Questions & Answers

• How do you determine which of your employees must be covered by a SEP?
• How much can you contribute to a SEP?
• What are the definitions of highly compensated employee, key employee, and top-heavy plan, and why are these definitions important?
• How does a SEP affect other retirement plans?
• Can employees also contribute to their SEP-IRAs?
• How does a SEP allocate contributions among employees?
• When can employees withdraw funds from their SEP-IRAs?
• When can you set up a SEP and make deductible contributions?
• What are the different ways to establish a SEP?

How do you determine which of your employees must be covered by a SEP?

There are different rules for the different classes of employees, as follows:

• Qualifying employees: All qualifying employees must be covered by a SEP. A qualifying employee is an employee who has:

Tip: While you must include qualifying employees in a SEP, you can always establish participation requirements that are less restrictive than those listed above. If, for example, you want to allow employees over the age of 18 to participate, you may.

Caution: An employee who meets the criteria above in any year must be covered under the SEP for that year even if he or she is not employed by you at the end of the year.

Example(s): Employee Smith is 30 years old and has worked for you for 7 years. In June, you fire Smith. In August, you set up a SEP for your remaining employees. If Smith received more than $650 in compensation for the year, he must be included in the SEP.

• Leased employees: An employee leased from an employment organization generally must be included in the SEP if he or she provided substantially full-time services for you for at least one year and worked under your primary direction or control. (Certain exceptions apply.)
• Excludable employees: You don’t have to include an employee in a SEP if he or she is covered by a union agreement (and his or her retirement benefits were bargained for in good faith by you and the union), or is a nonresident alien employee who has no earned income from U.S. sources.

How much can you contribute to a SEP?

It depends. Contributions that you make to an employee’s SEP-IRA cannot exceed the lesser of 25 percent of the employee’s compensation or $61,000 (in 2022). (Don’t include your contribution to the employee’s SEP when calculating the 25 percent of compensation.) Generally, you can only consider an employee’s first $305,000 in compensation in calculating the amount of contribution that you can make to a SEP (in 2022).

If you’re self-employed, contributions to your own SEP-IRA are calculated differently. While the above limits also apply to you, your compensation is considered to be your net earnings from self-employment. Basically, your net earnings from self-employment represent the net income that you earned in the business that established the SEP, less the deduction for contributions to your SEP and the deduction allowed to you for one-half of the self-employment tax. This effectively reduces your maximum contribution rate to 20 percent of compensation or $61,000 (in 2022), whichever is less.

Tip: The calculation of a self-employed individual’s deductible contribution can sometimes be complex, especially if you have employees or if your plan is integrated with Social Security. Your tax advisor should be able to assist you in making these difficult calculations. The IRS also provides worksheets in Publication 560.

What are the definitions of highly compensated employee, key employee, and top-heavy plan, and why are these definitions important?

There are nondiscrimination rules requiring that plan contributions not discriminate in favor of shareholders, officers, or highly compensated employees. Typically, the nondiscrimination rules are satisfied by providing either an equal percentage of pay or a flat dollar amount for all participating employees. The allocation formula can also take Social Security into account (called “permitted disparity”). In very general terms, this allows you to make larger contributions for employees earning more than the Social Security taxable wage base (or some percentage of the taxable wage base).

Plans that are top-heavy have additional requirements, including a minimum contribution of 3 percent of compensation for each participant who isn’t a key employee.

For 2022, a highly compensated employee is an individual who:

• Was a 5 percent owner of the employer during 2021 or 2022, or
• Had compensation in 2022 in excess of $135,000 and, at the election of the employer, was in the top 20 percent of employees in terms of compensation for that year. (This $135,000 limit is subject to cost of living adjustments each year.)

A key employee is an individual who:

• Is a 5 percent owner of the employer
• Is a 1 percent owner of the employer with annual compensation of more than $150,000, or
• Is an officer of the employer with compensation in excess of $165,000 (for 2021 and 2022)

With a top-heavy SEP, for a plan year:

• The sum of the account balances of participants who are key employees for the plan year exceeds 60 percent of the total sum of account balances for all employees under the plan, or
• The plan is part of a top-heavy group

How does a SEP affect other retirement plans?

The IRS treats a SEP as a profit-sharing (defined contribution) plan. If you also maintain a qualified profit-sharing plan (other than the SEP), special rules apply. Generally, the 25 percent deduction limit for qualified profit-sharing plans is reduced by any allowable deductions for contributions to the SEP-IRA accounts of individuals who participate in both the SEP and the profit-sharing plan. If you contribute to a defined benefit plan in addition to a SEP-IRA, special deduction limits may apply.

Tip: If you’re trying to coordinate contributions to multiple retirement plans, seek the assistance of a tax professional.

Can employees also contribute to their SEP-IRAs?

Yes. At its simplest level, a SEP is a collection of IRAs for you and your employees to which you, as employer, can contribute. Your employees can also contribute to these IRAs. As with all IRAs, however, your employees can contribute no more than $6,000 for 2022 ($7,000 if they’re age 50 or older), and the deductibility of employee contributions is subject to the IRA phaseout rules.

Caution: The employee contribution limit is an aggregate IRA annual limit – for example, in 2022, an employee cannot contribute $6,000 to a SEP-IRA and another $6,000 to a separate IRA (traditional or Roth).

Caution: SEP-IRAs can not accept Roth contributions.

Caution: Prior to 1997, SEPs could include salary-reduction arrangements (SAR-SEPs), under which employees could elect to have you contribute part of their pay to their SEP-IRAs. SAR-SEPs, however, can no longer be established (although those established before 1997 can continue to operate in some cases).

If you are self-employed and establish a SEP, you can make two types of contributions. First, you can contribute as an employer to the SEP-IRA, based on the rules previously explained. Second, you can contribute up to the annual maximum to your SEP-IRA (or to any other IRA you own) independently of your employer contribution to your SEP-IRA. Whether or not you can deduct the contribution you make to your IRA depends on your specific situation.
How does a SEP allocate contributions among employees?

When you establish a SEP, it must provide in writing the requirements that employees must satisfy to share in the allocation of contributions and must detail the manner in which contributions will be allocated. SEP allocation formulas almost always take the form of a percentage of compensation.
When can employees withdraw funds from their SEP-IRAs?

Once you make a contribution to SEP-IRAs, your employees can withdraw their funds at any time. You cannot prevent an employee from withdrawing funds, nor can you condition your contributions on an employee’s promise not to make a withdrawal. All traditional IRA rules apply, and withdrawals made prior to an employee reaching age 59½ may be subject to a federal 10 percent premature distribution tax, and perhaps a state penalty, too.

When can you set up a SEP and make deductible contributions?

To take a deduction for contributions for a particular year, you must set up the SEP and make the contributions by the due date of your business’s income tax return for that year. In the case of a SEP, an extension of time to file the business’s income tax return also extends the period allowable for making contributions.

Example(s): Joseph, a self-employed carpenter, wants to establish a SEP for year one. Joseph’s income tax return for year one is due April 15 of year two. Joseph would ordinarily have until April 15 of year two to set up a SEP and make a contribution for year one. Joseph, however, files for and obtains an extension of time to file his year-one income tax return until October 15 of year two. Joseph has until October 15 of year two to establish a SEP and make contributions to the SEP for year one.

Tip: Consider: What if you have enough money to pay the taxes due on your federal income tax return or to make a contribution to your SEP, but not both? Calculate your tax return as if you made the SEP contribution. File for an extension (paying the tax due). You now have until the extended due date of the tax return to make the SEP contribution. Be careful, though. Failure to make the SEP contribution means additional tax will be due, along with interest. In addition, be sure to file your return by the extended due date.

What are the different ways to establish a SEP?

There are a few ways to establish a SEP. You can use Form 5305-SEP, which satisfies all SEP requirements (if no modifications are made). This form does not need to be filed with the IRS. However, you cannot use Form 5305-SEP if you:

• Currently maintain any other qualified retirement plan
• Previously maintained a defined benefit plan that is now terminated
• Have any eligible employees for whom IRAs have not been established
• Use the services of leased employees
• Are a member of an affiliated service group or a group of commonly controlled businesses, unless all eligible employees are covered by the SEP
• Want to integrate contributions with Social Security

Alternatively, you can use prototype or master SEP plans to establish a SEP. Banks, credit unions, savings and loan associations, insurance companies, and other financial institutions obtain approval from the IRS for their plans and offer them to customers. These prepackaged SEPs may allow for more flexibility than a SEP set up with Form 5305-SEP and can allow for integration with Social Security.

You can also have a custom-designed SEP plan. This requires retaining an attorney to draft the necessary documentation and obtaining a favorable opinion letter from the IRS. Given the cost and complexity involved and the widespread availability of prototype plans, individually designed SEPs are not frequently used.