Determining the maximum SEP contribution



A Simplified Employee Pension (SEP) plan is a variant of an Individual Retirement Account (IRA) in the United States. This kind of pension plan provides employers a simple way to make contributions to their workers' retirement plan. In a SEP, the employer can pay contributions to an IRA opened in the employee's name, rather than making contributions in a pension account opened under the name of the company. Because of its simple way of contributing, SEP is advantageous for small business owners. It is also offered to self-employed people. The contributions are directly made to an IRA established for each worker.



To be eligible to a SEP plan, the employee must fulfill these requirements: the employee must be 21 years old and above; has been working for the employer in at least 3 of the last 5 years; and has received $500 as compensation from the employer in 2009 and 2010. An IRA is a retirement account that provides a tax free or tax deferred way of saving money for retirement. Although the original IRA was established in 1974, there are many types of IRAs. These IRAs are available for both employed as well as self-employed people. Aside from SEP, other types of IRAs include the traditional IRA and Roth IRAs. In a traditional IRA, tax deductible plan contributions are allowed up to $4,000 annually. Contributions may increase if you are 50 years old and above. However, once you withdraw your contributions, it will be subjected to income tax.

Although Roth IRAs are not tax deductible, they provide more flexibility than the traditional IRA. You can withdraw your contributions without being subjected to tax or penalty. How much can an employer contribute to a SEP? According to the Internal Revenue Service (IRS), an employer's annual contributions to a worker's SEP IRA must not exceed the lesser of the following: 25% of compensation or $49,000 for 2009 and 2010. The $49,000 is subject to annual cost of living adjustments for later years. Remember that the worker's compensation in excess of the compensation cap, is not to be used to calculate the contribution limit. The compensation cap is $230,000. It is the maximum amount that may be contributed to an employer sponsored plan. For self employed people, the same limits on contributions made to an employee's SEP-IRA are applied. However, there are special rules that are applied when deciding on the maximum deductible contribution for self-employed individuals.

There are three formulas that employers can use to allocate SEP contributions. All the formulas meet the requirements of the IRS. These formulas include pro-rata, flat-dollar formula, and social security integrity. In pro-rata formula, employees will receive the same percentage of their eligible compensation. In the flat-dollar formula, employees will receive the same dollar amount as their contribution. Meanwhile, in social security integration, employees with higher pay will receive larger percentage of their contributions.