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Simplified Employee Pension (SEP)

What is a SEP? The Simplified Employee Pension (SEP) plan was designed with the intent that employers could use their employees’ own IRAs to hold a pension arrangement that would involve only minimal administrative work once contributions were made to the IRAs. A SEP consists of employer contributions (as opposed to employee salary deferrals).
A. How do I establish a SEP plan? There are three ways to establish a SEP:
1. IRS model SEP. You can go to the IRS Web site ( to obtain Form 5305-SEP. The completed form does not need to be filed with the IRS nor do we need a copy; however, the employer is required to give copies of the completed 5305-SEP to all eligible employees and must retain the original in the employer’s files.
Note: In certain situations, the IRS Model SEP cannot be used (for example, if the employer maintains a qualified retirement plan). In those situations, a prototype SEP or individually designed SEP must be used.
2. Prototype SEP. With a prototype SEP, a sponsor (typically, a financial institution, mutual fund company, etc.), drafts a SEP document and submits it to the IRS. The IRS issues an opinion letter indicating that the prototype is acceptable. The benefit of a prototype SEP is that it can be less restrictive than the IRS Model SEP. For example, with the IRS Model SEP, the plan year must be the calendar year. With a prototype SEP, the employer can base the SEP plan year on a fiscal year rather than being limited to the calendar year.
3. Individually-designed SEP. An employer can also go to an attorney and have an individually-designed SEP drafted. This is typically the most expensive and least-used alternative for establishing a SEP.
B. What is the deadline for 2007 SEP contributions? To make a SEP contribution for 2007, an employer has until the due date of the business tax return, including extensions, to establish and make contributions to a SEP. In 2008, corporations must file their income tax returns by March 17 (since March 15 falls on a Saturday). The tax-filing deadline for sole proprietors in 2008 is April 15.
C. How much can be contributed to a SEP? As of 2007, the SEP contribution limit is 25% of compensation not to exceed $45,000 ($46,000 for 2008).
D. Does the contribution limit change for self-employed individuals? No. The limit for self-employed individuals is 25% of compensation (not to exceed $45,000). However, because of how “compensation” is defined, the self-employed person’s maximum contribution limit essentially becomes 20% of their net self-employment income less 1/2 of their self-employment tax. This is an oversimplified example. Your self-employed clients (sole proprietors and partners) will want to consult their tax advisor to determine their specific contribution limit. However, you can alert them to the issue.
E. What if my client has employees? If a contribution is made to the SEP for a particular year, each eligible employee must receive a contribution. If the IRS Model SEP is used, the employer selects a specific percentage and each employee receives the same percentage. The prototype and individually-designed SEPs allow the employer to vary the percentage slightly according to a specific IRS-approved formula.
Example: Sandra owns a toy factory. She has two employees: Mark (who makes $30,000/year) and Karen (who makes $40,000/year). Sandra adopts the IRS Model SEP and decides to make a 10% SEP contribution. Sandra contributes 10% to her own SEP-IRA, $3,000 (10% of $30,000) to Mark’s SEP-IRA, and $4,000 (10% of $40,000) to Karen’s SEP-IRA.
F. Does my client have to include all of the employees in the SEP? The IRS Model SEP can be drafted to exclude employees who are under age 21 and/or employees who have not worked for the employer for at least three of the preceding five years and/or employees who make less than $500/year. The employer can also elect to exclude employees who are covered by a collective bargaining agreement and certain non-resident aliens. The SEP Plan must cover all other employees. The prototype SEP and individually-designed SEP have a bit more leeway in establishing eligibility criteria, but not much.
Note: The employer needs to be careful when establishing the criteria for eligible employees. For example, if the employer just started the business this year and establishes a three-year service requirement, no one can receive a SEP contribution, including the employer.
For more information on SEPs and how they impact your practice, contact your PBS Business Development Director today at (888) 458-5798!

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