SEP Contribution Limits

The maximum amount that can be contributed to an employee's simplified employee pension (SEP) plan account is the lesser of 25 percent of the employee's compensation for the year (up to $225,000 considered in 2007 and $230,000 in 2008) or $46,000 in 2008 ($45,000 in 2007). The employer's annual contribution limit also includes any elective contributions made by the employee under a salary reduction SEP (SARSEP).

Example Catherine LeGrande earned $200,000 in compensation from her employer prior to any contributions made to her SEP in 2007. The maximum amount that Catherine's employer may contribute to her SEP in 2007 is $45,000 (25% x $200,000 being greater than the $45,000 limit).

Amounts contributed by the employer are not taxable as income to the employee in the year they are contributed if they don't exceed the limit for the year. In addition to being taxable income, excess contributions are subject to a 6 percent penalty tax. However, the penalty tax may be avoided if the employee withdraws the excess amount before the date by which the tax return for the year must be filed.

Contributions by the self-employed. If you are self-employed and contribute to your own SEP-IRA, your contributions as your own employer are essentially limited to a maximum of 20 percent of net earnings (instead of 25 percent of compensation). This is because special rules apply when determining your maximum deduction for your contributions. However, you can still make elective deferrals and catch-up contributions to get you to the contribution limit for the year.

Nondiscrimination requirement. An employer who establishes a SEP plan is not actually required to make any contributions to the employees' SEP-IRAs. But if the employer does decide to make contributions to this type of individual retirement arrangement, the contributions cannot discriminate in favor of any officer, shareholder, or highly compensated employee.

For 2008, employer contributions are considered discriminatory unless they bear a uniform relationship to the first $230,000 ($225,000 in 2007) of the total compensation of each employee who has a SEP-IRA. The IRS has stated that a rate on contribution that actually decreases as compensation increases is considered uniform. Although this may seem like a paradox, the key here is uniformity and equal treatment for all eligible employees.

Example Acme Inc. adopts a SEP plan and is considering how much to contribute for each active employee. For employees with five years of service or less, the company would like to contribute 10 percent of their total compensation for the year. For employees with over five years of service, the company wants to contribute 15 percent of their total compensation. With this contribution scheme, however, the SEP will be considered discriminatory because employer contributions do not bear a uniform relationship to each employee's compensation. Instead, Acme Inc. decides to contribute 15 percent of an employee's first $20,000 in compensation and 10 percent of all compensation above $20,000. This SEP contribution method is not discriminatory, even though the rate of contribution decreases as compensation increases, because it bears a uniform relationship to each employee's compensation.

Coordination with other plans. If an employer maintains one or more defined contribution plans in addition to a SEP, the combined contribution amounts of all the plans have to fit within to the overall contribution limit for a defined contribution plan. Although a SEP is not really a defined contribution plan, it is considered to be one for purposes of the overall contribution limit.

Did You Know? A SEP account is essentially an IRA and is generally governed by the same rules as traditional IRAs. As such, an employee can make a traditional IRA contribution of up to $5,000 or $6,000, if catch-up contributions are allowed, in 2008 ($4,000 or $5,000 in 2007) to his or her SEP account. Any excess contributions by the employee are taxed to the employee under traditional IRA rules.

In 2008, the limit for additions to a defined contribution plan is the lesser of 25 percent of an employee's compensation or $46,000 ($45,000 in 2007). This amount is indexed annually for inflation.