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A simplified employee pension (SEP) is a written arrangement that allows an employer to make contributions toward his or her own and employees' retirement without becoming involved in more complex retirement plans. The contributions are made to special IRAs (SEP-IRA) set up for each individual qualifying employee.
An employer can use IRS Form 5305-SEP to satisfy the written arrangement requirement for a SEP. A SEP can be established at any time during the year, or up to the due date of the tax return for the year (including extensions). Contributions to the SEP for a given year must be made by the due date of the income tax return, including any extensions, for that tax year.
Establishing a retirement plan for yourself, and your employees if you have any, is one of the few tax reduction strategies that you can use after the tax year ends.
If you have a SEP plan in place, you don't have to make any contributions to the plan in any given year. But, if you do make contributions for a year, the contributions must be based on a written allocation formula (for example, "2 percent of each employee's pay") and must not discriminate in favor of highly compensated employees.
For 2011, the SEP rules permit an employer to contribute, and deduct, an annual maximum of 25 percent of the employee's compensation or $49,000, whichever is less, to each participating employee's account. You can contribute the same amount for your own plan. (For 2012, this amount increased to $50,000.) However, for the business owner, the deduction allowed for the contribution is lower. The business owner's maximum deduction is the net earnings of the business, minus the deduction for one-half the self-employment tax, and minus your contribution to the plan.
Prior to 1997, an employer could establish a Salary Reduction Arrangement SEP (SARSEP) under which employees could elect to make contributions out of their own pay, up to a certain dollar limit per year, per employee. This choice is called an elective deferral. Although new SARSEPs can no longer be set up, you may continue to make contributions to a SARSEP that was established before 1997. For 2011, the dollar limit for each employee's annual elective deferrals is the lesser of:
This is a combined limit: it applies to contributions to a SEP and any of the following: