Simplified Employee Plans: A Primer

A simplified employee plan (SEP) is a type of defined contribution plan that is funded exclusively with employer contributions.

For years before 2002, contributions could not exceed 15% of each eligible employee’s compensation. After EGTRRA and the Job Creation and Worker Assistance Act of 2002, that deduction limit was increased to 25% of compensation (up to a maximum compensation limit of $280,000 in 2019; as indexed) capped at the Internal Revenue Code Section 415(c) dollar limit ($56,000 in 2019).

All contributions to a SEP must bear a uniform relationship to the compensation of each eligible participant (unless the employer uses a prototype SEP document that allows for a contribution formula that is integrated with Social Security).

For example, when using the Form 5305-SEP to establish the plan, if the executive director of an organization gets a 25% contribution, then all SEP participants must also get a 25% contribution for the year. The employer is permitted to modify the contribution percentage each year and can elect not to make a SEP contribution for the year.

For self-employed persons, compensation means “earned income” based on the individual’s Schedule C to the Form 1040 (or schedule K-1 for partners in partnerships), as adjusted for the deduction for one half of self-employment taxes (Schedule SE) and the contribution to the SEP. Because of that adjustment, the self-employed will use a figure of 20% of the net business income minus one-half of the self-employment taxes to be equivalent to 25% of includible compensation.

The employer must establish a SEP plan. It may either adopt the IRS Form 5305-SEP as its SEP, or it may adopt a prototype SEP plan. Most mutual fund organizations, banks, savings and loans, trust companies, insurance companies, etc. offer SEPs and SEP documents that employers may use.

SEP contributions are deposited into IRAs owned by the SEP participants. This gives employees the flexibility to invest their retirement accounts without limits imposed by the employer. Although the employer may deposit SEP contributions with one product provider, the participant may immediately transfer the assets to another IRA.

There are no limits on which types of employers may adopt SEP plans, but generally, only smaller employers use SEP plans. SEP contributions must be made for every employee who satisfies all of the following requirements:

• attained age 21 at any time during the year for which contributions are being made;
• has worked for the employer in any three of the preceding five years; and
• has compensation in excess of $600 (for 2019). This amount is indexed.

Nonresident aliens and employees covered by a collective bargaining agreement may also be excluded.

Since SEPs are not subject to the reporting and disclosure portions of ERISA, the annual report filings, summary annual return or summary plan description rules do not apply. Similarly, the fee disclosure requirements do not apply to SEPs. There are very minor filing requirements which can generally be satisfied by distributing to each participant the IRS Form 5305-SEP, the form used to adopt the SEP. Also, each participant must receive a written statement from the employer which discloses the SEP contribution made by the employer for that employee in that year. Sometimes the funding vehicle provider sends this notice.

There is no discretion for vesting or for excluding part-time and seasonal employees who must be included if they meet the eligibility requirements. Similarly, even employees who terminate during the year may be required to receive a contribution. For some employers, these mandates outweigh the other advantages of the SEP.

Advantages of SEP Plans

1. Simple. These plans are easy to describe to employees and easy for employers to administer. Since they are funded exclusively through IRAs, the employer generally satisfies its obligations by sending the contributions directly to the IRA vendor. There are minimal fiduciary, administrative and recordkeeping obligations. The IRA vendor is generally responsible for IRS reporting on contributions and distributions.

2. Inexpensive. Generally, the only costs borne by the employer are the contributions to the SEP. There are no administrative, recordkeeping, legal, accounting, actuarial or product fees related to the establishment or maintenance of a SEP.

3. Good Starter Plan for Small Employers. Although there is no legal restriction on the employer’s size, many larger employers will not find SEPs to be attractive for their purposes. However, for smaller employers, these plans make excellent starter plans. They introduce employer funding for retirement without the complicated and expensive burdens imposed on trusteed qualified plans. If a SEP becomes unsatisfactory to the employer, termination is very easy and no IRS or DOL filings are necessary.

4. Few Administrative Requirements. If the employer uses the IRS Form 5305-SEP, all of the reporting and disclosure requirements can be met by giving each participant a copy of the executed Form 5305-SEP along with the instructions and sample forms. If the employer adopts an IRS approved prototype SEP, then the employer must meet minimal administrative obligations. The prototype package offered by the funding vehicle provider usually includes all of the materials necessary to satisfy these requirements. However, a statement of employer contributions must be given to every eligible employee each year. These requirements are much easier than the administrative burdens imposed on other qualified plans.

Disadvantages of SEP Plans

1. Inflexible. SEP plans offer a trade-off of simplicity for inflexibility. To keep the plans simple, the Code imposes defined limits and reduced flexibility on plan provisions. Therefore, employers do not have the flexibility to exclude certain employees, modify allocation formulas, vest contributions or restrict distributions.

2. Potentially High Investment Costs to Participants. Since each SEP is an individually owned IRA, there are usually no pricing advantages to the participants. Each IRA must independently bear the investment and product costs of the product provider.

3. Employer Contributions Are Immediately Owned by the Participants. Since the IRA is owned by the participant, all employer contributions are immediately owned by the participant. There is no guarantee that the employee will save the contribution for retirement. For some employers, this is an unacceptable result.

4. No Loans. Since SEPs are funded through IRAs, all IRA rules apply. Therefore, participants cannot take loans from SEPs. Any withdrawals are distributions, subject to taxation and penalties, if applicable.

Thomas J. Granger is Second Vice President, Qualified Plans at Security Benefit.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA or its members.