"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:
officers earning more than $130,000 (adjusted for inflation, $160,000 in 2011),
5%+ owners, or
1%+ owners earning more than $150,000 (not inflation adjusted).
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.
Bob Burns owns a small advertising company with two employees. His company has a SEP and made contributions amounting to:
Assuming Burns is the only key employee, the plan is not top-heavy. The total employer contributions for key employees (Burns) is exactly 60% of the contributions made for all employees. The total contribution for all three employees was $20,000, and Burns' share was $12,000 ($12,000 / $20,000 = 60%). For a plan to be top-heavy, more than 60% must be contributed for key employees.
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 $245,000 in 2011).
Employers who establish non-model SEPs may take Social Security taxes into account in 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*. 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).
ABC Co. would like to maintain a SEP which provides for a 13% contribution for its employees - but also wishes to offset those contributions for its payment of Social Security taxes. ABC sets up a plan that provides a 8% contribution of each participant's total compensation (compensation both above and below the Social Security wage base). Under the plan, each participant who compensation in excess of the Social Security wage base will receive an additional 5% contribution on the amount of 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 15% of compensation, it is within the overall limits for SEP contributions.
Model SEPs, established by using Form 5305-SEP, do not include the option of integration. Model SEPs may not be integrated.
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 an ordinary IRA, early withdrawals are subject to a 10% penalty tax. In addition, amounts withdrawn are generally subject to tax, unless rolled over. (see Distributions)
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 bad investment performance, allowing impermissible withdrawals, and other problems associated with plans in which the employer acts as trustee.
Reporting and Disclosure
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 requirements for employee participation in the SEP,
the formula under which employer contributions to the SEP will be allocated among participants' IRAs,
the name or title of the individual who is designated by the employer to provide additional information to participants concerning the SEP and employer contributions to it, and
if the employer selects or substantially influences employees to choose the IRAs into which employer contributions will be made, the terms of those IRAs.
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:
allows other meaningful investment options which do not restrict withdrawals are available to participants, and
the employer does not select, recommend, or otherwise influence any participant's choice of an available investment option under the IRAs.
Administrators of Non-Model SEPS must also provide certain general information about SEPs and individual retirement accounts, such as:
what a SEP is and how it operates,
statutory provisions prohibiting discrimination in favor of highly paid employees,
a participant's right to receive contributions under a SEP and the allowable sources of contributions to a SEP-IRA,
the statutory limit on contributions to SEP-IRAs,
consequences of excess contributions to a SEP-IRA and how to avoid them.
how a participant must treat contributions to a SEP-IRA for tax purposes,
statutory provisions concerning withdrawal of funds from a SEP-IRA and the consequences of premature withdrawal,
a participant's rights regarding contributions made under a SEP to his or her IRA, and
a participant's ability to roll over or transfer funds from a SEP-IRA to another IRA, SEP-IRA, or retirement bond, and how such a rollover or transfer may be effected without causing adverse tax consequences.
Withholding on contributions
Contributions to a SEP are not considered wages for income tax withholding purposes if it is reasonable to believe that the contributions will be excludable from the employee's income.
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.)
If the employee participates in a Salary Reduction SEPs (SARSEP) the employer must pay FICA and FUTA taxes on the amount being contributed by the employee.
IRA custodian disclosures
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.