A Simplified Employee Pension (SEP) allows employers to contribute to retirement accounts for themselves and their employees. Contributions are made to individual SEP‑IRAs, which employees own and control. A SEP‑IRA may also be structured as a Roth SEP‑IRA.
Establishing a SEP Plan
A SEP can be set up any time up to the employer’s tax return due date, including extensions.
To establish a SEP:
- Adopt a written agreement
- Provide information to eligible employees
- Set up a SEP‑IRA for each eligible employee
SEP plans generally have no annual filing requirement.
Eligible Employees
Employers may set less restrictive rules, but not more restrictive than:
- Age 21
- Worked for the employer in 3 of the last 5 years
- Earned at least the minimum compensation threshold for the year
The 3‑of‑5 rule counts any amount of work during a year.
How Contributions Are Made
- Only employers contribute (except for legacy SAR SEPs).
- Contributions are based on a uniform percentage of compensation for all eligible employees.
- The employer may change the percentage each year or contribute nothing.
- Contributions must be made by the employer’s tax return due date, including extensions.
- Contributions must follow a written allocation formula and cannot favor highly compensated employees.
Annual Contribution Limit
Employer contributions to each SEP‑IRA cannot exceed the lesser of:
- 25% of compensation, or
- The annual SEP contribution limit
Compensation above the annual compensation cap cannot be used in the calculation.
SEP contributions:
- Are not included in taxable wages
- Must be reflected in the retirement‑plan checkbox on wage statements
- Are taxable if contributed to a Roth SEP‑IRA and reported as plan distributions
If the employer maintains another defined contribution plan, total annual additions across all plans cannot exceed the defined‑contribution limit.
All SEP contributions are 100% immediately vested.
Compensation Rules
Employee Compensation
Includes:
- Wages and salaries
- Professional service fees
- Other amounts for personal services such as commissions, tips, fringe benefits, and bonuses
Self‑Employed Compensation
Self‑employed individuals use net earnings from self‑employment, reduced by:
- Employer‑equivalent portion of self‑employment tax
- Their own SEP contribution deduction
Because the deduction and net earnings depend on each other, self‑employed individuals must use an adjusted contribution rate:
This determines the allowable SEP contribution for their own account.
Net earnings include:
- Distributive share of partnership income (excluding separately stated items)
- Guaranteed payments for services
Net earnings do not include:
- S corporation shareholder income
- Items excluded from gross income
Employer Deduction Limits
Employers may deduct SEP contributions for common‑law employees up to:
- 25% of total eligible compensation
Compensation above the annual limit cannot be considered.
Self‑employed individuals deduct their own SEP contributions on their personal return, not as a business expense.
SAR SEP
A SAR SEP is a pre‑1997 SEP that allowed salary‑reduction contributions. These elective deferrals must be included in taxable wages.