3701 / What is a simplified employee pension?

Editor’s Note: Under the SECURE Act 2.0, employers can allow employees participating in SIMPLE or SEP plans to have their salary reduction contributions deposited into Roth accounts (these contributions are considered taxable income and included in boxes 1,3, and 5 of the employee's W-2, as well as box 12 with code F (SEPs) or code S (SIMPLE IRAs)).  Employer contributions to these Roth accounts are not subject to federal tax withholding, FICA or FUTA, and should be reported on Form 1099-R for the year they are allocated to the participant's account.

A simplified employee pension (SEP) is a traditional individual retirement account or individual retirement annuity ( Q 3641) that is adopted by a business to provide retirement benefits for the business owners and employees and may accept an expanded rate of contributions over traditional IRAs.¹ The SEP IRA is owned by the employee.

The SEP rules permit an employer to contribute a limited amount of money each year on behalf of its employees. A self-employed individual may contribute to his/her own SEP. All contributions must be in the form of money; property cannot be contributed. Although contributions are not required every year, any contributions made by an employer in a given year must be based on a written formula and must not discriminate in favor of highly-compensated employees.

More specifically, in order for an IRA to qualify as a SEP, certain requirements must be satisfied:

(1)   Participation: The employer must contribute to the SEP of each employee (including certain “leased” employees, see Q 3929) who is at least 21 years old, has performed services for the employer during the year for which the contribution is made (including any such employee who, because of death or termination of employment, is no longer employed on the date contributions are actually made), and for at least three of the immediately preceding five years has received at least $750 in compensation for 2023 and 2024 ($650 for 2021-2022,² $600 in 2015-2020, and $550 in 2010-2014) from the employer for the year.³ These participation rules also apply to employees who are subject to the minimum distribution requirements ( Q 3686). The employer may not require that an employee be employed as of a particular date in the year.⁴

Employees covered by a collective bargaining agreement may be excluded from participation if retirement benefits have been the subject of good faith bargaining. Similarly, nonresident aliens may be excluded if they received no income from the employer that is considered to be from U.S. sources.⁵

(2)   Nondiscrimination requirement: Employer contributions must not discriminate in favor of any highly compensated employee ( Q 3930). Employees who are excluded from participation as nonresident aliens, or because they are covered by a collective bargaining agreement, are not considered for purposes of determining whether there is discrimination.⁶

Unless employer contributions bear a uniform relationship to total compensation (or earned income in the case of self-employed individuals) they are considered discriminatory. But compensation or earned income in excess of $XXX,000 in 2025 (projected) ($345,000 in 2024, $330,000 for 2023, $305,000 for 2022, $290,000 in 2021, $285,000 in 2020, and $280,000 in 2019)⁷ is not to be taken into account for these purposes.⁸ This compensation limit is indexed for inflation.⁹ Presumably, a constant percentage of compensation would meet the nondiscrimination requirement. A rate of contribution that decreases as compensation increases will be considered uniform.¹⁰ The IRS has informally approved a method of contribution that in effect requires that an identical dollar amount be contributed on behalf of all participants.¹¹

SEPs can be integrated under the rules applicable to qualified plans ( Q 3863).¹²

(3)   Contributions based on written allocation formula: Employer contributions must be determined under a definite written allocation formula that specifies the manner in which the allocation is computed and what requirements an employee must satisfy to share in the allocation. But the employer may vary the allocation formula from year to year so long as there is a timely amendment to the plan that indicates the new formula.¹³ No minimum funding standards are imposed.

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Planning Point: The allocation formula may be written to provide that contributions be based on a fixed percentage of the employee’s compensation, a fixed dollar amount for all participants, or that contributions be determined each year by the employer (a discretionary contribution). Discretionary contribution formulas are the most common. The employer may uniformly vary the percentage of compensation contributed year by year or contribute nothing for a particular year, but the SEP document must state how the employer contribution will be allocated. An employer may vary the formula or percentage from year to year (for example, to change from a fixed contribution to a discretionary contribution), provided the SEP is timely amended.¹⁴

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(4)   No withdrawal restrictions: The employer contribution may not be conditioned on the employee’s keeping any part of it in the pension and the employer may not prohibit withdrawals from the plan.¹⁵

(5)   Top heavy plans: If the SEP is top-heavy plan ( Q 3917), it is subject to the minimum contribution rules applicable to such plans ( Q 3922).¹⁶ Employer contributions to a SEP may be taken into account in determining whether qualified plans of the employer are top-heavy ( Q 3917).