8. SIMPLIFIED EMPLOYEE PENSION (SEP) A simplified employee pension (SEP) is a written arrangement (a plan) that allows an employer to make contributions toward his or her own (if a self- employed individual) and employees' retirement, without becoming involved in more complex retirement plans. The contributions are made to IRAs (SEP-IRAs) of the participants in the plan. Under a SEP, IRAs are set up for, at a minimum, each qualifying employee (defined below). IRAs may have to be set up for leased employees (defined below), but they do not have to be set up for excludable employees (defined below). An employer can use Form 5305-SEP to satisfy the written arrangement requirement for a SEP. A SEP can be established at any time during a year. However, the time for making contributions for a year under a SEP agreement is limited. See Time limit for contributions, later. Note. The SEP plan under which contributions are made can be set up after the close of the year for which contributions are made. However, the plan must exist at the time the contributions are made and they must be made within the time limit. An employer who signs a SEP agreement is not required to make any contribution to the SEP-IRAs that are set up. But, if the employer does make contributions, the contributions must be based on a written allocation formula and must not discriminate in favor of highly compensated employees (defined below). Definitions A self-employed individualis an employee for SEP purposes. He or she is also the employer. Even if the self-employed individual is the only qualifying employee, he or she can have a SEP-IRA. A qualifying employee is one who: Is at least 21 years old, Has worked for the employer during at least 3 of the 5 years immediately preceding the tax year, and Has received from the employer at least $374 in compensation in the tax year. Note. An employer can establish less restrictive participation requirements for its employees than those listed, but not more restrictive ones. Leased employees. The person or firm for whom you perform services (the recipient) may have to include you in a SEP if you are a "leased employee" and are treated as an employee of the recipient. A leased employee is any person who is not an employee of the recipient and who is hired by a leasing organization, but who performs services for another (the recipient of the services). You are a leased employee if: 1) Your services are provided under an agreement between the recipient and the leasing organization, 2) Your services are performed for the recipient, or for the recipient and related persons, on a substantially full-time basis, for a period of at least one year, and 3) Your services are of a type historically performed by employees in the recipient's field of business. Excludable employees. The following employees can be excluded from coverage under a SEP: Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by their union and their employer, and Nonresident alien employees who have no U.S. source earned income from their employer. A highly compensated employee is an employee who during the year or preceding year: 1) Owns more than 5% of the capital or profits interest in the employer (if not a corporation); or more than 5% of the outstanding stock or more than 5% of the total voting power of all stock of the employer corporation; 2) Received annual compensation from the employer of more than $93,518; 3) Received annual compensation from the employer of more than $62,345 and was a member of the top-paid group (20%) of employees during the year; or 4) Is an officer whose annual compensation exceeds $56,110.50. Contributions The SEP rules permit an employer to contribute each year to each employee's SEP-IRA and deduct up to 15% of the employee's compensation or $30,000, whichever is less. These contributions are funded by the employer. Figuring the 15% limit. For purposes of determining the 15% limit, compensation does not include your employer's contribution to your SEP-IRA, and is limited to $228,860. Example. Barry's employer has a SEP for its employees. Barry's compensation for 1992, before his employer's contribution to his SEP-IRA, was $20,000. Barry's employer can contribute up to $3,000 (15% x $20,000) to Barry's SEP-IRA. Deduction limit for a self-employed person. If you are self-employed and contribute to your own SEP-IRA, special rules apply when figuring your maximum deduction for these contributions. For determining the 15% limit on contributions, discussed above, your compensation is your net earnings from self-employment. See Net earnings from self-employment, below. Note that, for SEP purposes, your net earnings (compensation) must take into account your deduction for contributions to your own SEP-IRA. Because your deduction amount and your net earnings amount are each dependent on the other, this adjustment presents a problem. To solve this problem, you make the adjustment to net earnings indirectly by, in figuring your maximum deduction, reducing the contribution rate called for in the plan. Use the following worksheet to find this reduced contribution rate and your maximum deduction. Make no reduction to the contribution rate for any common-law employees. 1) Contribution rate in plan shown as a decimal...............................................-------- 2) Rate in line (1) plus one.............................-------- 3) Reduced rate for self-employed person (divide line (1) by line (2))..................-------- 4) Net earnings from self-employment (if more than $228,860, see regulations) not reduced for contributions to your SEP-IRA.........................$------- 5) Maximum deduction for contributions to self-employed person's SEP-IRA (multiply line (4) by line (3)).......................$------- Example. You are a sole proprietor and have employees. The terms of your SEP provide that you contribute for yourself 15% of your net earnings, and for your employees 15% of their pay. Your net earnings from your business (not taking into account a deduction for contributions to your own SEP-IRA) are $196,000. In figuring this amount, you deducted your employees' pay of $60,000 and contributions for them of $9,000 (15% of $60,000). You also reduced your earnings by the deduction for one-half of your self-employment tax. Using the worksheet, you figure your maximum deduction for contributions to your own SEP-IRA as follows. 1) Contribution rate in plan shown as a decimal............................................... .15 -------- 2) Rate in line (1) plus one............................. 1.15 -------- 3) Reduced rate for self-employed person (divide line (1) by line (2)).................. .130435 -------- 4) Net earnings from self-employment (if more than $228,860, see regulations) not reduced for contributions to your SEP-IRA.........................$196,000 5) Maximum deduction for contributions to self-employed person's SEP-IRA (multiply line (4) by line (3)).......................$ 25,565 -------- Net earnings from self-employment. For SEP purposes, your net earnings are your gross income from your business minus allowable deductions for that business. Allowable deductions include contributions to your employees' SEP-IRAs. You also take into account the deduction allowed for one-half of your self-employment tax, and the deduction for contributions to your own SEP-IRA. Net earnings do not include tax-free items (or deductions related to them), but do include foreign earned income and housing cost amounts. Net earnings include a partner's distributive share of partnership income or loss (other than separately treated items such as capital gains or losses). If paid for services to or for the partnership, net earnings include guaranteed payments to a limited partner. They do not include distributions of income or loss to a limited partner. Time limit for contributions. To deduct contributions for a year, the employer must make the contributions not later than the due date (including extensions) of the employer's return for the year. Overall limit - employer with defined contribution and SEP plans. If an employer contributes to a defined contribution retirement plan (a plan under which an individual account is set up for each participant), annual additions to an account are limited to the lesser of (1) $30,000 or (2) 25% of the participant's compensation. Moreover, for purposes of these limits, contributions to more than one such plan must be added. Since a SEP is considered a defined contribution plan for purposes of these limits, employer contributions to a SEP must be added to other contributions to defined contribution plans. Tax treatment of employer's contributions. Unlike your contributions to IRAs, contributions to your SEP-IRA by your employer are excluded from your income rather than deducted from it. Your employer's contributions to your SEP-IRA should not be included in your wages on your Form W-2, Wage and Tax Statement, unless there are contributions in excess of the applicable limit, or unless there are contributions under a salary reduction arrangement. Contributions to a salary reduction arrangement. Form W-2 should include contributions under a salary reduction arrangement (discussed later) for social security and Medicare tax purposes only. If there are no excess contributions, you do not include any contributions in your gross income; nor do you deduct any of them. If there are excess employer contributions, you must include them in your gross income, without any offsetting deduction, and your Form W-2 should include the amount. Excess employer contributions you withdraw before your return is due. If your employer contributes more to your SEP-IRA than 15% of your compensation or $30,000, whichever is less, you will not have to pay the 6% tax (discussed in Chapter 7) on it if you withdraw this excess amount (and any interest or other income earned on it) from your SEP-IRA before the date for filing your tax return, including extensions. However, you may have to pay an additional 10% tax (discussed in Chapter 7) on the early withdrawal of the interest or other income earned on the excess contribution. Excess employer contributions you withdraw after your return is due. If employer contributions for the year are $30,000 or less, you may withdraw any excess employer contributions from your SEP-IRA after the due date for filing your tax return, including extensions, free of the 10% tax on premature distributions, discussed earlier. However, the excess contribution is subject to the annual tax. Contributions you make to your SEP-IRA. If you make contributions to your SEP-IRA independent of employer SEP contributions, you can deduct them the same way as contributions to a regular IRA. However, your deduction may be reduced or eliminated because, as a participant in a SEP, you are covered by an employer retirement plan. See Chapter 4, How Much Can I Contribute and Deduct? Excess contributions you make. For information on excess contributions you make to your SEP-IRA independent of employer SEP contributions, see Chapter 7, What Acts Result in Penalties? Tax treatment by self-employed individuals. If you are self-employed (a sole proprietor or partner) and have a SEP plan, take your deduction for contributions to your own SEP-IRA on line 27, Form 1040. Salary Reduction Arrangement A SEP may include a salary reduction arrangement. Under the arrangement, you can elect to have your employer contribute part of your pay to your SEP-IRA. Only the remaining portion of your pay is currently taxable. The tax on the contribution is deferred. Thus, this choice is called an elective deferral. Form 5305A-SEP can be used by an employer to set up such an arrangement. Restrictions on election. You can choose elective deferrals only if: o At least 50% of employees eligible to participate choose elective deferrals, o There were no more than 25 eligible employees at any time during the preceding year, and o The amount deferred each year by each eligible highly compensated employee as a percentage of pay is no more than 125% of the average deferral percentage of all other eligible employees (ADP test). Compensation in excess of $228,860 cannot be considered in figuring an employee's deferral percentage. Exceptions. An elective deferral arrangement is not available for a SEP maintained by a state or local government, or any of their political subdivisions, agencies, or instrumentalities, or to a tax-exempt organization. Limits on deferrals. In general, the total income you can defer under a salary reduction arrangement included in your SEP and certain other elective deferral arrangements, for 1992, is limited to $8,728. This limit applies only to the amounts that represent a reduction from your salary, not to any contributions from employer funds. Elective deferrals, not exceeding the ADP test, are excluded from your income in the year of deferral, but are included in wages for social security, Medicare, and unemployment (FUTA) tax purposes. Overall limits on SEP contributions. Contributions, including elective deferrals (salary reductions), made by your employer to the SEP-IRA are subject to the overall limit of 15% of your compensation (up to $228,860 for 1992) or $30,000, whichever is less. Distributions (Withdrawals) An employer cannot prohibit withdrawals from a SEP-IRA. Also, an employer cannot condition contributions to a SEP-IRA on the keeping of any part of them in the account. Distributions (withdrawals) from a SEP-IRA are subject to IRA rules. For information on these rules, including tax treatment of distributions, tax-free rollovers, required distributions, and income tax withholding, see Chapter 6, When Can I Withdraw and Use Assets From an IRA?