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Timing Rules for SEPs and SIMPLE-IRAs Part I

For the most part, SEPs (Simplified Employee Pensions) and SIMPLE (Savings Incentive Match Plan for Employees)-IRAs live up to their billing as easy ways to set aside tax-favored retirement funds for employees and employers. However, contribution rules for these plans are not necessarily straight-forward.

SEP plans: Business owners can set up and fund their SEP by the due date of their business tax return (including extensions). For businesses using the calendar year as their tax year, the deadline to set up and contribute to a SEP plan is March 15th or April 15th, depending on what type of entity they are, or their extended due date if an extension is filed

SEPs may be an attractive alternative for smaller businesses because they can be set up (as a SEP-IRA for each participant) for little or no cost at a bank, investment firm or insurance company; and they offer relatively high contribution and deduction limits, minimal paperwork and no annual Form 5500 filing. The plan must cover employees who are at least age 21 and have performed service for the business in at least three of the last five years. All eligible employees must participate in the plan, including part-time employees, seasonal employees, and employees who die or terminate employment during the year.

SEPs aren’t so simple, however. Although an SEP promises streamlined requirements and flexibility, it does, however, exhibit some unusual quirks that businesses should be aware of before adopting one. A key quirk is the differentiation between the maximum contribution rate for employees and a self-employed employer. Whether for the employer or employee, contributions may be based only on the first $255,000 of compensation for 2013 ($260,000 for 2014).

For employees, the maximum annual contribution is the lesser of (1) 25% of the employee’s compensation, or (2) $51,000 for 2013 ($52,000 for 2014).

For the self-employed employer, when figuring the contribution for his or her own SEP-IRA, compensation is net earnings from self-employment (i.e. earnings net of one-half of the employer’s self-employment tax), less contributions to the employer’s own SEP-IRA.

Thus the calculation of item (1) above for a self-employed person involves a circular calculation; a simpler way to express that calculation for a self-employed person is: his compensation multiplied by [contribution rate (expressed as a decimal) ÷ (contribution rate +1)].

Illustration – Sam, a self-employed individual who owns the entire interest in an unincorporated business, wants to make the maximum deductible contribution to a SEP, where the SEP plan contribution rate is 25%. The maximum deductible amount that Sam (as an employer) may contribute is .25 ÷ 1.25. This is .200, or 20%. Assume that Sam’s net earnings for the year from this business are $100,000 (net of one-half of the social security tax and one-half of the Medicare tax, which are deductible under Code Sec. 164(f)). The maximum deductible contribution that Sam can make for the year is $20,000.

Note, however, that under Code Sec. 164(f)(1), net earnings are computed without regard to the additional 0.9% additional Medicare self-employment tax.

By Jeremy Smith, CPA