8.16 Salary-Reduction SEP Set Up Before 1997

Qualifying small employers may offer employees the option of deferring a portion of their salary to an IRA. There are two types of salary-reduction IRAs, with different eligibility and contribution rules: (1) salary-reduction SEPs established before 1997 and (2) “SIMPLE” IRA accounts established after 1996.

After 1996, an employer may establish a SIMPLE plan but not a salary-reduction SEP. Rules for SIMPLE IRAs established after 1996 are at 8.17–8.18. A salary-reduction SEP that was established before 1997 may continue to receive contributions under the prior law rules discussed below, and employees hired after 1996 may participate in the plan, subject to those rules.

Salary-reduction SEPs established before 1997.

Salary reductions are allowed for a year only if the employer had no more than 25 employees eligible to participate in the SEP at any time during the prior taxable year. Furthermore, at least 50% of the eligible employees must elect the salary-reduction option, and the deferral percentage for highly compensated employees may not exceed 125% of the average contribution of regular employees.

If salary reductions are allowed, the maximum salary-reduction contribution under the law for 2012 was $17,000 ($22,500 for participants age 50 or older if the plan permitted the extra deferral), although a lower limit may be imposed by the plan terms. These are the same limits as for 401(k) plans (7.18). Deferrals over $17,000 ($22,500 if extra deferral for participants age 50 or older was allowed) are taxable, and if not timely distributed to the employee, can be taxed again when distributed from the plan. The deferral limits for 2013 will be in the e-Supplement at jklasser.com .

If an employee contributes to both a SEP and a 401(k) plan, the annual limit applies to the total salary reductions from both plans. If an employee makes salary-reduction contributions to a SEP and also to a tax-sheltered annuity plan (7.21), the annual limit generally applies to the total salary reductions to both plans. In some cases, employees with at least 15 years of service may be able to defer an additional $3,000 to the tax-sheltered annuity plan (7.21).