The Purpose of a SEP

The "simplified" aspect of SEPs is the primary reason for their use. Business owners who want to establish an easy-to-administer retirement plan may be especially interested in these plans.

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, SEPs are not qualified plans, which helps explain why they have 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—

these contributions are not currently taxable, and

the contributions grow on a tax-deferred basis, giving the employer a tax-favored method for providing substantial benefits to employees.

Reporting Requirements

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 rollover amounts and recharacterizations.

In addition, the SEP-IRA trustee or issuer must also report any distributions on an IRS Form 1099R.

Contribution Limits

An employer can deduct contributions to an employee's SEP-IRA up to the lesser of (1) 25% of compensation up to the maximum compensation that may be taken into account for each employee ($230,000 for 2008), or (2) the Section 415 defined contribution dollar limit ($46,000 for 2008). Thus, the practical limit is $46,000.

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.

Highly Compensated Employees

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).

Vesting

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.

Funding Options

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).