Simplified Employee Pensions (SEPs)

A simplified employee pension (SEP) is a written arrangement that allows an employer to make contributions toward his or her own and employees' retirement without becoming involved in more complex retirement plans. The contributions are made to special IRAs (SEP-IRA) set up for each individual qualifying employee.

An employer can use IRS Form 5305-SEP to satisfy the written arrangement requirement for a SEP. A SEP can be established at any time during the year, or up to the original due date of the tax return for the year (April 15^th for most people). Contributions to the SEP for a given year must be made by the due date of the income tax return, including any extensions, for that tax year.

If you have a SEP plan in place, you don't have to make any contributions to the plan in any given year. But, if you do make contributions for a year, the contributions must be based on a written allocation formula (for example, "2 percent of each employee's pay") and must not discriminate in favor of highly compensated employees.

Individuals participating in a SEP may elect to contribute up to the smaller of $11,000 in 2002 ($12,000 in 2003) or 100 percent of their compensation to the plan.

For 2002 and 2003, the SEP rules permit an employer to contribute, and deduct, an annual maximum of 25 percent of the employee's compensation or $40,000, whichever is less, to each participating employee's account. For the business owner, however, the contribution limit is lower.

The business owner's maximum employer contribution to their own SEP is the net earnings of the business, minus the deduction for one-half the self-employment tax, multiplied by a percentage that is somewhat lower than the percentage used to compute the employees' contribution. For example, if your employees were receiving the maximum contribution of 15 percent of pay, you would have to use 13.0435 percent. If your employees receive 10 percent, your percentage would be 9.0909. You can compute your percentage for other rates by taking the employees' rate, expressed as a decimal, and dividing it by that rate plus one. The maximum effective applicable percentage limit for self-employed individuals in 2002 and 2003 is 20 percent.

Example If the employees' rate was 10.5 percent, you could compute the owner's rate by dividing 0.105 by 1.105 to arrive at .0950, or 9 1/2 percent.

Prior to 1997, an employer could establish a Salary Reduction Arrangement SEP (SARSEP) under which employees could elect to make contributions out of their own pay, up to a certain dollar limit per year, per employee. This choice is called an elective deferral. Although new SARSEPs can no longer be set up, you may continue to make contributions to a SARSEP that was established before 1997. For 2002, the dollar limit for each employee's elective deferrals is $11,100 ($12,000 in 2003).