A simplified employee pension (SEP) is a written arrangement that allows an employer to make contributions toward his or her own and employees' retirement without becoming involved in more complex retirement plans. The contributions are made to special IRAs (SEP-IRA) set up for each individual qualifying employee.

An employer can use IRS Form 5305-SEP to satisfy the written arrangement requirement for a SEP. A SEP can be established at any time during the year. Contributions to the SEP for a given year must be made by the due date of the income tax return, including any extensions, for that tax year.

If you have a SEP plan in place, you don't have to make any contributions to the plan in any given year. But, if you do make contributions for a year, the contributions must be based on a written allocation formula (for example, "2 percent of each employee's pay") and must not discriminate in favor of highly compensated employees.

For 2010 and 2011, the SEP rules permit an employer to contribute, and deduct, an annual maximum of 25 percent of the employee's compensation or $49,000, whichever is less, to each participating employee's account. For the business owner, however, the contribution limit is lower.

Leslie, a participant in a SEP sponsored by her employer, earns $70,000 in compensation from the employer. Her employer may contribute up to $17,500 (the lesser of 25% x $70,000 or $49,000) to her SEP for the 2011 tax year. The amount contributed by the employer is not taxable income to Leslie in the year that it is contributed. Thus, the employer's contribution is not included in wages on her Form W-2, although the amount is reported as non-taxable income.

Contributions for business owners. The annual limits on your contributions for your employee's SEP-IRA accounts also apply to contributions you make to your own SEP-IRA. Thus, your contribution can not exceed $49,000 or 25% of your net earnings.

Net earnings from self-employment is your gross income from your trade or business (provided your personal services are a material income-producing factor) minus allowable business deductions. Allowable deductions include contributions to SEP and qualified plans for common-law employees and the deduction allowed for one-half of your self-employment tax. Net earnings from self-employment do not include items excluded from gross income (or their related deductions) other than foreign earned income and foreign housing cost amounts.

If your employees were receiving the maximum contribution of 25 percent of pay, you would have to use 20 percent. If your employees receive 15 percent, your percentage would be 13.0435. Similarly, if your employees' rate was 10.5 percent, you could compute the owner's rate by dividing 0.105 by 1.105 to arrive at .0950, or 9.5 percent.

Prior to 1997, an employer could establish a Salary Reduction Arrangement SEP (SARSEP) under which employees could elect to make contributions out of their own pay, up to a certain dollar limit per year, per employee. This choice is called an elective deferral. Although new SARSEPs can no longer be set up, you may continue to make contributions to a SARSEP that was established before 1997. In 2011, individuals participating in a SARSEP may elect to contribute up to the smaller of $16,500 or 100 percent of their compensation to the plan. Participants in a SARSEP plan who are age 50 and older may contribute an additional $5,500 in 2011.

Distributions or withdrawals from a SEP-IRA are subject to the same rules that apply to regular IRAs.

For more information, see our discussion of SEPs in the context of employee benefits.

Among the Business Tools is a SEP IRA checklist intended to aid in keeping such plans in compliance with tax rules. It is in Adobe Portable Document Format (.pdf), and you will need the free Acrobat Reader to view and print the file.