A simplified employee pension (SEP), also known as an SEP-IRA (individual retirement account), can be defined as a pension plan for small business owners and their employees and the self-employed. Created by Congress and monitored carefully by the Internal Revenue Service (IRS), SEPs are designed to give small business owners and employees the same ability to set aside money for retirement as traditional large corporate pension funds.

The Small Business Job Protection Act of 1996 also established the Savings Incentive Match Plan for Employees (SIMPLE), a streamlined SEP that is exempt from certain government reports and tests, provided that employers contribute 2 percent of each eligible employee's salary or match employee contributions up to 3 percent of wages. Employee contributions into a SIMPLE plan cannot exceed $6,000 per year, and employer contributions or matching funds cannot exceed $2,000 per year.

SEPs can also be much more flexible and attractive than corporate pensions. They can even be used to supplement such pensions and corporate 401(k) plans. Many full-time employees use SEPs as a way to save and invest more money for retirement than they might normally be expected to put away under IRS rules. Forbes magazine described SEPs as a "moonlighter's delight" in a 1993 article. The reason for the magazine's enthusiasm is that SEPs, while created for the self-employed and small business people, also allow full-time employees to contribute a portion of self-employment income from consulting or freelancing.

The rules governing SEPs are fairly simple, but are subject to change with any Congressional action, so yearly checks of IRS publications 560 (retirement plans for the self-employed) and 590 (IRAs) are necessary. Through 1994, SEPs could be set up with a simple form and did not require any separate trustee, which is required of larger, more complicated pension plans. The maximum allowable tax-deductible SEP contribution per employee is 15 percent of salary or income (up to a maximum income of $150,000) or $22,500, whichever is less. The maximum amount an employer can contribute to his or her own plan is 13.0435 percent of income. Still, compared to the $2,000 allowable standard IRA contribution, which has not been fully tax deductible for all contributors since 1986, the advantages of SEPs are obvious. SEPs can also be combined with variable annuities as a strategy to avoid outliving retirement savings. Variable annuities are established when investors entrust their money to an insurance company for investment, with the insurance company agreeing to repay the investors at a set rate and time according to contractual terms. Furthermore, people can contribute to their existing IRAs and 401(k)s and still hold an SEP. SEPs were made still more attractive in January 1996 by amendments to the IRS code that prohibited states from imposing "source taxes" on the pensions and other retirement funds of their former residents now residing elsewhere.

One word of caution for small business owners: SEP plans must be set up for everyone in the company, including part-time employees. This does not mean that the SEP must be funded each year. If the company is experiencing a lean year, funding of the SEP may be skipped. All of the SEP's funding is deductible as a business expense in the year it is made.

A similar program is the salary reduction simplified employee pension (SARSEP). SARSEPs are similar to 401(k) plans, in which employees defer part of their annual compensation into an IRA. Any employer contributions to the program are deductible as business expenses. The employer can still establish a separate SEP to handle employer contributions. SARSEPs are available to businesses with 25 or fewer employees, but at least 50 percent of a company's employees must elect to participate in the program to launch it.

[ Clint Johnson ,

updated by Grant Eldridge ]


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Janicki, Michael. "New Federal Law Restricts State Taxation of Nonresidents' Pensions." Tax Adviser 27, no. 5 (May 1996): 279.

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Turville, Mary A. "Pension Provisions in the 1996 Tax Acts." National Public Accountant 41, no. 12 (December 1996): 21.

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