Self-employed individuals, as well as other employers, can set up simplified employee pension (SEP) plans. A SEP plan allows an employer to make contributions toward employees' retirement, and, if self-employed, his or her own retirement, without becoming involved in more complex retirement plans.

A self-employed individual is an employee for SEP purposes. He or she is also the employer. Even if the self-employed individual is the only qualifying employee, he or she can have a SEP-IRA.

We focus on the rules affecting employees. For rules affecting employers, contact the IRS.


A simplified employee pension (SEP) is a written arrangement (a plan) that allows an employer to make deductible contributions for the benefit of participating employees. The contributions are made to individual retirement arrangements (IRAs) set up for participants in the plan. Under a SEP, traditional IRAs are set up for, at a minimum, each qualifying employee (defined below). IRAs may have to be set up for leased employees (defined below), but they do not have to be set up for excludable employees (defined below). Traditional IRAs set up under a SEP plan are referred to in this publication as SEP-IRAs.

Qualifying employee. A qualifying employee is one who meets all of the following conditions:

1. Is at least 21 years old,


2. Has worked for the employer during at least 3 of the 5 years immediately preceding the tax year, and


3. Has received from the employer at least $400 in compensation in the tax year.

Note. An employer can establish less restrictive participation requirements for its employees than those listed, but not more restrictive ones.

Leased employees. The person or firm for whom you perform services (the recipient) may have to include you in a SEP if you are a "leased employee" and are treated as an employee of the recipient. A leased employee is any person who is not an employee of the recipient and who is hired by a leasing organization, but who performs services for another (the recipient of the services). You are a leased employee if all of the following apply.

1. Your services are provided under an agreement between the recipient and the leasing organization.


2. Your services are performed for the recipient, or for the recipient and related persons, on a substantially full-time basis, for a period of at least one year.


3. Your services are performed under the primary direction and control of the recipient.

Excludable employees. The following groups of employees can be excluded from coverage under a SEP:

1. Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by their union and their employer, and


2. Nonresident alien employees who have no U.S. source earned income from their employer.

The SEP rules permit an employer to contribute (and deduct) each year to each participating employee's SEP-IRA up to 15% of the employee's compensation or $30,000, whichever is less. These contributions are funded by the employer.

An employer who signs a SEP agreement does not have to make any contribution to the SEP-IRAs that are set up. But, if the employer does make contributions, the contributions must be based on a written allocation formula and must not discriminate in favor of highly compensated employees (defined later).

Highly compensated employee. A highly compensated employee is any employee who meets either of the following two conditions.

1. The employee owns (or owned last year) more than 5% of the capital or profits interest in the employer (if not a corporation); or more than 5% of the outstanding stock, or more than 5% of the total voting power of all stock, of the employer corporation.


2. The employee's compensation from the employer for last year was more than $80,000 and (if the employer elects to apply this clause for last year) the employee was in the top 20% when ranked on the basis of last year's compensation.

For purposes of determining the 15% limit, compensation is generally limited to $160,000, not including your employer's contribution to your SEP-IRA.

Example. Barry's nonunion employer has a SEP for its employees. Barry's compensation for 1998, before his employer's contribution to his SEP-IRA, was $180,000. Barry's employer can contribute up to $24,000 (15% × $160,000) to Barry's SEP-IRA.


If you are self-employed and contribute to your own SEP-IRA, special rules apply when figuring your maximum deduction for these contributions.

Compensation for the self-employed. For determining the 15% limit on contributions, discussed above, your compensation is your net earnings from self-employment, defined later. Note that, for SEP purposes, your net earnings (compensation) must take into account your deduction for contributions to your own SEP-IRA. Because your deduction amount and your net earnings amount are each dependent on the other, this adjustment presents a problem.

To solve this problem, you make the adjustment to net earnings indirectly by, in figuring your maximum deduction, reducing the contribution rate called for in the plan. Use the following worksheets to find this reduced contribution rate and your maximum deduction. Make no reduction to the contribution rate for any common-law employees.

Net earnings from self-employment. For SEP purposes, your net earnings are your gross income from your business minus allowable deductions for that business. Allowable deductions include contributions to your employees' SEP-IRAs. You also take into account the deduction allowed for one-half of your self-employment tax, and the deduction for contributions to your own SEP-IRA.

What to include. Include the following items in your net earnings.

1. Foreign earned income and housing cost amounts.


2. If you are a partner, your distributive share of partnership income or loss (other than separately treated items such as capital gains and losses).


3. If you are a limited partner, guaranteed payments for services to or for the partnership.


4. Elective contributions or deferrals under any of the following plans.


1. 401(k) plans.


2. 403(b) plans (tax-sheltered annuities).


3. SEP plans (salary reduction arrangements).


4. Savings incentive match plans for employees (SIMPLE plans)


5. Cafeteria plans.


6. 457 plans (plans of state and local governments and certain tax-exempt organizations).

What not to include. Do not include the following items in your net earnings.

1. Tax-free items (or deductions related to them).


2. If you are a limited partner, distributions of income or loss.

To deduct contributions for a year, the employer must make the contributions by the due date (including extensions) of the employer's return for the year.

If an employer contributes to a defined contribution retirement plan (a plan under which an individual account is set up for each participant), annual additions to an account are limited to the lesser of (1) $30,000 or (2) 25% of the participant's compensation. Moreover, for purposes of these limits, contributions to more than one such plan must be added. Since a SEP is considered a defined contribution plan for purposes of these limits, employer contributions to a SEP must be added to other contributions to defined contribution plans.


Your employer's contributions to your SEP-IRA are excluded from your income rather than deducted from it. Your employer's contributions to your SEP-IRA should not be included in your wages on your Form W-2, Wage and Tax Statement, unless there are contributions under a salary reduction arrangement (explained later).

Unless there are excess contributions, you do not include any contributions in your gross income; nor do you deduct any of them.

Excess employer contributions. If your employer contributes more than is allowed, you must include the excess in your gross income, without any offsetting deduction.

Excess employer contributions you withdraw before your return is due. If your employer contributes more to your SEP-IRA than 15% of your compensation or $30,000, whichever is less, you will not have to pay the 6% tax (discussed above under Excess Contributions) on it if you withdraw this excess amount (and any interest or other income earned on it) from your SEP-IRA before the date for filing your tax return, including extensions. However, you may have to pay an additional 10% tax (discussed above under Premature Distributions (Early Withdrawals)) on the early withdrawal of the interest or other income earned on the excess contribution.

Excess employer contributions you withdraw after your return is due. If employer contributions for the year are $30,000 or less, you can withdraw any excess employer contributions from your SEP-IRA after the due date for filing your tax return, including extensions, free of the 10% tax on premature distributions, discussed earlier. However, the excess contribution is subject to the annual 6% excise tax. Also, you may have to pay the additional 10% tax on the early withdrawal of interest or other income earned on the excess contribution.


You can make contributions to your SEP-IRA independent of employer SEP contributions. You can deduct them the same way as contributions to a regular IRA. However, your deduction may be reduced or eliminated because, as a participant in a SEP, you are covered by an employer retirement plan. See How Much Can I Deduct? in the section for Traditional IRAs.

Excess contributions you make. For information on excess contributions you make to your SEP-IRA independent of employer SEP contributions, see What Acts Result in Penalties? in the section under Traditional IRAs.

Self-employed individuals. If you are self-employed (a sole proprietor or partner) and have a SEP plan, take your deduction for employer contributions to your own SEP-IRA on line 29, Form 1040. If you also make deductible contributions to your SEP-IRA (or any other IRA you own) independent of your employer contributions, take your deduction on line 23, Form 1040.


A SEP may include a salary reduction arrangement. Under the arrangement, you can elect to have your employer contribute part of your pay to your SEP-IRA. Only the remaining portion of your pay is currently taxable. The tax on the contribution is deferred. This choice is called an elective deferral. Form 5305A-SEP can be used by an employer to set up such an arrangement.

An employer cannot start a new simplified employee pension (SEP) that includes a salary reduction arrangement. Only SEPs that allowed employees to choose elective deferrals as of December 31, 1996, can include salary reduction arrangements.

Restrictions on election. You can choose elective deferrals only if all three of the following conditions exist.

1. At least 50% of employees eligible to participate choose elective deferrals.
2. There were no more than 25 eligible employees at any time during the preceding year.
3. The amount deferred each year by each eligible highly compensated employee as a percentage of pay is no more than 125% of the average deferral percentage of all other eligible employees (ADP test). Generally, compensation that is more than $160,000 cannot be considered in figuring an employee's deferral percentage.

An elective deferral arrangement is not available for a SEP maintained by a state or local government, any of their political subdivisions, agencies, or instrumentalities, or a tax-exempt organization.

Limits on deferrals. In general, the total income you can defer under a salary reduction arrangement included in your SEP and certain other elective deferral arrangements, for 1998, is limited to $10,000. This limit applies only to the amounts that represent a reduction from your salary, not to any contributions from employer funds.

Elective deferrals, not exceeding the ADP test (see Restrictions on election, earlier), are excluded from your income in the year of deferral, but are included in wages for social security, Medicare, and unemployment (FUTA) tax purposes.

Overall limits on SEP contributions. Contributions, including elective deferrals (salary reductions), made by your employer to the SEP-IRA are subject to the overall limit of 15% of your compensation (generally up to $160,000 for 1998) or $30,000, whichever is less.


An employer cannot prohibit withdrawals from a SEP-IRA. Also, an employer cannot condition contributions to a SEP-IRA on the keeping of any part of them in the account.

Distributions (withdrawals) from a SEP-IRA are subject to traditional IRA rules. For information on these rules, including tax treatment of distributions, tax-free rollovers, required distributions, and income tax withholding, see Can I Move Retirement Plan Assets? and When Can I Withdraw or Use IRA Assets? in the section on Traditional IRAs.