Module 3: SEPs

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In 1978 Congress provided employers with an easier way of providing retirement benefits for themselves and their employees through Simplified Employee Pensions (SEPs). A SEP is simply an individual retirement account or annuity (IRA) which may receive a higher level of contributions from the IRA holder’s employer. Any employer, regardless of size, may establish a SEP. Because the employer is not required to establish a trust, as with other retirement plans, the employer avoids many of the fiduciary and administrative responsibilities associated with other qualified plans. The IRS has developed a simple one-page form to establish a SEP. This is the simplest, most efficient, and least expensive way for a small business to establish a retirement plan for its employees. As with all qualified plans, SEP contributions are not taxable when contributed and are deductible by the employer in the tax year they are made. Earnings in the accounts grow tax-deferred. Participants are taxed on any withdrawals in the year they are taken.

Another type of SEP, a Salary Reduction SEP, or SARSEP, allows employees to defer salary, similar to a 401(k) plan. To maintain a SARSEP, an employer must have no more than 25 eligible employees.. With the advent of SIMPLE plans in 1996, the tax code now prohibits the establishment of new SARSEPs. Employers and employees may, however, continue to make contributions to SARSEPs established before 1997.

A Simplified Employee Pension (SEP) is an employee’s individual retirement account or annuity (IRA) which may receive an increased rate of contributions from the IRA holder’s employer. To operate properly, each eligible employee must have an IRA to accept the employer’s contributions. Any employer, whether it is a corporation, partnership, or even a one-person sole-proprietorship with no other employees, may establish a SEP. SEPs are particularly useful for persons regularly employed by a company but who “moonlight” for themselves as independent contractors. That is why SEPs are sometimes referred to as a “moonlighter's retirement plan”. While originally designed for small business employers, there is no limit on the size of employer that may set up a SEP.

A SEP plan must be in writing and must include a formula for the allocation of contributions and provisions governing participation, vesting and nondiscrimination. The plan must be established no later than the business' income tax filing date for the year that it is contributing. A SEP is the only type of employer-sponsored retirement plan that can be established after the employer’s tax year has ended. This makes SEPs extremely attractive for businesses that do not know their financial condition until tax time. However, the plan must exist at the time the contributions are made and the contributions must be made within the applicable time limits (discussed below).

An employer is not required to make contributions to a SEP. However, if an employer makes contributions, they must be made under a written formula that indicates how the employer will calculate each employee’s share. Annual contributions by the employer are limited to the lesser of 25% of the employee's compensation or $40,000 (adjusted for inflation, $45,000 in 2007). SEP contributions need not be made every year. The decision to contribute or not is left solely to the employer.

employees receive disclosure statements indicating the existence of the plan, that IRAs involve a degree of investment risk, and that the plan administrator will notify employees of any contributions to the SEP no later than January 31st of the following year.

Since the employer will claim a tax deduction for contributions under a SEP, the IRAs established under a SEP arrangement must be traditional IRAs, not Roth IRAs. All eventual distributions from the account will be fully taxable to the employee, and are subject to the same restrictions as traditional IRAs.

The IRS has developed a one-page tax form, 5305-SEP that meets all the requirements of a Simplified Employee Pension plan and does not require any special document preparation. Form 5305-SEP is the simplest, most efficient, and least expensive way for a small business to establish a retirement plan for its employees. By using the IRS model, the employer need not develop an individual plan.

Since Form 5305-SEP is a “pre-approved” plan, no favorable ruling from the IRS is required when establishing a Model SEP, nor is it filed with the IRS. The employer simply retains a signed, dated copy of the completed form with its business records.

Employers who establish a model SEP, and have furnished each eligible employee with a copy of the completed form and other required information set forth in the instructions, need not file annual reports with the IRS. However, this exception from the annual reporting obligations is not available if the employer selects, recommends, or influences employees to choose IRAs into which contributions will be made under the SEP, and those IRAs are subject to special provisions that limit a participant's ability to withdraw funds (other than restrictions applicable to IRAs in general).

The IRS allows employers to create unique SEP plans for their employees. Many financial institutions have also received approval from the IRS for the use of their own prototype SEPs, allowing them to combine plan administration and investment services. This “one-stop” shopping for retirement plan and investment services is attractive to busy employers.

Unlike the Model SEP plans, these unique non-model SEP's must be approved by the IRS. A copy of the proposed SEP must be filed with the IRS with a request for a “favorable ruling”. Likewise, any proposed amendments to the plan must also be filed with the IRS even if those amendments are required due to changes in the tax code.

Employers with fewer than 100 employees may claim a tax credit equal to 50% of the cost to establish a SEP, SIMPLE or other qualified plan. The credit is limited to $500 per year for each of the first three years of the plan's existence.

If an employer contributes to a SEP, the employer must contribute for each employee who has reached the age of 21, has worked for the employer in at least three of the immediately preceding five years, and received at least $300 in compensation from that employer for the year that the contribution is made. The $300 per employee compensation requirement is indexed for inflation -- for 2007 the compensation threshold is $500. Employers can set less (but not more) restrictive participation requirements if they wish — by simply filling in the appropriate amounts on Form 5305-SEP.

Example: Spinning Disc Music Co, Inc. maintains a SEP. Doug Roberts worked for Spinning Disc while in college in 2002, 2003, and 2004, never working more than 35 days in a particular year. In February 2007, Doug turns 21. In April, Doug begins working for Spinning Disc on a full-time basis, earning $30,000. Spinning Disc must make a SEP contribution for Doug in 2007 because he meets the minimum age requirement, the minimum compensation requirement for 2007, and has worked for Spinning Disc in 3 of the 5 years preceding 2007.

The “three-out-of-five” year service requirement for SEP participation is unique among qualified plans, but it is an effective means of restricting participation to those employees who have devoted a substantial amount of time to a company. Most other types of qualified plans allow employees to participate after one or two years of service.

All employees who are employed by a commonly-controlled group of businesses or all employees of an affiliated group are treated as if they were employed by a single employer. The “single employer” rule for controlled groups can work to the advantage of a business owner who owns several businesses but wants to have the low administrative and documentation costs of one SEP for all of its employees.

If an employer uses “leased employees”, those employees generally must be included in SEP coverage. Leased employees include those whose services are provided under an agreement between the employer and a leasing organization. To be eligible for SEP participation, a leased employee’s services must be performed for the employer on a substantially full-time basis for at least one year and must be of a type historically performed by employees in that organization’s field of business.

Employers must contribute on behalf of all employees who meet the SEP eligibility requirements during the year for which a contribution is made. This includes any individuals who are no longer employed when the contribution is made: employers must contribute on behalf of those no longer working who meet the eligibility requirement, employees who died during the year, and even those whose whereabouts is unknown.

If a former or current employee established an IRA but closed it prior to the date of the employer’s SEP contribution, the employer must establish an IRA on behalf of that employee. The employer must deliver a notice either in person or by mail to the employee’s last known address. The same applies for employees who have never opened an IRA. The IRS permits employers to safeguard the tax qualification of their SEPs by establishing IRAs on behalf of employees who refuse to do so or cannot be located.

If an employee is not required to participate in a SEP as a condition of employment, the employee’s election not to participate may also prevent all other employees of the employer from participating in the SEP. For this reason, employers who establish a SEP should mandate participation in the plan by all eligible employees.

Employers need not make SEP contributions for employees who are nonresident aliens and have no U.S. source of earned income. SEP plans may also exclude employees who are covered by a collective bargaining agreement in which retirement benefits were negotiated. The employer indicates its decision to include or exclude these employees by checking the appropriate boxes on Form 5305-SEP.

Employer contributions to a SEP must not discriminate in favor of any officer, shareholder or “highly compensated employee” as defined in the Internal Revenue Code. These employees are known as the "prohibited group". Generally, the IRS considers a SEP plan “nondiscriminatory” if the employer contributes:

Example: Spinning Disc Music Co. installs a SEP in which it contributes for each active employee. The company proposes to contribute to the SEP 10% of the total compensation of each employee who has completed up to five years of service and 12% of the total compensation of each employee who has completed more than five years of service. The IRS will rule Spinning Disc's SEP to be discriminatory because employer contributions are based on non-compensation factors, i.e. years of service. This type of plan does not bear a uniform relationship to each employee's compensation.

Example: Spinning Disc Music Co. proposes to contribute to the SEP 10% of the an employee's first $50,000 of compensation and 12% of any compensation in excess of $50,000. This formula would also be disallowed by the IRS since it favors higher-paid employees at the expense of lower-paid workers.

Example: Spinning Disc installs a SEP under which it will contribute 15% of an employee's first $15,000 in compensation and 10% of all compensation above $15,000. The company's SEP will not be considered discriminatory because the rate of contribution decreases as compensation increases.

Example: Spinning Disc proposes to contribute $6,500 to each eligible employee's SEP-IRA, regardless of the employee's income. Although not based on compensation, the IRS will allow such a "fixed dollar" formula.

To limit the size of contributions made on behalf of highly-paid employees, employers must limit the total amount of annual compensation taken into consideration when making a SEP contribution to $150,000 (adjusted for inflation — or $225,000 in 2007).

Example: Spinning Disc Music has three eligible employees: Doug Roberts earned $30,000 in 2007, John Thompson earned $50,000, and Jane Morgan, the owner, earned $260,000. The SEP plan calls for a 10% contribution to each employee's IRA. Spinning Disc will contribute $3,000 to Roberts' IRA (10% of $30,000) and $5,000 for Thompson (10% of $50,000). When computing the contribution for Morgan, Spinning Disc may only consider her first $225,000 of compensation, so the contribution to her IRA will be $22,500 (10% of the "maximum" $225,000).

For SEP nondiscrimination purposes, all employees who are employed by a commonly-controlled group of businesses or all employees of an affiliated group are treated as if they were employed by a single employer. This eliminates the possibly of an employer creating another business entity to hire highly-paid employees and offering them more advantageous benefits than other employees. In short, all employees of a controlled group of businesses must be treated “equally”.

The employer's deduction to a SEP is limited to 25% of compensation paid to participating employees (excluding SEP contributions) during the tax year up to a maximum of $40,000 per employee (adjusted for inflation, $45,000 in 2007). Furthermore, when computing the annual contribution, employers may only consider an employee's first $150,000 of compensation — adjusted for inflation ($225,000 for 2007).

Amounts contributed to an employee’s SEP by his or her employer are not included in the employee’s taxable income -- provided they do not exceed these applicable limits. An employer that makes contributions to a SEP may take a deduction for allowable SEP contributions just as for any other type of tax-qualified retirement plan.

Example: Alex Griffin earns $80,000 in compensation from his employer in 2007. In addition, his employer contributes $8,000 to his IRA which qualifies as a SEP. The $8,000 contributed by Alex's employer to his SEP is not taxable as income to Alex in 2007 — and the employer may deduct $88,000 as a business expenses (salary plus contribution).

Contributions that exceed the contribution limits are subject to a 6% penalty tax. However, the penalty tax may be avoided if the employee withdraws the excess amount before the date by which his or her tax return must be filed. Excess contributions that are withdrawn are taxable to the employee — as ordinary income.

Since an employer’s fiscal year may or may not coincide with the SEP's “plan year” special rules apply when calculating an employer’s tax deduction for contributions to a SEP plan. If the plan year of the SEP and the tax year of the employer are the same — contributions are deductible for the taxable year if the contributions are made by the due date of the employer's tax return, plus extensions.

Example: Spinning Disc Music, Inc. maintains a SEP on a calendar year basis and is a calendar year taxpayer. For the 2007 tax year, Spinning Disc may take deductions for contributions made for tax year 2007 up to March 15, 2008 (plus extensions). [Corporations file taxes 2½ months after the close of their tax year, so for "calendar year corporations" the corporate income tax filing deadline is March 15.]

If the SEP is on a calendar year and employer uses fiscal year, contributions are deductible for the taxable year within which the calendar year ends. Contributions are deductible for that tax year if they are made by the due date of the employer's tax return, plus any extensions. Put another way, the employer claims the tax deduction for the fiscal (tax) year in which the plan (calendar) year ends.

Example: Spinning Disc Music, Inc. maintains a SEP on a calendar year basis and Spinning Disc's tax year is a fiscal year ending on June 30. The SEP contributions made by Spinning Disc on behalf for the 2007 plan year will be deductible for the fiscal year beginning July 1, 2007, and ending June 30, 2008, if made by September 15, 2008 (plus extensions).

	\|------------2007 ------------		-------\|--------------2008 --		-----------------
SEP year	Jan 1 ------	---------------	Dec 31
Fiscal year		July 1 ------	------------------	June 30
deduct up to:					Sept 15

The employer deduction cannot exceed 25% of the total compensation paid to eligible employees for the calendar year ending within the employer's tax (fiscal) year. Where a SEP is maintained on the basis of an employer's taxable year, the 25% limit applies to compensation actually paid to eligible employees during the employer's taxable year.

Example: Hayes Electronics Corporation, a calendar year taxpayer, adopts a SEP on January 1, 2007. At the end of 2007, it calculates that it has paid $700,000 to all of its employees. Ten of its employees met the eligibility requirements for SEP contributions — compensation for those employees totaled $300,000. The maximum amount that Hayes could deduct for its 2007 contribution is $75,000 (25% of $300,000).

The tax code imposes a 10% excise tax on employers who contribute more than the overall 25% deduction limit. Any contributions in excess of this limit may not be deducted in by the employer the year of the contribution. However, the excess contributions may be carried forward into the next year. The employer may deduct the excess contributions then, provided the next year’s total contributions — including the carried over excess — do not exceed the limit in the next year. However, the carry-over is subject to the 10% penalty.

The 10% excise tax applies to an employer’s total contributions to the SEP plan. There is an additional 6% penalty on excess contributions that applies to individual SEP-IRAs that exceed the annual contribution limit (lesser of 25% of compensation or $40,000 adjusted for inflation). Participants may avoid this penalty by withdrawing the excess by their tax filing date, plus extensions. The withdrawn excess is included in the participant's taxable income that year.

For employers who maintain a non-model SEP and other qualified plans, a SEP deduction reduces deductible contributions made to those other plans. If an employer contributes to a SEP, the contribution is “counted” as an employer contribution to a defined contribution plan. The SEP contribution is added to any other employer contributions to other defined contribution plans. The limit “total additions” to defined contribution plans is the lesser of 100% of the employee's compensation or $40,000 (adjusted for inflation, $45,000 in 2007). Thus, a SEP cannot be used to evade the limit on the total contribution made to an employee’s account in a defined contribution plan.

In calculating the 25% limit on contributions for self-employed individuals, compensation refers to net earnings from self-employment. Net earnings from self-employment is gross income from the individual's business, minus allowable business deductions. Allowable deductions include contributions to employees’ SEP-IRAs, the deduction allowed for one-half of the self-employment tax, and the deduction for contributions to the individual's own SEP. These must be deducted from the self-employed individual’s “gross” income before calculating the contribution to the individual's SEP.

This adjustment for contributions to the plan creates some confusion when expressing contributions to the SEP as a percentage of income. For example, an owner’s self-employed income is $100,000. A contribution of $20,000, is expressed as a 25% contribution — that is 25% of the $80,000 income after the contribution: $20,000 / ($100,000 — $20,000). So, a plan that contributes 25% post-contribution income to a SEP, in effect, contributes only 20% of the owner’s pre-contribution income. Use the following fomula to restate post-contribution percentages in pre-contribution terms:

Example: Travis Jackson, a sole proprietor, sets up a SEP for himself and his employees to contribute 15% of each participant’s compensation. For the employees, Jackson will contribute the full 15% of their compensation. However, as owner, Jackson's contribution on his own behalf is based on the business’ net income less one-half of the self-employment tax and the amount of his contributions to the plan. The net earnings of the business this year are $131,000. This represents earnings after the employees have been paid and the SEP contributions on their behalf, but before any contribution for Jackson. The self-employment tax this year is $8,800. The deductible contribution for Jackson is $16,512:

Net business earnings:

less one-half of self-employment tax:

Net after self-employment tax:

multiply by reduced percentage

SEP-IRA contribution

$131,000

- 4,400

$126,600

x 13.0435%

$ 16,512

"Top-heavy" plans are those which disproportionately benefit “key personnel” over the rank-and-file employees. If key employees are entitled to more than 60% of the plan’s total value, the plan is “top heavy”. Key employees are:

In applying the “60% rule” to a SEP, employers may measure either the total values in the employee SEP-IRAs as of the “determination date” (i.e., the last day of the previous year), or the total of employer contributions made for SEP participants.

Qualified retirement plans that are "top-heavy" are subject to more stringent requirements to maintain their tax status, including minimum contributions or benefits for plan participants who are non-key employees. For SEPs that are top-heavy, the employer must make a minimum contribution of 3% of compensation for each participant who is not a key employee. In addition, employers must limit the total amount of annual compensation taken into consideration when making a SEP contribution to $150,000 (adjusted for inflation — or $225,000 in 2007).

Employers who establish non-model SEPs may take Social Security taxes into account when calculating SEP contributions. This process is known as "integration". Integration is an advantage for employers, since they can offset SEP contributions by the portion of Social Security (OASDI) taxes they pay on behalf of their employees. Keep in mind that Social Security taxes are only collected up to the maximum “wage base”. Any compensation in excess of the “wage base” is not subject to OASDI taxes (The Social Security wage base for 2007 is $97,500 — this is adjusted annually for inflation). Integration effectively reduces — within limits — employer contributions on compensation up to the wage base (or some other “integration level”).

The maximum permitted disparity , or "offset", for a plan that uses the Social Security wage base as the integration level, is the lesser of 5.7% or the base contribution percentage. The written SEP plan formula must specifically state the level of compensation at which the rates of contribution change (i.e., the integration level).

Example: ABC Co. sets a SEP to provide a 13% contribution for its employees — but also wishes to offset those contributions for its payment of Social Security taxes. ABC’s plan provides a 8% contribution of each participant's total compensation (compensation both above and below the Social Security wage base). Each participant whose compensation is in excess of the Social Security wage base will receive an additional 5% contribution on “excess compensation”. The base contribution percentage is 8%. The excess contribution percentage is 13% (8% plus 5%).

Because 13% does not exceed the base contribution percentage by more than 5.7%, this formula satisfies the permitted disparity requirements. In addition, because the formula does not exceed 25% of compensation, it is within the overall limits for SEP contributions.

The employee's right to employer contributions in a SEP is always 100% vested. In other words, the employee has the full right to withdraw the contributions in his account at all times. An employer may not prohibit withdrawals from a SEP. Nor may an employer require that its contributions to the SEP be kept in the account. This feature is a significantly different from other types of qualified plans, which generally allow more gradual forms of vesting. It also means that SEP benefits are "portable". Employees may take their benefits with them in the form of an IRA when they terminate employment.

Although the employee retains an absolute right to his employer's SEP contributions at all times, as with a “regular” IRA, early withdrawals are subject to a 10% penalty tax. In addition, amounts withdrawn are generally subject to tax, unless rolled over.

While the 100% vesting rule may seem very restrictive from the employer's point-of-view, it may actually work to the employer's favor. Since the funding vehicle for a SEP is the employee's IRA, the employer is generally relieved of any fiduciary liability for poor investment performance, allowing impermissible withdrawals, or other problems the employer may face when acting as the trustee.

An employer is permitted to establish a Model SEP plan by using IRS Form 5305-SEP plan. Employers who adopt a Model SEP must furnish each participant with information about the SEP and the SEP agreement. This requirement is satisfied by simply furnishing each participant with a copy of the completed Form 5305-SEP contribution agreement, the questions and answers that are printed on the Form 5305-SEP, and a statement each year showing any contribution made to the participant’s individual retirement account or annuity. The employer of also must furnish each participant a copy of any amendments to the plan and a written explanation of its effects, within 30 days of the effective date of the amendment. The employer should retain the original Form 5305-SEP and any amendments. These disclosures satisfy both IRS and Department of Labor requirements regarding Model SEPs. This is a very economical means of providing required employee communication when compared to having conventional summary plan descriptions prepared by outside professionals.

Non-Model SEPs are technically subject to the same complex reporting rules that apply to qualified plan. The IRS and Department of Labor allow employer who establish Non-Model SEPs to use an alternate, simplified reports. The Internal Revenue Service requires employers provide employees with a basic understanding of what a SEP is and how it works. The Department of Labor requires employers to provide eligible employees with the following specific information items:

The first three requirements may be met by furnishing the non-model SEP agreement to participants, provided that the SEP agreement is written in a manner calculated to be understood by the average plan participant. The final requirement is usually met through disclosure materials furnished by the financial institution in which the participant's IRA is maintained.

This alternative method of compliance for the Department of Labor is available for all Non-Model SEPs, except in cases where the employer selects, recommends, or substantially influences its employees to choose the IRAs into which employer contributions will be made and those IRAs that prohibit the withdrawal of funds by participants for any period of time. Non-Model SEPs having such restrictions are subject to the full reporting and disclosure requirements under ERISA, unless the plan:

Amounts paid by an employer to an employee’s “regular” SEP-IRA are not subject to FICA or FUTA taxes (Social Security, Medicare and unemployment taxes). Employers must note the employees’ active participation in the SEP by checking the "pension plan" box on their W-2. Form. (this is helpful in determining the possible deductibility of the employee’s contributions to other IRA he or she may have.)

Custodians, such as banks or insurance companies, who hold IRA assets must notify the IRS of contributions made into the account annually. In addition, if withdrawals were taken from the IRA, the custodian must send the IRA holder a Form 1099-R, and this information is also filed with the IRS.

In regular SEP plans, the employer decides if it will make a contribution and how large that contribution will be. In a Salary Reduction SEP (SARSEP), employees choose to have the employer make contributions to their SEP-IRAs instead of paying them the equivalent amount as salaries. In this respect, SARSEPs are similar to a Cash or Deferred Arrangement or 401k plan — allowing the employee to defer income that would have otherwise would been have received (and taxed).

The maximum annual deferral amount for an employee’s “elective deferrals” is the same amount as for 401ks and tax-sheltered annuities: $15,500 in 2007 (adjusted annually for inflation). Eligible employees age 50 and older may contribute a additional $5,000 annually as a catch-up provision. These limitations apply only to the amount by which an employee’s salary is reduced, and not to any contributions the employer chooses to fund. The “regular SEP” rules discussed above apply to employer contributions in a SARSEP.

New SARSEPs have been prohibited since 1997, however, employers may continue to make contributions, under pre-1997 rules, to existing SARSEPs. In addition, employees hired after 1996, may participate in existing SARSEPs. To maintain a SARSEP, an employer must have no more than 25 eligible employees. At least 50% of the eligible employees must choose to participate — that is, make salary reduction contributions — in order for a SARSEP to continue in operation.