Simplified Employee Pensions

Simplified employee pensions (SEPs) combine features of both IRAs and defined-contribution plans.⁽¹⁾ As with IRAs, all contributions for an employee go into a personal account that he or she fully owns. As with other retirement plans, the employer establishes the plan and determines the contribution, but the employee controls how the money is invested, as if the plan were an IRA. That feature alone relieves the employer of substantial administrative responsibility. Although the employer's size is not a criterion for establishing a SEP, this type of retirement plan is used almost exclusively by small businesses. In 2002, 6 percent of employees of small establishments with defined-contribution plans were covered by SEPs.

An employer may avoid many of the more complex requirements of qualified plans by setting up a SEP. In place of the various nondiscrimination rules that apply to qualified plans, businesses using SEPs must follow two simple rules that limit their ability to target tax benefits toward highly compensated employees: first, they must include all qualifying employees in the plan, and second, they must contribute to each employee's account an amount proportional to his or her compensation.

In addition, SEPs are subject to the dollar limits on contributions that apply to defined-contribution plans. However, the percentage-of-compensation limit on contributions--15 percent--is lower for SEPs than it is for other defined-contribution plans (the limit on which increased to 100 percent in 2002).