The problem with SEPs.

• Author: Peterson, John M.
• Position: Simplified employee pensions

Simplified employee pensions (SEPs) are frequently promoted by investment advisers as "no-cost" substitutes for qualified profitsharing plans. Likewise, salary reduction SEPs (SARSEPs) are promoted as "no cost" alternatives to Sec. 401(k) plans. While there are certain similarities in the applicable rules, SEPs and SARSEPs are subject to special rules and limitations not applicable to qualified plans that are often misunderstood or misinter-preted by the person (usually not a professional adviser) "administering" the SEP program.

The misunderstandings that seem to occur most frequently include:

* Coverage of part-time employees: Unlike a qualified plan (in which employees who always work less than 1,000 hours a year may be excluded), a SEP arrangement must cover part-time employees (except for the limited exclusion for employees who make less than $396 (as indexed) during the year).

* Coverage of terminated employees: A SEP arrangement must cover all employees who are eligible at any time during the year. Qualified plans are usually structured to exclude employees whose employment terminates before completion of 500 hours (standardized plans) or who are not employed on the last day of the year (nonstandardized plans).

* Permitted disparity: The IRS version of the SEP document (Form 5305 SEP) does not provide for integration with Social Security, although some institutional SEP documents do so provide.

* Fiscal years: The Service's version of the SEP document requires use of a calendar plan year (although a few institutional forms provide for election of a fiscal year).

* Controlled groups/other plans: The IRS SEP document may not be used (1) unless all members of a controlled or affiliated service group adopt the SEP, (2) if the employer currently maintains any qualified plan or (3) if the employer ever maintained a defined benefit pension plan.

* SARSEP limits: The SARSEP alternative to a qualified Sec. 401(k) plan is only available if the employer has 25 or fewer eligible employees (tested on the basis of prior year demographics) and only if at least 50% of the eligible employees elect to participate (contribute). Neither of these limits applies to qualified Sec. 401(k) plans.

* ADP test: In applying the Sec. 401(k) ADP test to SARSEPs, the "times 2/plus 2%" alternative limitation is not available (i.e., a SARSEP must always comply with the "1.25 times" general rule). In addition...