Flexibility of SEP Plan Contributions

Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in Massachusetts is representative of a common question on Simplified Employee Pension Plans (SEP).

"What flexibility does a plan sponsor have regarding employer contributions to a Simplified Employee Pension (SEP) Plan?"

Highlight of the discussion on employer contributions to SEPs

As described below, an employer has considerable flexibility in making annual contributions to a SEP plan. SECURE Act 2.0 has broadened that flexibility.

By way of background, a SEP plan allows employers to make contributions to IRAs (sometimes called SEP-IRAs) established for each eligible participant under the plan. Each participant owns and controls their own IRA. The maximum deductible contribution that a business can make to a SEP plan is 25 percent of all eligible participants’ compensation, and each participant’s annual maximum contribution amount is 25 percent of the individual’s compensation up to $69,000 for 2024.

SEP plans can be adopted and amended using the IRS model SEP (i.e., Form 5305-SEP, Simplified Employee Pension-Individual Retirement Accounts Contribution Agreement), an IRS-approved prototype offered by various vendors, or a SEP plan document that is individually designed for the employer. The type of document used will determine which contribution allocation formulas are available.

Flexible Employer Contribution Formulas

SEP plan contributions are discretionary, meaning, a sponsor will determine each year whether an annual contribution will be made under the plan or not. Under Internal Revenue Code section (IRC §) 408(k)(5), SEP plan contributions must be made under a written allocation formula. However, an employer has the flexibility to adopt an allocation formula that provides that contributions are a uniform percentage of employees’ compensation (i.e., pro rata), a uniform dollar amount for each participant (i.e., flat dollar) or take into consideration Social Security (i.e., integrated). The type of SEP plan document used will affect the allocation formulas that are available. For example, the IRS’s model SEP (Form 5305-SEP) specifies that the discretionary contribution for each eligible employee will be the same percentage of compensation.

Optional Treatment as Roth Contributions

Effective as of January 1, 2023, Section 601 of SECURE 2.0 allows plan sponsors of SEPs to offer participants an opportunity to elect that employer contributions are made to a Roth IRA. Importantly, a participant election to have the SEP contribution made to a Roth IRA must be made before the contribution is made to the applicable Roth IRA. IRS Notice 2024-2 Q. K-2 and

A. K-2.

Participants should understand that if they elect SEP employer contributions to be contributed as Roth contributions, the amount of the contribution is included in their taxable income in the year the contributions are made to the Roth IRA. For example, beginning in the 2025 plan year, ABC Company permits participants to elect that employer contributions be made as Roth contributions. ABC Company actually deposits its employer contributions for the 2025 plan year in February, 2026. Participants who elected to have their share of employer contributions for 2025 made as Roth contributions would report the amount of that contribution as taxable income for 2026. Consistent with the IRS guidance provided in IRS Notice 2024-2 Q. K-5 and A. K-5, the employer contributions are not subject to withholding, FICA or FUTA because they are not considered wages. Instead, the employer contributions are reported in boxes 1 and 2a on Form 1099-R.

At this point, the industry is waiting for the IRS to issue an updated Form 5305-SEP and approved language regarding employer Roth contributions under its Listings of Required Modifications. In the interim, plan sponsors may offer participants the option to elect that employer SEP contributions be made to a Roth IRA, and later amend their SEP documents once the IRS issues the updated IRS Form 5305-SEP and/or approved language under its Listing of Required Modifications.

Conclusion

A sponsor of a SEP plan has flexibility in making annual employer contributions to a participant’s traditional IRA. SECURE Act 2.0 further enhanced contribution options by allowing plan sponsors to offer participants the ability to have employer SEP plan contributions made to Roth IRAs. Plan advisors and employers should be aware of the options for employer contributions to a SEP plan.