SEP INVESTMENTS

Financial institutions authorized to hold and invest SEP contributions include banks, savings and loan associations, insurance companies, certain regulated investment companies, federally-insured credit unions and brokerage firms. SEP contributions can be put into stocks, mutual funds, money market funds, savings accounts and other similar types of investments.

You and your employees will receive a statement from the financial institutions investing your SEP contributions both at the time you make the first SEP contributions and at least once a year after that. Each institution must provide a plain-language explanation of any fees and commissions it imposes on SEP assets withdrawn before the expiration of a specified period of time.

COMMONLY ASKED QUESTIONS ABOUT SEP

    If an employer maintains a SEP for its employees, can the employees also make
      contributions to Individual Retirement Accounts?

Yes. If the employees choose to do so, they may combine IRA and SEP contributions in one account. NOTE: Because SEP contributions make an individual an "active participant in a qualified plan" for IRA purposes, IRA contributions of certain employees may not be tax deductible. See IRS Publication 590.

   Can an employee eligible to participate in a SEP choose not to participate?

No. All eligible employees must participate. An employer can set up an IRA for the employee at a financial institution and make the appropriate contribution.

   Does the employer have to pay Social Security or federal unemployment compensation taxes
     on SEP contributions for employees?

No.

    Do employers in companies with Salary Reduction SEPs have to pay Social Security
      taxes on their employees' pre-tax contributions? 

Yes. In addition, employees have to pay their portion of Social Security taxes.

    When are income taxes paid on money in a SEP account?

Income taxes are paid when money is withdrawn from a SEP account.

    When can money be withdrawn from a SEP account?

SEP money can be withdrawn without penalty at age 59-1/2. Earlier withdrawals are generally subject to a 10% additional income tax unless the participant becomes disabled or receives distributions in the form of an annuity that are part of substantially equal payments over life or life expectancy.

401k Fact-

Defined Contribution Plans, also known as individual account plans, defined contribution plans specify the amount of funds placed in a participant's account (for example, 10 percent of salary). The amount of funds accumulated and the investment gains or losses solely determine the benefit received at retirement. The employer bears no responsibility for investment returns, although the employer does bear a fiduciary responsibility to select or offer a choice of sound investment options. There are several basic types of defined contribution plans, including simplified employee pension plans, profit sharing plans, money purchase plans, 401(k) and profit sharing plans---Target Labs (www.targetlab.com) setup a 401k, and this small company is very pleased with its reception company-wide.

Simplified Employee Pensions -- known as SEPs -- represent an easy, low-cost retirement plan option for employers. Instead of establishing a separate retirement plan, in a SEP the employer makes contributions to his or her own Individual Retirement Account (IRA) and the IRAs of his or her employees, subject to certain percentages of pay and dollar limits. Employers who establish SEPs can:

   Make tax deductible contributions to their own and their employees' IRAs.

   Omit or reduce contributions in years when contributions are unaffordable.

   Avoid the administrative costs and the reporting requirements of conventional plans.

Whether a SEP is appropriate for your business will depend on factors such as revenue, firm size and the age, compensation and retirement needs of the business owner and work force. You may want to discuss other retirement plan options with a professional advisor.

   A SEP can provide a significant source of income at retirement.

   Contributions to a SEP are tax deductible and your business pays no taxes on the earnings
     on a SEP's investments.

   You are not locked into making contributions in future years. You can decide each year
     whether to pay into the SEP and how much to contribute.

   Once you put money into a SEP you have no further responsibility for the amounts
     contributed. The funds are managed by a financial institution.

   A SEP can be established and operated without the administrative expenses, consulting fees 
     or commissions usually associated with maintaining a conventional retirement plan.

   You ordinarily do not have to file any documents with the government.

   SEPs can be set up by sole proprietors, partnerships and corporations, including
     S corporations.

   You can deduct contributions to a SEP for a previous tax year if you make contributions
     by the due date of the employer's tax return, including any extensions.

Advantages for your employees

  The money you contribute to your employees' SEP accounts, as well as the investment earnings,
    belongs to them -- even if they stop working for you.

  Employers' contributions to the SEP-IRA are not included in employees' income for income
    tax purposes.

  Employees pay no taxes on the amounts in their SEP accounts until they start withdrawing the funds.

  Employees can change the financial institution where their SEP is invested.

  In case of an employee's death, the assets in a SEP will go to someone the employee has 
    chosen.

  SEP contributions can continue until employees retire, but they must start withdrawing 
    assets from a SEP when they reach age 70-1/2. 

ESTABLISHING A SEP

You can set up a SEP by using the Internal Revenue Service's "Model SEP" agreement Form 5305-SEP. All you have to do is:

  (1)  Decide the percentage of pay you want to contribute to the SEP.  The contribution is
       limited to 15% of pay or $24,000* (for 1997), whichever is smaller.  A uniform 
       percentage of pay must be contributed for each employee.
       * This number is indexed for inflation each year.

  (2)  Fill out Internal Revenue Service Form 5305-SEP, a quarter-page form with six blank
       spaces. This form is not filed with the Internal Revenue Service.

 

  (3)  Set up an IRA at a financial institution to receive your SEP contributions. An IRA 
       can be set up by or for your employees to receive the contributions you make for them.

  (4)  Mail the SEP contributions to the financial institutions. 

  (5)  Give employees eligible to be included in the SEP a completed copy of the Form 5305-SEP
       and the other documents and disclosures listed in the instructions, including an annual statement to each participating 
       employee of the amounts contributed to their account for the year.

No other reporting or disclosure ordinarily is required.

 

You cannot use the IRS "Model SEP" if you currently maintain any type of qualified retirement plan or have ever maintained a pension plan for yourself and your employees that promised to pay specific benefits at retirement -- a "defined benefit" pension plan. You also cannot use the Model SEP if you have any eligible employees for whom accounts have not been established. For this purpose, eligible employees include certain individuals who have a specific relationship to the employer. For example, eligible employees for purposes of SEP contributions include "leased employees", and members of an "affiliated" or "commonly controlled" group of employers of which you are a member. These are technical terms that are defined in the Internal Revenue Code. For example, the term " leased employees" is defined in section 414(n) of the Code. The term, "affiliated group" is defined in Code section 1504, and the term "controlled group" is defined in Code section 1563. If you believe any of these terms apply to you, you should consult a professional advisor.

Although using the IRS Form 5305-SEP is an easy way to set up a SEP, you do not have to use this model agreement. Many financial institutions have their own SEP arrangements that have been approved by the Internal Revenue Service. In addition, employers may design their own SEP subject to the legal requirements.

If you use a non-model SEP, the law allows you to take into account Social Security contributions you made for your employees. If you want to do this, consult your professional advi sor.

 

WHO MUST BE INCLUDED IN A SEP

Generally, any employee who performs services for certain affiliated or commonly controlled employers (see the discussion on page 6 regarding these terms) must be included in a SEP. However, there are five exceptions to this general rule. Employers may exclude from the SEP:

  Employees who have not worked for the company during three out of the last five years.

  Employees who earn less than $400* (for 1997) a year.
    >* This number is indexed for inflation each year.

  Employees who have not reached age 21 during the calendar year for which contributions
    are made.

  Employees covered by a collective bargaining agreement, if retirement benefits
    were the subject of good-faith bargaining.

  Non-resident immigrants who do not earn U.S. source income from you.

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SALARY REDUCTION SEPs

Starting January 1, 1997, employers may no longer set up Salary Reduction SEPs. However, the Small Business Job Protection Act of 1996 (Public Law 104-188) established Savings Incentive Match Plans for employees involving IRAs--known as the SIMPLE IRA. Employers may set up a SIMPLE IRA which allows salary reduction contributions of up to $6,000 annually.

If an employer had a salary reduction SEP in effect on December 31, 1996, the employer may continue to allow salary reduction contributions to the plan. Employees are generally permitted to contribute up to 15% of pay or $9,500* (for 1997) a year, whichever is less, to a Salary Reduction SEP, provided the employee earns at least $400 (for 1997).
* This number is indexed for inflation each year.

There are certain maximum permissible amounts that may be contributed on behalf of company owners and certain highly-paid employees ("highly compensated employees") in comparison to amounts contributed for other eligible employees. The amount (percentage of pay) contributed for these highly compensated employees cannot be more than 125% of the average percentage of pay contributed by all other eligible employees. Employers must notify employees by March 15 of the following year if the contributions for the preceding year exceed the limits.

An employer can have both an employer-funded SEP and a Salary Reduction SEP. The total amount contributed for any employee, however, cannot be more than 15% of pay.

Definitions You Need To Know

Some of the terms used in this publication are defined below. The same term used in another publication may have a slightly different meaning.

Annual additions. Annual additions are the total amounts of all of your contributions in a year, employee contributions (not including rollovers), and forfeitures allocated to a participant's account.

Annual benefits. Annual benefits are the benefits to be paid yearly in the form of a straight-life annuity (with no extra benefits) under a plan but excluding the benefit attributable to employee contributions or rollover contributions.

Business. A business is an activity in which a profit motive is present and some type of economic activity is involved. Service as a newspaper carrier under age 18 is not a business, but service as a newspaper dealer is. Service as a sharecropper under an owner-tenant arrangement is a business. Service as a public official is not.

Common-law employee. A common-law employee is any individual who, under common law, would have the status of an employee. A common-law employee can also include a leased employee.

A common-law employee is a person who performs services for an employer who has the right to control and direct both the results of the work and the way in which it is done. For example, the employer:

• Provides the employee's tools, materials, and workplace, and
• Can fire the employee.

Common-law employees are not self-employed and cannot set up retirement plans with respect to income from their work, even if that income is self-employment income for social security tax purposes. For example, common-law employees who are ministers, members of religious orders, full-time insurance salespeople, and U.S. citizens employed in the United States by foreign governments cannot establish retirement plans with respect to their earnings from those employments, even though their earnings are treated as self-employment income.

However, a common-law employee can be self-employed as well. For example, an attorney can be a corporate common-law employee during regular working hours and also practice law in the evening as a self-employed person. In another example, a minister employed by a congregation for a salary is a common-law employee even though the salary is treated as self-employment income for social security tax purposes. However, fees reported on Schedule C (Form 1040) for performing marriages, baptisms, and other personal services are self-employment earnings for Keogh plan purposes.

Compensation. Compensation for plan allocations is the pay a participant received from you for personal services for a year. You can generally define compensation as including:

1. Wages and salaries,
2. Fees for professional services, and
3. Other amounts received (cash or noncash) for personal services actually rendered by an employee, including, but not limited to:
   1. Commissions and tips,
   2. Fringe benefits, and
   3. Bonuses.

Compensation also includes amounts deferred in the following employee benefit plans, unless you elect not to include any amount contributed under a salary reduction agreement (that is not included in the gross income of the employee).

1. Qualified cash or deferred arrangement (section 401(k) plan).
2. Salary reduction agreement to contribute to a tax-sheltered annuity (section 403(b) plan), a SIMPLE IRA plan, or a SARSEP.
3. Section 457 nonqualified deferred compensation plan.
4. Section 125 cafeteria plan.

The limit on elective deferrals is discussed later under Salary Reduction Simplified Employee Pension (SARSEP) and Keogh Plans.

Other options. In figuring the compensation of a participant, you can treat any of the following amounts as the employee's compensation.

1. The employee's wages as defined for income tax withholding purposes.
2. The employee's wages that you report in box 1 of Form W-2.
3. The employee's social security wages (including elective deferrals).

Compensation generally cannot include:

• Reimbursements or other expense allowances (unless paid under a nonaccountable plan), or
• Deferred compensation (either amounts going in or amounts coming out), other than certain elective deferrals unless you elect not to include those elective deferrals in compensation.

For a self-employed individual, compensation means the earned income, discussed later, of that individual.

Contribution. A contribution is an amount you pay into a plan for all those (including self-employed individuals) participating in the plan. Limits apply to how much, under the contribution formula of the plan, can be contributed each year for a participant.

Deduction. A deduction is the amount of plan contributions you can subtract from gross income on your federal income tax return. Limits apply to the amount deductible.

Earned income. Earned income is net earnings from self-employment, discussed later, from a business in which your services materially helped to produce the income.

You can have earned income from property that your personal efforts helped create, such as books or inventions on which you earn royalties. Earned income includes net earnings from selling or otherwise disposing of the property, but it does not include capital gains. It includes income from licensing the use of property other than goodwill.

If you have more than one business, but only one has a retirement plan, only the earned income from that business is considered for that plan.

Employer. An employer is generally any person for whom an individual performs or did perform any service, of whatever nature, as an employee. A sole proprietor is treated as his or her own employer for retirement plan purposes, and a partnership is the employer of each partner. A partner is not an employer for retirement plan purposes.

Highly compensated employees. Highly compensated employees are individuals who:

• Owned more than 5% of the capital or profits in your business at any time during the year or the preceding year, or
• For the preceding year, received compensation from you of more than $80,000 and, if you so elect, was in the top 20% of employees when ranked by compensation.

Leased employee. A leased employee who is not your common-law employee must generally be treated as your employee for retirement plan purposes if he or she:

1. Provides services to you under an agreement between you and a leasing organization,
2. Has performed services for you (or for you and related persons) substantially full time for at least 1 year, and
3. Performs services under your primary direction or control.

Exception. A leased employee is not treated as your employee if the employee is covered by the leasing organization under its qualified pension plan and leased employees are not more than 20% of your nonhighly compensated work force. The leasing organization's plan must be a money purchase pension plan providing:

• Immediate participation,
• Full and immediate vesting, and
• A nonintegrated employer contribution rate of at least 10% of compensation for each participant.

Net earnings from self-employment. Compensation is your net earnings from self-employment. For SEP and Keogh plans, net earnings from self-employment is your gross income from your trade or business (provided your personal services are a material income-producing factor) minus allowable deductions for your business. Allowable deductions include contributions to SEP and Keogh plans for common-law employees and the deduction allowed for one-half of your self-employment tax.

Earnings from self-employment do not include items that are excluded from gross income (or their related deductions) other than foreign earned income and foreign housing cost amounts. For the deduction limits, earned income is net earnings for personal services actually rendered to the business. You take into account the income tax deduction for one-half of self-employment tax and the deduction for contributions to a qualified plan made on your behalf when figuring net earnings. Net earnings include a partner's distributive share of partnership income or loss (other than separately stated items, such as capital gains and losses). It does not include income passed through to shareholders of S corporations. Guaranteed payments to limited partners qualify as net earnings from self-employment if they are paid for services to or for the partnership. Distributions of other income or loss to limited partners do not qualify.

For SIMPLE plans, compensation is your net earnings from self-employment (line 4 of Short Schedule SE (Form 1040)) before subtracting any contributions made to the SIMPLE IRA plan for yourself.

Owner-employee. An owner-employee is:

• A sole proprietor, or
• A partner who owns more than 10% of either the capital interest or the profits interest in a partnership.

Participant. A participant is an eligible employee who is covered by your retirement plan.

Partner. A partner is an individual who shares ownership of an unincorporated trade or business with one or more persons. For retirement plans, a partner is treated as an employee of the partnership.

Self-employed individual. An individual in business for himself or herself is self-employed. Sole proprietors and partners are self-employed. Self-employment can include part-time work.

Not everyone who has net earnings from self-employment for social security tax purposes is self-employed for Keogh plan purposes. See Common-law employee, earlier. Also see Net earnings from self-employment.

In addition, certain fishermen may be considered self-employed for setting up a Keogh plan. See Publication 595, Tax Highlights for Commercial Fishermen, for the special rules that apply. rrp

Sole proprietor. A sole proprietor is an individual who owns an unincorporated business by himself or herself. For retirement plans, a sole proprietor is treated as both an employer and an employee.

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