United States: The Simplified Employee Pension (SEP), a Roth 401(k) Alternative

Last Updated: July 14 2006

As you may be aware, the Job Creation and Worker Assistance Act of 2002 provided changes in simplified employee pension (SEP) plans that made the contribution limits for them equal to the limits for defined contribution plans (profit-sharing plans, 401(k) plans, etc.).

Thanks to these changes, generous amounts can be contributed to SEPs set up for the benefit of small business owners who earn healthy incomes from their ventures. An additional bonus with SEPs is that a newly formed SEP is also: (1) incredibly easy to establish (unlike other types of retirement plans), and (2) a powerful retroactive tax planning tool (unlike other types of retirement plans). In fact, some people suggest that SEPs are the "no-brainer" first choice for most high-income small business owners who have not yet set up tax-advantaged retirement plans.

Setting Up a SEP

A SEP is generally very easy to establish. SEPs are available to self-employed individuals (sole proprietors and owners of single-member LLCs treated as sole proprietorships), partnerships (including multimember LLCs treated as partnerships) and corporate employers alike. Establishing a SEP merely entails completing and signing Form 5305-SEP (Simplified Employee Pension-Individual Retirement Accounts Contribution Agreement). In addition, and as contrasted with defined contribution plans, there is no requirement to file annual retirement reports for a SEP.

Since the SEP can be established as late as the extended due date of the self-employed person’s or employer’s tax return for the taxable year for which the SEP is to first apply, a SEP can be considered a powerful retroactive tax planning tool. For example, if you as a sole proprietor (or as a partnership or corporation) have extended your calendar year 2005 income tax return to October 16, 2006, you can establish a SEP as late as that date, make the initial contribution and claim a potentially hefty deduction on your 2005 return. In general, other types of retirement plans must be in existence by the end of the year for which the plan is to first apply.

Funding and Participation Requirements

The first step in funding a SEP is to set up an IRA for each eligible participant with a qualified IRA trustee (e.g., a bank, insurance company, mutual fund company or brokerage company). The self-employed individual or employer then makes contributions directly to each participant’s IRA.

If the business has one or more employees (other than the owner), the Internal Revenue Code defines an eligible employee for SEP participation purposes as one who has:

  1. Attained age 21;
  2. Performed any services for the employer during at least three of the preceding five years; and
  3. Received at least $450 in compensation (this is the inflation adjusted amount for both 2005 and 2006).

The employer is always free to establish less restrictive eligibility requirements. All eligible employees must participate in the plan, including ones who die or quit during the year. If an eligible employee cannot be located or is unable or unwilling to set up an IRA, the employer can execute the necessary paperwork to establish an IRA on behalf of the employee in order to prevent the SEP from being disqualified.

Annual Contribution Limits

For 2005, the maximum contribution to a SEP account set up for an employee (including a sole shareholder-employee of the sponsoring corporation) is the lesser of: (1) 25% of the participant’s compensation ($210,000 maximum for 2005), or (2) $42,000. For 2006, the $210,000 limit on compensation is increased to $220,000 and the $42,000 maximum contribution is increased to $44,000. Those 2005 contribution limits are much greater than the 2005 contribution limits for IRA or 401(k) accounts, which are $4,500 and $18,000, respectively.

For purposes of calculating the maximum contribution to a selfemployed individual’s SEP account, compensation is defined as: (1) self-employment income from the business that established the SEP, minus (2) the above-the-line deduction for 50% of selfemployment tax, minus (3) the individual’s deductible SEP contribution. This formula results in an effective maximum contribution percentage of 20%, and the contribution caps of $42,000 for 2005 and $44,000 for 2006 still apply.

For example, John, the owner of a single-member LLC with no employees, extended his 2005 return until October 16, 2006. On or before that date, he establishes a SEP for himself. His 2005 self-employment earnings from the LLC are $200,000 and his deduction for 50% of his self-employment tax is approximately $8,300. John’s maximum SEP contribution for 2005, therefore, is $38,340 (($200,000 - $8,300) X 20%).

John can contribute that amount on or before October 16, 2006, and claim a corresponding deduction on his 2005 return. This is retroactive tax planning at its finest!

Conclusion

In some areas there may be disadvantages to establishing a SEP (as opposed to some other type of qualified plan). For example, if the business has employees other than the owner, those employees will often have to be covered with contributions made using the same percentage of compensation as for the owner. Furthermore, any contributions to employee accounts are immediately 100% vested, so that an employee may take all of the contributions made on his or her behalf and leave, compared with other qualified plans in which vesting requirements are generally imposed, which generally reduce the amount of employer contributions that can be taken. In addition, even when the SEP is established by a self-employed individual with no other employees, a defined benefit pension plan may permit an older individual to make bigger deductible contributions than the SEP does.

We believe you should probably view SEPs as the retirement plan equivalent of LLCs. In other words, a small business owner should generally evaluate the wisdom of establishing a SEP before considering other retirement plan alternatives, just as he or she should generally evaluate the wisdom of forming an LLC before considering other business entity alternatives.

If you have any questions about SEPs, or the Roth 401(k) plans discussed previously, or about retirement savings strategies, please contact us.

For more information, please contact Michael A. Gillen, director of the Duane Morris Tax Accounting Group

As required by United States Treasury Regulations, you should be aware that this communication is not intended to be used, and it cannot be used, for the purpose of avoiding penalties under United States federal tax laws.

This newsletter is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

Duane Morris is a registered service mark of Duane Morris LLP.

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