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Taxmap/pubs/p535-007.htm#TXMP36b9ec6c Chapter 3 Retirement Plans

Pension Plan

Taxmap/pubs/p535-007.htm#TXMP6e3405ee What's New for 2004

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Compensation limit.

For 2004, the maximum compensation used for figuring contributions and benefits increases to $205,000. This amount increases to $210,000 in 2005.

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Elective deferrals.

The limit on elective deferrals increases to $13,000 for tax years beginning in 2004 and then increases $1,000 each tax year thereafter until it reaches $15,000 in 2006. These new limits will apply for participants in SARSEPs, 401(k) plans (excluding SIMPLE plans), and deferred compensation plans of state or local governments and tax-exempt organizations. The $15,000 figure is subject to cost-of-living increases after 2006.

Catch-up contributions. A plan can permit participants who are age 50 or over at the end of the calendar year to also make catch-up contributions. The catch-up contribution limit for 2004 is $3,000. This limit increases by $1,000 each year thereafter until it reaches $5,000 in 2006. The limit is subject to cost-of-living increases after 2006. The catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts.

• The catch-up contribution limit.
• The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.

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SIMPLE plan salary reduction contributions.

The limit on salary reduction contributions to a SIMPLE plan increases to $9,000 beginning in 2004 and then increases to $10,000 in 2005. The $10,000 figure is subject to adjustment after 2005 for cost-of-living increases.

Catch-up contributions. A SIMPLE plan can permit participants who are age 50 or over at the end of the calendar year to make catch-up contributions. The catch-up contribution limit for 2004 is $1,500. This limit increases by $500 each year thereafter until it reaches $2,500 in 2006. The limit is subject to cost-of-living increases after 2006. The catch-up contributions a participant can make for a year cannot exceed the lesser of the following amounts.

• The catch-up contribution limit.
• The excess of the participant's compensation over the salary reduction contributions that are not catch-up contributions.

Introduction

This chapter discusses retirement plans you can set up and maintain for yourself and your employees. Retirement plans are savings plans that offer you tax advantages to set aside money for your own and your employees' retirement.

In general, a sole proprietor or a partner is treated as an employee for retirement plan purposes.

SEP, SIMPLE, and qualified plans offer you and your employees a tax favored way to save for retirement. You can deduct contributions you make to the plan for your employees. If you are a sole proprietor, you can deduct contributions you make to the plan for yourself. You can also deduct trustees' fees if contributions to the plan do not cover them. Earnings on the contributions are generally tax free until you or your employees receive distributions from the plan.

Under certain plans, employees can have you contribute limited amounts of their before-tax pay to a plan. These amounts (and the earnings on them) are generally tax free until your employees receive distributions from the plan.

In general, individuals who are employed or self-employed can also set up and contribute to individual retirement arrangements (IRAs).

Useful items

You may want to see:

See chapter 14 for information about getting publications and forms.

Taxmap/pubs/p535-007.htm#TXMP2127a7b1 Simplified Employee   Pension (SEP)

SEP

A simplified employee pension (SEP) is a written plan that allows you to make deductible contributions toward your own and your employees' retirement without getting involved in more complex retirement plans. A corporation also can have a SEP and make deductible contributions toward its employees' retirement. However, certain advantages available to qualified plans, such as the special tax treatment that may apply to lump-sum distributions, do not apply to SEPs.

Under a SEP, you make the contributions to a traditional individual retirement arrangement (called a SEP-IRA) set up for each eligible employee.

SEP-IRAs are set up for, at a minimum, each eligible employee. A SEP-IRA may have to be set up for a leased employee, but need not be set up for an excludable employee. For more information, see Publication 560.

Taxmap/pubs/p535-007.htm#TXMP3741f1d8 Form 5305-SEP.

You may be able to use Form 5305-SEP, Simplified Employee Pension—Individual Retirement Accounts Contribution Agreement, in setting up your SEP.

Taxmap/pubs/p535-007.htm#TXMP37561e1e Contribution Limits

Contribution Limits

Contributions you make for 2004 to a common-law employee's SEP-IRA are limited to the lesser of $41,000 ($42,000 for 2005) or 25% of the employee's compensation. Compensation generally does not include your contributions to the SEP, but does include certain elective deferrals unless you choose not to include them.

Taxmap/pubs/p535-007.htm#TXMP5249dee5 Annual compensation limit.

You generally cannot consider the part of an employee's compensation over $205,000 ($210,000 for 2005) when you figure your contribution limit for that employee.

Taxmap/pubs/p535-007.htm#TXMP4c292c0c More than one plan.

If you also contribute to a defined contribution retirement plan (defined later), annual additions to all of a participant's accounts are limited to the lesser of $41,000 or 100% of the participant's compensation. When you figure this limit, you must add your contributions to all defined contribution plans. A SEP is considered a defined contribution plan for this limit.

Taxmap/pubs/p535-007.htm#TXMP5fc3c015 Contributions for yourself.

The annual limits on your contributions to a common-law employee's SEP-IRA also apply to contributions you make to your own SEP-IRA.

Taxmap/pubs/p535-007.htm#TXMP7894121a Deduction Limit

Deduction Limit

The most you can deduct for employer contributions (other than elective deferrals) for a common-law employee is 25% of the compensation (limited to $205,000 per participant) paid to him or her during the year from the business that has the plan, not to exceed $41,000 per participant.

In 2005, the $205,000 and $41,000 amounts increase to $210,000 and $42,000.

Taxmap/pubs/p535-007.htm#TXMP72be81bc Deduction of contributions for yourself.

When figuring the deduction for employer contributions made to your own SEP-IRA, compensation is your net earnings from self-employment minus the following amounts.

1. The deduction for one-half of your self-employment tax.
2. The deduction for contributions to your own SEP-IRA.

The deduction for contributions to your own SEP-IRA and your net earnings depend on each other. For this reason, you determine the deduction for contributions to your own SEP-IRA indirectly by reducing the contribution rate called for in your plan. Use Worksheet 3-A, shown under Qualified Plan, later, to figure the rate.

Taxmap/pubs/p535-007.htm#TXMP3563b351 SEP and defined contribution plan.

If you also contributed to a qualified defined contribution plan, you must reduce the 25% deduction limit for that plan by the allowable deduction for contributions to the SEP-IRAs of those participating in both the SEP plan and the defined contribution plan.

Taxmap/pubs/p535-007.htm#TXMP6b187fd9 SEP and another qualified plan.

If you also contributed to any other type of qualified plan, treat the SEP as a separate profit-sharing (defined contribution) plan when applying the overall 25% deduction limit described in section 404(h)(3) of the Internal Revenue Code.

If your SEP contribution is more than the deduction limit (nondeductible contribution), you can carry over and deduct the difference in later years. However, the contribution carryover, when combined with the contribution for the later year, is subject to the deduction limit for that year.

Taxmap/pubs/p535-007.htm#TXMP2bbfb7db Employee contributions.

Employees can also make contributions of up to $3,000 (or $3,500 if they are 50 or older) for 2004 to their SEP-IRAs independent of the employer's SEP contributions. However, the employee's deduction for IRA contributions may be reduced or eliminated because the employee is covered by an employer retirement plan (the SEP plan). See Publication 590 for details.

Taxmap/pubs/p535-007.htm#TXMP004e0418 Salary Reduction   Simplified Employee   Pension (SARSEP)

SEP, Salary Reduction

An employer is no longer allowed to set up a SARSEP. However, participants in a SARSEP set up before 1997 (including employees hired after 1996) can continue to have their employer contribute part of their pay to the plan.

A SARSEP is a SEP set up before 1997 that included a salary reduction arrangement. Under the arrangement, employees can choose to have you contribute part of their pay to their SEP-IRAs rather than receive it in cash. This contribution is called an elective deferral because employees choose (elect) to set aside the money and the tax on the money is deferred until it is distributed.

This choice is available only if all the following requirements are met.

• The SARSEP was set up before 1997.
• At least 50% of the eligible employees choose the salary reduction arrangement.
• You had 25 or fewer eligible employees (or employees who would have been eligible if you had maintained a SEP) at any time during the preceding year.
• Each eligible highly compensated employee's deferral percentage each year is no more than 125% of the average deferral percentage (ADP) of all nonhighly compensated employees eligible to participate (the ADP test). See Publication 560 for the definition of a highly compensated employee and information on how to figure the deferral percentage.

Taxmap/pubs/p535-007.htm#TXMP473b1d98 Limit on elective deferrals.

In general, the total income an employee can defer under a SARSEP and certain other elective deferral arrangements for 2004 is limited to the lesser of $13,000 or 25% of the employee's compensation (as defined in Publication 560). This limit applies only to amounts that reduce the employee's pay, not to any contributions from employer funds.

Taxmap/pubs/p535-007.htm#TXMP7f442d06 Catch-up contributions.

A SEP can permit participants who are age 50 or older at the end of the calendar year to make catch-up contributions. The catch-up contribution limit for 2004 is $3,000 ($4,000 for 2005). Elective deferrals are not treated as catch-up contributions for 2004 until they exceed the limit discussed earlier under Limit on elective deferrals, the SARSEP ADP test (see Publication 560), or the plan limit (if any). However, the catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts.

• The catch-up contribution limit.
• The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.

Catch-up contributions are not subject to the limit discussed under Limit on elective deferrals, earlier.

Taxmap/pubs/p535-007.htm#TXMP44be9856 Deduction limit and elective deferrals.

Compensation, as discussed earlier, under Deduction Limit, includes elective deferrals. Elective deferrals are no longer subject to this deduction limit. However, the combined deduction for a participant's elective deferrals, and other SEP contributions, cannot exceed $41,000.

Taxmap/pubs/p535-007.htm#TXMP0ca090c7 Employment taxes.

Elective deferrals that meet the ADP test are not subject to income tax in the year of deferral, but they are included in wages for social security, Medicare, and federal unemployment (FUTA) tax.

Taxmap/pubs/p535-007.htm#TXMP2c674b1e Reporting SEP Contributions on Form W-2

Reporting SEP Contributions on Form W-2

Your contributions to an employee's SEP-IRA are excluded from the employee's income. Do not include these contributions in your employee's wages on Form W-2 for income, social security, or Medicare tax purposes. However, your SEP contributions under a salary reduction arrangement are included in your employee's wages for social security and Medicare tax purposes only.

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Example.

Jim's salary reduction arrangement calls for 10% of his salary to be contributed by his employer as an elective deferral to Jim's SEP-IRA. Jim's salary for the year is $30,000 (before reduction for the deferral). The employer did not choose to treat deferrals as compensation under the arrangement. To figure the deferral, the employer multiplies Jim's salary of $30,000 by 9.0909%, the reduced rate equivalent of 10%, to get the deferral of $2,727.27. (This method is the same one you, as a self-employed person, use to figure the contributions you make on your own behalf. See Worksheet 3-A, under Qualified Plan, later.)

On Jim's Form W-2, his employer shows total wages of $27,272.73 ($30,000 − $2,727.27), social security wages of $30,000, and Medicare wages of $30,000. Jim reports $27,272.73 as wages on his individual income tax return.

If his employer chooses to treat the deferrals as compensation, Jim's deferral would be $3,000 ($30,000 x 10%). In this case, the employer uses the rate called for under the arrangement (not the reduced rate) to figure the deferral and the ADP test. On Jim's Form W-2, the employer shows total wages of $27,000 ($30,000 − $3,000), social security wages of $30,000, and Medicare wages of $30,000. Jim reports $27,000 as wages on his return.

In either case, the maximum deductible contribution would be $6,000 ($30,000 x 20%).

Taxmap/pubs/p535-007.htm#TXMP3f3749bb More information.

For more information on employer withholding requirements, see Publication 15, (Circular E), Employer's Tax Guide.

For more information on SEPs, see Publication 560.

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