|Mistake||Find the Mistake||Fix the Mistake||Avoid the Mistake|
|7) Total contributions (employee elective deferrals and nonelective employer contributions) exceeded the maximum legal limits.||Calculate 25% of each employee’s compensation and compare the total contribution made for the employee to the lesser of that amount or the dollar limitation for that year ($57,000 in 2020 and $56,000 in 2019).||Two possible correction methods:
a. Distribution method
b. Retention method
|Calculate the allocations based on the plan terms and then check to make sure none of the proposed allocations violate the Internal Revenue Code.|
Internal Revenue Code (IRC) Section 402(h) and IRC 415(c) limits the amount of contributions (including employee elective deferrals) made to an employee’s SEP-IRA to the lesser of:
- the dollar limit for that year ($57,000 in 2020, $56,000 in 2019, and $55,000 in 2018), or
- 25% of the employee’s compensation.
The amount of compensation you may consider for each participant is limited ($285,000 in 2020, $280,000 in 2019, and $275,000 in 2018). If your SARSEP plan document specifies lower contribution limits, then the lower limits control.
There are special rules if you’re self-employed. When calculating the deduction for contributions made to your own SEP-IRA, compensation is your net earnings from self-employment, which takes into account both the deduction for one-half of your self-employment tax and the deduction for contributions to your own SEP-IRA. 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. For more information on the deduction limitations for self-employed individuals, see Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).
Employer contributions to a SEP-IRA won’t affect the amount you can contribute to a Roth or traditional IRA. However, this may preclude you from receiving a tax deduction for contributions to a traditional IRA. See IRA Deduction Limits and Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs).
How to find the mistake:
Calculate 25% of each employee’s compensation compensation (limited to $285,000 in 2020, $280,000 in 2019, and $275,000 in 2018) and compare the total contributions made for the employee to the lesser of that amount or the dollar limitation for that year ($57,000 in 2020, and $56,000 in 2019, and $55,000 in 2018). Review the special calculations in Publication 560 if you are a partner or self-employed.
How to fix the mistake:
There are two methods to correct a failure to limit employer contributions to employees.
- The amount in excess of the annual limit, adjusted for earnings through the date it’s corrected, should be distributed from the affected employee’s SEP-IRA and returned to the employer if it exceeds $100. If it isn’t feasible to determine what the actual investment earnings would have been, you may use a reasonable rate of interest. Use the Department of Labor’s Online Calculator to determine earnings if it is not feasible to determine actual earnings in the IRA account. The affected employee doesn’t include the distributed amount in income, but the plan sponsor must report it on Form 1099-R with a taxable amount of zero.
- Alternatively, if the plan sponsor makes a VCP submission, the excess amount may be retained in the IRAs associated with the SARSEP. If this correction method is used, a special additional payment of at least 10% of the excess amount will apply. This is in addition to the $250 user fee for the VCP submission. The additional compliance fee only applies if the excess amount is above $100.
Under both correction methods, the plan sponsor is not entitled to a deduction for the excess contributions.
Example: Employer I maintains a SARSEP plan. For the 2019 year, the contributions made for two employees, Tom and Ursula, exceeded the annual limit in IRC Section 415. Tom had an excess of $3,000 and Ursula had an excess of $300.
Generally, Employer I would have to get Tom and Ursula to take the excess monies as adjusted for earnings out of their SEP-IRAs by taking distributions and returning it to Employer I.
Correction programs available:
The example shows an operational problem because the employer failed to follow the terms of the plan by exceeding the IRC Section 402(h) and IRC Section 415 limits stated in the plan document and the Internal Revenue Code. Therefore, if Employer I meets the eligibility requirements of SCP, they may be able to use SCP to correct the failure by using the distribution of excess amounts correction method. Employer I would have to determine whether:
- Appropriate practices and procedures were originally in place to facilitate compliance with requirements for maximum contribution limits.
- The failure is insignificant.
Voluntary Correction Program:
Under VCP, correction is the same as described under “Corrective action.” Employer I files a VCP submission to the IRS under Revenue Procedure 2019-19 via the Pay.gov website following the procedures in Section 11. Employer I uses Form 14568, Model VCP Compliance Statement (PDF), including Form 14568-C, Model VCP Compliance Statement - Schedule 3: SEPs and SARSEPs (PDF) to describe the failures and how they are corrected. User Fees for VCP submissions are generally based upon the current value of all IRAs that are associated with the SARSEP plan. If Employer X chooses to retain the excess amounts in participants’ IRAs associated with the SARSEP, they must use VCP. If this correction method is used, a special additional payment of at least 10% of the excess amount will apply. This is in addition to the VCP submission user fee. The extra payment is a sanction payment that will be collected as part of a voluntary closing agreement that will be signed by the plan sponsor and the IRS.
Audit Closing Agreement Program:
Under Audit CAP, correction is the same as described under “Corrective action.” Employer I and the IRS enter into a Closing Agreement outlining the corrective action and negotiate a sanction that is not excessive, considers facts and circumstances, and bears a reasonable relationship to the nature, extent and severity of the failures, based upon all relevant factors described in section 14 of Rev. Proc. 2019-19.
How to avoid the mistake:
After initially calculating participant contribution allocations based on your SARSEP plan document terms, make sure none of the proposed allocations violate IRC Section 402(h) and IRC Section 415. If the contribution allocation exceeds the limit, adjust it before you transfer the money into the SEP-IRAs.