CONTRIBUTIONS

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, $49,000 in 2011). Furthermore, when computing the annual contribution, employers may only consider an employee's first $150,000 of compensation - adjusted for inflation ($245,000 for 2011).

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 2011. 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 2011 - 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  Excess contributions that are withdrawn are taxable to the employee - as ordinary income.



 Timing of Contributions

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.




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 2010 plan year will be deductible for the fiscal year beginning July 1, 2010, and ending June 30, 2011, if made by September 15, 2011 (plus extensions).



|------------2010 ------------
-------|--------------2011 --
-----------------
SEP year
Jan 1 ------
---------------
Dec 31
Fiscal year
July 1 ------
------------------
June 30
deduct up to:
Sept 15




 Calculating the deductible amount

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, 2011. At the end of 2011, 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 2011 contribution is $75,000 (25% of $300,000).



 Excess contributions

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 ($49,000 in 2011).  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.


 Effect on other plan contributions

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, $49,000 in 2011). 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.




 Limit for self-employed persons

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:


pre-contribution % =

       post-contribution %
   1 + post-contribution %
Example: Travis Jackson, a sole proprietor with two employees, sets up a SEP-IRA  and he wants to contribute 15% of his self-employed compensation.  As an 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 business expenses (including 15% SEP-IRA contributions for the two employees), but before any contribution to Jackson's SEP-IRA.  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

Jackson's nominal rate of contribution 15% is reduced to 13.0435% using the formula described above  (15% divided by 115%).