Simplified employee pension plans (SEPs) are employer-funded plans under which an employer makes contributions to an employee's SEP-IRA (individual retirement account or individual retirement annuity). SEP plans are attractive to business owners because they are easy to establish and administer.
Sole proprietorships, partnerships, corporations, and tax-exempt organizations are all eligible to establish SEPs. The employer must put the plan in writing and must make deductible contributions by tax-filing time plus extensions. There are three options for setting up the plan:
execute the IRS Model Agreement, Form 5305-SEP;
execute a master or prototype plan, which has received a favorable opinion letter from the IRS; or
execute a custom-designed plan.
Businesses that seek a simplified way to establish the SEP should use either the IRS model SEP agreement or a prototype plan.
Some employers are not eligible to use the IRS model SEP agreement, but may be eligible to use a prototype. These are employers who:
maintain another qualified plan;
use the services of leased employees;
have an eligible employee who has not established an IRA;
are part of an affiliated service group, controlled group of corporations or are under common control unless all eligible employees of all such employers participate in the SEP;
wish to integrate SEP contributions with Social Security; or
do not pay the cost of SEP contributions.
Every employee who is age 21 or over during the year for which contributions are made and who has performed services for the employer in three of the five years preceding the year for which contributions are made must participate in the SEP. Service is defined as any interval of time in which the employee has performed any work for the employer in a particular year.
Once an employee becomes eligible to participate, he or she will share in contributions only if compensation for the year is more than a specified annual threshold ($600 for 2016). If an employee meets these requirements, the employer must make a contribution on the employee's behalf for that year even if the employee is no longer employed at the time the contribution is made. There are no exceptions, even for employees who are older than age 70½.
Some employers are reluctant to establish a retirement plan because of the administrative requirements associated with reporting to the IRS and Department of Labor. These employers may instead opt for a SEP because these plans provide valuable retirement benefits with a minimum of paperwork and reporting obligations.
Technically, a SEP is not a qualified plan, which helps explain why it has simpler administrative requirements. Nonetheless, a SEP makes it possible for an employer to make tax-deductible contributions to an employee's retirement account. The employee benefits because the contributions:
are not currently taxable, and
grow on a tax-deferred basis, giving the employer a tax-favored method for providing substantial benefits to employees.
The employer must notify employees that they are active participants in a pension plan on their W-2 forms in every year that an employer or employee SEP contribution is made. The employer has no other reporting requirements. The trustee or issuer of the employee's SEP-IRA must report the following to the IRS on Form 5498:
the December 31 value of the SEP-IRA;
SEP contributions received in prior calendar year;
regular IRA contributions made, if any, for prior tax year; and
any rollovers or amounts recharacterized as Roth contributions.
In addition, the SEP-IRA trustee or issuer must also report any distributions on an IRS Form 1099R.
An employer can deduct contributions to an employee's SEP-IRA up to the lesser of:
25% of compensation up to the maximum compensation that may be taken into account for each employee ($265,000 for 2016), or
the Section 415 defined contribution dollar limit ($53,000 for 2016).
An employee can contribute to a personal IRA in addition to the SEP, but these contributions may not be deductible since an employee whose employer contributes to a SEP on his or her behalf is considered an active participant in an employer-sponsored qualified retirement plan. The employer is not obligated to make a SEP contribution each year. The employer cannot be selective about annual contributions; they must be made for all eligible employees or for none.
A SEP may not allow contributions which discriminate on behalf of highly compensated employees. In other words, an employer cannot make a 10%-of-salary contribution for executives versus only 2% for clerical staff. Contributions to a SEP must bear a uniform relationship to the compensation of each employee and must be made according to a documented formula.
While contributions must meet the uniform relationship standards, the IRS allows a limited disparity with regard to contributions based on income above and below the Social Security taxable wage base. When certain conditions are met, this provision allows employers to provide a slightly higher contribution percentage on behalf of employees whose earnings exceed the taxable wage base.
Social Security integration is not available for employers using the IRS's model SEP document (Form 5305-SEP).
All contributions are immediately 100% vested to the employee. The money contributed can be withdrawn at any time by the employee. However, any withdrawal is taxable to the employee when taken out, and the 10% premature distribution penalty may apply.
Employees may establish a personal IRA for SEP contributions, and if any eligible employee does not open an IRA, the employer must establish one for him or her. IRA rules govern SEP investments. That means life insurance and/or collectibles (with the exception of gold and silver coins issued by the U.S.) are not permitted funding vehicles for a SEP. Typical IRA investments include fixed and variable annuities, certificates of deposit, mutual funds, money market funds and securities (through a self-directed IRA).
When an individual receives a distribution from a SEP-IRA, federal income tax is due on the proceeds in the year the payment is received. If the proceeds are paid out in a lump sum, the tax must be paid on the entire amount in one year. Averaging is not available for SEP-IRA lump-sum distributions.
If the employee takes a distribution before age 59½, the amount withdrawn is subject to ordinary income tax and a 10% penalty tax, unless the amount:
was paid due to death or disability,
is part of a series of substantially equal periodic payments which have been calculated based on life expectancy,
is used to pay unreimbursed medical expenses,
is used to purchase health insurance for an unemployed individual,
is used for qualified higher education expenses, or
is used within 120 days to pay the acquisition costs of a first-time home buyer.
Qualified reservist distributions. The additional 10% tax on early distributions does not apply to a qualified reservist distribution. A qualified reservist distribution is a distribution from an IRA or an elective deferral account made after September 11, 2001, to a military reservist or a member of the National Guard who has been called to active duty for at least 180 days or for an indefinite period. All or part of a qualified reservist distribution can be recontributed to an IRA.
An individual must begin receiving payments of a minimum required amount from a SEP-IRA by April 1 of the year following the calendar year in which he or she reaches age 70½ (not the later of 70½ or year of retirement as with qualified retirement plans). If this does not happen, a 50% penalty tax is imposed on the amount that should have been paid out for the year but was not. If the individual can prove that the failure to make the minimum distribution was due to reasonable error, the IRS may waive the excise tax (see IRS Form 5329 for further information). Contributions must continue for those who work past age 70½, even though distribution has begun.
Click here to jump to a detailed discussion of the required minimum distribution rules.
minimal paperwork and bookkeeping
flexibility regarding employer's decision to contribute each year
tax-deductible contributions for the employer
contributions not currently taxable to the employee
tax-deferred accumulation of funds.
virtually all employees, including part-time employees, must be covered under the plan, which could be quite costly
employees are fully vested immediately, which means the employer has no protection from high turnover
protection of SEP assets from creditors is not as great as under a qualified retirement plan subject to ERISA
employer flexibility with regard to contributions could be detrimental to employees in that a lack of commitment would prevent the plan from providing the retirement security originally intended.
Salary Reduction SEPs (SARSEPs) were replaced by SIMPLE (Savings Incentive Match Plan for Employees) retirement plans in 1997. While no new SARSEPs have been established since that time, smaller businesses that created these plans before 1997 may continue to fund them, and new employees may still elect to participate even if they were hired after December 31, 1996.
If you encounter a company that still has a SARSEP in place, you may want to refer to the rules below, which are applicable to pre-1997 SARSEPs protected by grandfather rules in the tax law.
Employers with 25 or fewer employees who were eligible to participate at any time during the previous calendar year can maintain Salary Reduction SEPs. Under this plan, each eligible employee may elect either to have contributions made to the plan or have that amount paid to them in cash. Employers must notify employees of contributions.
At least half of the eligible employees must elect to defer income to the plan.
The salary reduction SEP arrangement is very similar to a 401(k) plan. SARSEP elective deferrals are not currently taxed to the employee. The salary reduction amount is limited to an annual maximum in accordance with the following table:
|
|
Deferral Limit |
Deferral Limit |
|
2014 |
$17,500 |
$23,000 |
|
2015 |
$18,000 |
$24,000 |
|
2016 |
$18,000 |
$24,000 |
A SARSEP may (but is not required to) allow additional "catch-up" contributions (elective deferrals) by participants age 50 and over. A participant is deemed to be age 50 for a particular year if he or she turns 50 during that year. Catch-up contributions for a particular year cannot be greater than the lesser of:
the maximum incremental dollar amount allowable ($6,000 for 2016), or
the excess of the individual's compensation for the year over other elective deferrals made for the year, ignoring the additional catch-up amount.
The basic elective deferral limit and age-50+ catch-up amount are indexed to inflation.
In a SARSEP, the deferral percentage for each of the eligible "highly compensated employees" cannot exceed 125% of the average deferral percentage for all other eligible employees. The deferral percentage with respect to a particular employee is the amount of that employee's elective deferrals for the year, divided by the employee's total compensation for the year. Note that this is NOT the same as the nondiscrimination test for a 401(k) plan.
A highly compensated employee is defined as someone who:
owns more than 5% of the employer's business, or
receives compensation of more than $120,000 (for 2016, as indexed) and, if the employer so elects, is a member of the top-paid 20% group of employees.
Graphic: How the SEP Works
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