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Under IRC 408(k)(5), SEP contributions must be made under a written allocation formula. A SEP may provide that contributions are a fixed percentage of employees’ compensation, a fixed dollar amount for each participant, or that contributions are to be determined each year by the employer (a discretionary contribution). Discretionary contribution formulas are the most common. The employer may uniformly vary the percentage of compensation contributed year by year or contribute nothing for a particular year, but the SEP document must state how the employer contribution will be allocated. An employer may vary the formula or percentage from year to year (for example, to change from a fixed contribution to a discretionary contribution), provided the SEP is timely amended.
An integrated allocation formula is accepted for nondiscrimination requirements tests.
Under an integrated allocation formula, a SEP is permitted to provide limited disparity in contributions, under the same rules that apply to defined contribution plans under IRC 401(a). Therefore, a SEP may provide employees whose compensation is above the Social Security taxable wage base (TWB) a contribution that is a higher percentage of their compensation than the percentage provided for employees earning less than the TWB. IRC 402(h)(2)(B) effectively reduces the $52,000 (for 2014) contribution limit (see below) for HCEs in an integrated SEP by the product of the excess contribution percentage and the integration level. For example, if a SEP had an allocation formula of 16 percent of compensation up to the TWB ($117,000 in 2014) plus 21.7 percent of compensation in excess of the TWB, the 415 dollar limit is reduced by $6,669 ($117,000 x 5.7 percent) for 2014. Note that salary reduction contributions may not be integrated with Social Security.
Example: Employer X adopts a SEP with a contribution formula providing for an allocation of 10 percent of compensation to each employee who worked for five or less years for the employer and 12 percent of compensation to each employee who has worked for more than five years. This is discriminatory because the rate of contributions does not bear a uniform relationship to each employee’s compensation.