of nonhighly compensated eligible employees. For example, if nonhighly compensated employees elect salary reductions averaging 6 percent of compensation, no highly compensated employee can elect more than a 7.5 percent salary reduction.
Salary reductions, but not direct employer contributions, are subject to Social Security (FICA) and federal unemployment (FUTA) taxes. (8) The impact of state payroll taxes depends on the particular state's law. Both salary reductions and employer contributions may be exempt from state payroll taxes in some states.
7. If an employer maintains both a SEP and a qualified plan, employer contributions to the SEP reduce the amount that can be deducted for contributions to the qualified plan.
8. In a SEP plan, each participating employee maintains a traditional IRA. Employer contributions are made directly to the employee's IRA. Employer contributions, within the limits discussed above, are not included in the employee's taxable income.
9. Direct employer contributions to a SEP are not subject to Social Security (FICA) or federal unemployment (FUTA) taxes. The impact of state payroll taxes depends on the particular state's laws. Both salary reductions and employer contributions may be exempt from state payroll taxes in some states.
10. Certain employers adopting a plan may be eligible for a business tax credit of up to $500 for "qualified startup costs." See Chapter 10 for details.
11. An individual cannot make contributions to his or her own traditional IRA after attaining age 70 1/2. However, employers can make contributions to SEPs for employees who are over age 70 1/2. In fact, the age discrimination law, if applicable, would generally require such contributions to be made.
12. For individual IRA purposes, a SEP participant is treated the same as a participant in a regular qualified plan. That is, if the individual is an "active participant" in the plan, individual IRA contributions can be made and deducted, but the deduction is reduced or eliminated if adjusted gross income exceeds certain limits (see Chapter 5 for details). The full IRA deduction may be available to an individual who is not an active participant in a plan.
An employee covered under a SEP would be considered an active participant in any year in which salary reductions or employer contributions were allocated to his or her account. However, in a year in which no allocation was made to the individual's account, the individual would have a full individual IRA deduction available (within the limits explained in Chapter 5). (9) The higher SEP limit is not available for individual IRA contributions.
13. Certain lower-income taxpayers may claim a temporary, nonrefundable credit for "qualified retirement savings contributions." (10) This is known as the "saver's credit." "Qualified retirement savings contributions" include elective deferrals to salary reduction SEPs, as well as other elective deferrals and contributions to Roth or traditional IRAs. (However, the total is reduced by certain distributions received by the taxpayer or his spouse during the prior two taxable years and the current taxable year for which the credit is claimed, including the period up to the due date (plus extensions) for filing the federal income tax return for the current taxable year.)
The credit is allowed against the sum of the regular tax and the alternative minimum tax (minus certain other credits) and is allowed in addition to any other deduction or exclusion that would otherwise apply. In addition, to be eligible, the taxpayer must be at least 18 as of the end of the tax year and must not be claimed as a dependent by someone else or be a full-time student.
The amount of the credit is limited to an "applicable percentage" of the first $2,000 of IRA contributions and elective deferrals. The "applicable percentages" are as follows in 2009:
ADJUSTED GROSS INCOME Joint return Head of a household Over Not over Over Not over 0 $33,000 0 $24,750 33,000 36,000 24,750 27,000 36,000 55,500 27,000 41,625 55,500 41,625 All other cases Applicable Over Not over percentage 0 $16,500 50% 16,500 18,000 20% 18,000 27,750 10% 27,750 0%
Example: Max and Erma have adjusted gross income of $35,000 for 2009 and file a joint return. Their employers sponsor salary reduction SEPs and they each elected to make a salary reduction contribution of $3,000 to the plan. Neither has received any distributions in the current or two preceding taxable years. Max and Erma will be able to exclude their salary reduction contributions as well as each being eligible to claim a credit of $400 (20% x $2,000) ($800 collectively) on their federal income tax return for 2009.
14. Distributions to employees from the plan are treated as distributions from an IRA. All the restrictions on traditional IRA distributions apply and the distributions are taxed in the same manner. The taxation of distributions from traditional IRAs is discussed in Chapter 5.
HOW TO INSTALL A PLAN
Installation of a SEP can be very easy. The employer merely completes Form 5305-SEP. A copy of the form and instructions can be found at: http://pro.nuco.com/booksupplements/TTEB. To adopt a SEP, the employer completes the form and signs it prior to the tax filing date for the year in which the SEP is to take effect.11 The form does not have to be sent to the IRS or any other government agency.
A SEP adopted by filling out Form 5305-SEP is somewhat inflexible since it must follow the provisions set out on the IRS model form. Some of the provisions in this form are more stringent than are actually required by the SEP rules. In particular:
1. The plan set out on Form 5305-SEP is not integrated with Social Security.
2. By its terms, Form 5305-SEP cannot be used if the employer (a) currently maintains a qualified plan, or (b) maintained a qualified defined benefit plan at any time in the past covering one or more of the employees to be covered under the SEP.
If the employer wants to adopt a SEP plan that avoids the limitations of the IRS model form, the plan must be custom designed. Costs for custom designing and installing a SEP are comparable to those for a qualified profit sharing plan.
The reporting and disclosure requirements for SEPs are simplified if the employer uses Form 5305-SEP. The annual report form (5500 series) need not be filed if these forms are used. In other cases, reporting and disclosure requirements are similar to those for a qualified profit sharing plan.
WHERE CAN I FIND OUT MORE ABOUT IT?
IRS Publication 334, Tax Guide for Small Business, and Publication 535, Business Expense Deductions, available free from the IRS; revised annually.
(1.) This is the result of the combination of the IRC Section 415(c) limit (i.e., the lesser of $49,000 (in 2009) or 100% of compensation) and the IRC Section 402(h)(2) exclusion for contributions (which is 25% of compensation).
(2.) IRC Sec. 404(h)(1)(C).
(3.) The rules described in this chapter for SEPS are contained in IRC Section 408(k) unless otherwise indicated in the footnotes. The IRC formerly contained provisions for SEPs funded through salary reductions (SAR-SEPs). No new SAR-SEPs may be adopted after 1996; however, SAR-SEPs existing on December 31, 1996 may continue in effect and add new participants.
(4.) IRC Secs. 402(h)(2)(A), 404(a)(12), 404(n).
(5.) IRC Sec. 402(g).
(6.) IRC Sec. 414(v). Note that the limit will be lower if the amount of a participant's compensation, (after reduction for other elective deferrals) is less than the catch-up amounts.
(7.) IRC Sec. 408(k)(6).
(8.) IRC Secs. 3121(a)(5)(C), 3306(b)(5)(C).
(9.) Notice 87-16, 1987-1 CB 446, I.
(10.) IRC Sec. 25B.
(11.) Prop. Treas. Reg. [section]1.408-7(b).
Figure 24.1 SMALL BUSINESS RETIREMENT PLANS COMPARED SAR-SEP SEP (existing) Deadline for Due date of N/A--must setting up plan employer's already exist return, including extensions (usually April 15 of following year) Plan loans No No allowed Effect of adding Must cover Must cover employee(s) (unless earned (unless earned less than $550 less than $550 in 2009) in 2009) Maximum Lesser of 25% of $16,500 plus allowable compensation match; total contribution for or $49,000 subject to annual owner in 2009 additions limit Calculation of Does not include Does not include owner's elective deferrals elective deferrals compensation Over age 50 No $5,500 catch-ups (in 2009) allowable? Employer No other plan 25 or fewer limitations permitted if employees Form 5305-SEP used Vesting 100% at all times 100% at all times Solo SIMPLE IRA 401(k) plan Deadline for By October 1 of End of plan year setting up plan plan year (unless newly established employer) Plan loans No Yes allowed Effect of adding Must cover if Can set age & service employee(s) earned over requirements, can $5,000 vest match contributions Maximum $11,500, plus $16,500 plus allowable match of up to match; total contribution for 3% of subject to annual owner in 2009 compensation additions limit Calculation of Includes elective Includes elective owner's deferrals deferrals compensation Over age 50 $2,500 $5,500 catch-ups (in 2009) (in 2009) allowable? Employer Not > 100 None limitations employees earning >$5,000; No other plan covering same employees Vesting 100% at all times Graduated for employer contributions amounts (20% after 2 years, 40% after 3, to 100% after 6 years) Source: Presentation titled "Small Business Retirement Planning" by April K. Caudill, J.D., CLU, ChFC, for series of local chapter meetings of the Society of Financial Service Professionals; Copyright 2005, The National Underwriter Company.
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|Title Annotation:||Other Employer Retirement Plans|
|Publication:||Tools & Techniques of Employee Benefit and Retirement Planning, 11th ed.|
|Date:||Jan 1, 2009|
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