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SEP contributions are made on a discretionary basis, which means the employer decides each year whether or not to make a SEP contribution for eligible employees; furthermore, SEP contributions in excess of certain limits must be corrected in accordance with regulatory requirements, in order to avoid penalties. The requirements vary depending on the type of excess contribution. Employers who make excess SEP contributions should consult with their SEP providers or a tax professional regarding corrective measures.
Contribution Limit
An employer may contribute up to 25% of the eligible employee's compensation, providing the contribution does not exceed $46,000. The employee's compensation in excess of the compensation cap, which is $230,000 (indexed), is not used to determine the contribution limit - the compensation cap is the maximum compensation that may be considered for employer-plan purposes.
For contributions made to the plan, the employer will be eligible to receive a tax deduction within established regulatory limits.
The following example illustrates how the contribution limits apply:
Example 1
For the 2008 tax year, XYZ Corporation decided to make a 25% contribution for each eligible employee. These employees receive W-2 wages in the following amounts:
Mark - $250,000
Jane - $160,000
Mary - $80,000
Jim - $40,000
Each employee's SEP contribution is allocated as follows:
| Employee |
W-2 Wage |
Contribution Receive |
Comments |
Mark
|
$250,000
|
$46,000
|
- Only up to $230,000 can be considered when determining Mark's contribution.
- Twenty-five percent of Mark's eligible compensation is $57,500, but the maximum dollar amount that any employee can receive as contributions to a SEP plan is $46,000.
|
Jane
|
$160,000
|
$40,000
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- Jane receives 25% of her compensation, which happens to equal $40,000.
|
Mary
|
$80,000
|
$20,000
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- The maximum contribution is 25% of compensation or $46,000, whichever is less. Twenty-five percent of Mary's compensation is $20,000, which is less than $46,000. Jane receives the lesser of the two amounts.
|
Jim
|
$40,000
|
$10,000
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- The maximum contribution is 25% of compensation or $46,000, whichever is less. Twenty-five percent of Jim's compensation is $10,000, which is less than $46,000. Jim receives the lesser of the two amounts.
|
| Total |
$530,000 |
$116,000 |
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Contribution Formulas
An employer may chose among several formulas to allocate contributions:
- Pro-rata - With this formula, each eligible employee receives the same percentage of his or her eligible compensation. The pro-rata formula is demonstrated in the example above with XYZ Corporation.
- Flat-dollar formula - With this formula, each eligible employee receives the same dollar amount as a contribution.
- Social security integration - Here higher-paid employees receive a larger percentage of the contribution. With this formula, the employer assigns to the SEP plan an amount that is a percentage of the accumulated total of all eligible employees' compensation. Using a special formula, the employer then allocates a contribution percentage to each eligible employee. The allocation must be done according to specific regulatory requirements; otherwise, the SEP may be disqualified.
Example 2
For the employees and the figures in Example 1, XYZ determines that the total contribution to the SEP plan will be $110,000. Instead of allocating 25% to each employee, XYZ decides to allocate the $110,000 among the employees using the social security integration formula. As a result, higher paid employees will receive a higher percent (based on eligible compensation) than lower-paid employees. |
All three formulas meet IRS requirements.
Contribution Deadline
SEP employer contributions must be made to each employee's SEP IRA by the employers tax-filing deadline (including extensions).
Salary-Deferral SEPs (SARSEPs)
Salary-deferral SEPs allow eligible employees to make salary-deferral contributions to their SEP IRAs, which means employees can elect to defer receiving a portion of their compensation so that it will be contributed to their SEP IRA. These contributions are made on a pre-tax basis. In addition to these salary-deferral contributions, the employer may also make SEP (employer) contributions to each eligible employee's SEP IRA.
Effective for tax years beginning Jan 1, 1997, SARSEPs can no longer be established. Employers that established SARSEPs prior to Jan 1, 1997 are allowed to continue maintaining these plans.
SARSEP Employer Eligibility Requirement
An employer is eligible to maintain a SARSEP only if the employer meets the following requirements:
- At least 50% of employees eligible to participate in the SEP plan chose to participate in the salary-deferral arrangement.
- The employer has 25 or fewer employees who are eligible to participate in the SEP at any time during the preceding year.
- The salary deferrals of highly-paid employees meet certain IRS requirements. These requirements provide that contributions to the SEP are not made in a discriminatory manner favoring highly-compensated employees.
Deferral-Contribution Limits
Salary-deferral contributions cannot exceed certain limits, and amounts deferred in excess of these limits must be removed from the employee's SEP IRA. Excess contributions require special administrative handling and will be subject to penalties if not removed within a specific time frame.
The salary-deferral limits for SARSEP plans are as follows:
Tax Year |
Salary-Deferral Contribution Limit |
| 2004 |
$13,000 |
| 2005 |
$14,000 |
| 2006 |
$15,000 |
| 2007 |
$15,500 |
| 2008 and after |
$15,500 plus COLA increases |
Eligible employees who are at least age 50 by the end of the year may make additional contributions, which are referred to as catch-up contributions. Here are the catch-up contribution limits:
| Tax Year |
Catch-up Contribution Limit (for eligible employees age 50 and older) |
| 2004 |
$3,000 |
| 2005 |
$4,000 |
| 2006 |
$5,000 |
| 2007 |
$5,000 |
| 2008 and after |
$5,000 plus COLA increases |
Other rules could place additional limits on salary-deferral contribution amounts. Employees should consult with their employer and/or SEP IRA provider regarding limitations.
Next: SEP IRAs: Distributions
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