US Internal Revenue Service: p560--1998

8/14/2019 US Internal Revenue Service: p560--1998

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ContentsImportant Changes for 1998 ............. 1

Important Changes for 1999 ............. 2

Important Reminders ......................... 2

Introduction ........................................ 2

Definitions You Need To Know ........ 4

Simplified Employee Pension (SEP) 5Setting Up a SEP ........................... 5How Much Can You Contribute? .... 6How Much Can You Deduct? ......... 6Salary Reduction Simplified

Employee Pension (SARSEP) . 7Distributions (Withdrawals) ............. 8Additional Taxes ............................. 8Reporting and Disclosure

Requirements ........................... 8

SIMPLE Plans ..................................... 8SIMPLE IRA Plan ........................... 8SIMPLE 401(k) Plan ....................... 10

Keogh Plans ....................................... 10Kinds of Plans ................................. 11Setting Up a Keogh Plan ................ 11Minimum Funding Requirements .... 11Contributions ................................... 12Employer Deduction ....................... 12Elective Deferrals (401(k) Plans) .... 13Distributions .................................... 14Prohibited Transactions .................. 15Reporting Requirements ................. 16Keogh Plan Qualification Rules ...... 17

Appendix ARate Table, RateWorksheet, and DeductionWorksheet for Self-EmployedIndividuals With Keogh or SEPPlans ............................................. 19

How To Get More Information .......... 21

Index .................................................... 22

Important Changesfor 1998Participant's compensation. Beginning in1998, a participant's compensation includescertain deferrals unless you elect not to in-clude any amount contributed under a salaryreduction agreement (that is not included inthe gross income of the employee). The newrule, which takes into account amounts de-ferred in certain employee benefit plans, willincrease the tax-deferred amount that youmay contribute to a deferred contribution planat the election of the employee. See Com-pensation under Definitions You Need ToKnow, later.

Matching 401(k) plan contributions forself-employed individuals. Beginning in1998, matching contributions to a 401(k) planon behalf of a self-employed individual will nolonger be treated as elective contributionssubject to the limit on elective deferrals. Thematching contributions for partners and otherself-employed individuals will receive thesame treatment as the matching contributionsof other employees. For more information,

Departmentof theTreasury

InternalRevenueService

Publica tion 560Cat. No. 46574N

RetirementPlansfor Sma llBusiness(SEP, SIMPLE, andKeogh Plans)

For use in preparing

1998Returns


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Table 1. Key Retirement Plan Rules

Due date of employers return(including extensions).

TypeofPlan Maximum Contribution

Maximum Deduction

Same as maximumcontribution.

Smaller of $30,000 or 15%1

of participants compensation2

Last Date forContribution

Due date of employers return(including extensions).

Defined Contribution PlansDefined Contribution Plans

Money PurchaseSmaller of$30,000 or 25%

1of

participants compensation2.

SEP

Keogh

Profit-SharingSmaller of$30,000 or 25%

1of

participants compensation2.

Defined Benefit Plans

Amount needed to provide an annual retirement benefit nolarger than the smaller of $130,000 or 100% of theparticipants average taxable compensation for his or herhighest 3 consecutive years.

1Net earnings from self-employment must take the contribution into account.

2Generally limited to $160,000.

3Does not apply to SIMPLE 401(k) plans. The deadline for Keogh plans applies instead.

Elective employercontributions: 30 daysfollowing the end of themonth with respect to whichthe contributions are to bemade.

3

Employee: Salary reduction contribution, up to $6,000.SIMPLEIRAandSIMPLE401(k)

Matching contributions ornonelective contributions:Due date of employers return(including extensions).

Employer contribution: eitherdollar-for-dollar matchingcontributions, up to 3% of employees compensation

4, or

fixed nonelective contributions of 2% of compensation2.

15% of all participantscompensation2excluding SEP

contributions.

Wh

An10/

By

Fointosoofea

Anemext

Same as maximumcontribution.

Money PurchaseSame asmaximum contribution.

Profit-Sharing15% of allparticipants compensationexcluding plan contributions.

2

Defined Benefit Plans

Based on actuarialassumptions andcomputations.

Note: For a defined benefitplan subject to minimumfunding requirements,contributions are due inquarterly installments. SeeMinimum FundingRequirementsunder KeoghPlans.

4Under a SIMPLE 401(k) plan, compensation is generally limited to $160,000.


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Sharing Plans, IRAs, InsuranceContracts, etc.

5304SIMPLE Savings Incentive MatchPlan for Employees of Small Em-ployers (SIMPLE) (Not Subject tothe Designated Financial Institu-tion Rules)

5305SEP Simplified EmployeePension-Individual RetirementAccounts Contribution Agreement

5305ASEP Salary Reduction and Other

Elective Simplified EmployeePension-Individual RetirementAccounts Contribution Agreement

5305SIMPLE Savings Incentive MatchPlan for Employees of Small Em-ployers (SIMPLE) (for Use With aDesignated Financial Institution)

5329 Additional Taxes Attributable toIRAs, Other Qualified RetirementPlans, Annuities, Modified En-dowment Contracts, and MSAs

5330 Return of Excise Taxes Relatedto Employee Benefit Plans

5500C/R Return/Report of EmployeeBenefit Plan (With fewer than 100

participants) 5500EZ Annual Return of One-

Participant (Owners and TheirSpouses) Retirement Plan

Help from the Internal Revenue Service(IRS). See How To Get More Informationnear the end of this publication for informationabout getting publications and forms. Addi-tionally, for further information, contact em-ployee plans taxpayer assistance telephoneservice between the hours of 1:30 p.m. and3:30 p.m. Eastern Time, Monday throughThursday at (202) 6226074/6075. (Theseare not toll-free numbers.)

Note: All references to section in the

following discussions are to sections of theInternal Revenue Code (which can be foundat most libraries) unless otherwise indicated.

DefinitionsYou Need To KnowSome of the terms used in this publication aredefined below. The same term used in an-other publication may have a slightly differentmeaning.

Annual additions. Annual additions are thetotal amounts of all of your contributions in a

year, employee contributions (not includingrollovers), and forfeitures allocated to a par-ticipant's account.

Annual benefits. Annual benefits are thebenefits to be paid yearly in the form of astraight-life annuity (with no extra benefits)under a plan but excluding the benefit attrib-utable to employee contributions or rollovercontributions.

Business. A business is an activity in whicha profit motive is present and some type ofeconomic activity is involved. Service as anewspaper carrier under age 18 is not abusiness, but service as a newspaper dealer

is. Service as a sharecropper under anowner-tenant arrangement is a business.Service as a public official is not.

Common-law employee. A common-lawemployee is any individual who, under com-mon law, would have the status of an em-ployee. A common-law employee can alsoinclude a leased employee.

A common-law employee is a person whoperforms services for an employer who hasthe right to control and direct both the resultsof the work and the way in which it is done.For example, the employer:

Provides the employee's tools, materials,and workplace, and

Can fire the employee.

Common-law employees are not self-employed and cannot set up retirement planswith respect to income from their work, evenif that income is self-employment income forsocial security tax purposes. For example,common-law employees who are ministers,members of religious orders, full-time insur-ance salespeople, and U.S. citizens em-ployed in the United States by foreign gov-ernments cannot establish retirement planswith respect to their earnings from those em-

ployments, even though their earnings aretreated as self-employment income.

However, a common-law employee canbe self-employed as well. For example, anattorney can be a corporate common-lawemployee during regular working hours andalso practice law in the evening as a self-employed person. In another example, aminister employed by a congregation for asalary is a common-law employee eventhough the salary is treated as self-employment income for social security taxpurposes. However, fees reported on Sched-ule C (Form 1040) for performing marriages,baptisms, and other personal services areself-employment earnings for Keogh planpurposes.

Compensation. Compensation for plan allo-cations is the pay a participant received fromyou for personal services for a year. You cangenerally define compensation as including:

1) Wages and salaries,

2) Fees for professional services, and

3) Other amounts received (cash or non-cash) for personal services actually ren-dered by an employee, including, but notlimited to:

a) Commissions and tips,

b) Fringe benefits, and

c) Bonuses.

Compensation also includes amounts de-ferred in the following employee benefit plans,unless you elect not to include any amountcontributed under a salary reduction agree-ment (that is not included in the gross incomeof the employee).

1) Qualified cash or deferred arrangement(section 401(k) plan).

2) Salary reduction agreement to contributeto a tax-sheltered annuity (section 403(b)plan), a SIMPLE IRA plan, or aSARSEP.

3) Section 457 nonqualified deferred com-pensation plan.

4) Section 125 cafeteria plan.

The limit on elective deferrals is discussedlater under Salary Reduction Simplified Em-ployee Pension (SARSEP) and Keogh Plans.

Other options. In figuring the compen-sation of a participant, you can treat any ofthe following amounts as the employee'scompensation.

1) The employee's wages as defined forincome tax withholding purposes.

2) The employee's wages that you reportin box 1 of Form W2.

3) The employee's social security wages(including elective deferrals).

Compensation generally cannot include:

Reimbursements or other expense al-lowances (unless paid under a nonac-countable plan), or

Deferred compensation (either amountsgoing in or amounts coming out), otherthan certain elective deferrals unless youelect not to include those elective defer-rals in compensation.

For a self-employed individual, compen-

sation means the earned income, discussedlater, of that individual.

Contribution. A contribution is an amountyou pay into a plan for all those (includingself-employed individuals) participating in theplan. Limits apply to how much, under thecontribution formula of the plan, can be con-tributed each year for a participant.

Deduction. A deduction is the amount of plancontributions you can subtract from gross in-come on your federal income tax return.Limits apply to the amount deductible.

Earned income. Earned income is netearnings from self-employment, discussed

later, from a business in which your servicesmaterially helped to produce the income.

You can have earned income from prop-erty that your personal efforts helped create,such as books or inventions on which youearn royalties. Earned income includes netearnings from selling or otherwise disposingof the property, but it does not include capitalgains. It includes income from licensing theuse of property other than goodwill.

If you have more than one business, butonly one has a retirement plan, only theearned income from that business is consid-ered for that plan.

Employer. An employer is generally anyperson for whom an individual performs or did

perform any service, of whatever nature, asan employee. A sole proprietor is treated ashis or her own employer for retirement planpurposes, and a partnership is the employerof each partner. A partner is not an employerfor retirement plan purposes.

Highly compensated employees. Highlycompensated employees are individuals who:

Owned more than 5% of the capital orprofits in your business at any time duringthe year or the preceding year, or

For the preceding year, received com-pensation from you of more than $80,000and, if you so elect, was in the top 20%

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of employees when ranked by compen-sation.

Leased employee. A leased employee whois not your common-law employee must gen-erally be treated as your employee for retire-ment plan purposes if he or she:

1) Provides services to you under anagreement between you and a leasingorganization,

2) Has performed services for you (or foryou and related persons) substantiallyfull time for at least 1 year, and

3) Performs services under your primarydirection or control.

Exception. A leased employee is nottreated as your employee if the employee iscovered by the leasing organization under itsqualified pension plan and leased employeesare not more than 20% of your nonhighlycompensated work force. The leasing organ-ization's plan must be a money purchasepension plan providing:

Immediate participation,

Full and immediate vesting, and A nonintegrated employer contribution

rate of at least 10% of compensation foreach participant.

However, if the leased employee is yourcommon-law employee, that employee will beyour employee for all purposes, regardlessof any pension plan of the leasing organiza-tion.

Net earnings from self-employment.Compensation is your net earnings from self-employment. For SEP and Keogh plans, netearnings from self-employment is your grossincome from your trade or business (provided

your personal services are a materialincome-producing factor) minus allowabledeductions for your business. Allowable de-ductions include contributions to SEP andKeogh plans for common-law employees andthe deduction allowed for one-half of yourself-employment tax.

Earnings from self-employment do not in-clude items that are excluded from gross in-come (or their related deductions) other thanforeign earned income and foreign housingcost amounts. For the deduction limits,earned income is net earnings for personalservices actually rendered to the business.You take into account the income tax de-duction for one-half of self-employment taxand the deduction for contributions to a qual-ified plan made on your behalf when figuringnet earnings. Net earnings include a partner'sdistributive share of partnership income orloss (other than separately stated items, suchas capital gains and losses). It does not in-clude income passed through to shareholdersof S corporations. Guaranteed payments tolimited partnersqualify as net earnings fromself-employment if they are paid for servicesto or for the partnership. Distributions of otherincome or loss to limited partners do notqualify.

For SIMPLE plans, compensation is yournet earnings from self-employment (line 4 ofShort Schedule SE (Form 1040)) before sub-tracting any contributions made to theSIMPLE IRA plan for yourself.

Owner-employee. An owner-employee is:

A sole proprietor, or

A partner who owns more than 10% ofeither the capital interest or the profitsinterest in a partnership.

Participant. A participant is an eligible em-ployee who is covered by your retirementplan.

Partner. A partner is an individual who sharesownership of an unincorporated trade orbusiness with one or more persons. For re-tirement plans, a partner is treated as anemployee of the partnership.

Self-employed individual. An individual inbusiness for himself or herself is self-employed. Sole proprietors and partners areself-employed. Self-employment can includepart-time work.

Not everyone who has net earnings fromself-employment for social security tax pur-poses is self-employed for Keogh plan pur-poses. See Common-law employee, earlier.Also see Net earnings from self-employment.

In addition, certain fishermen may be

considered self-employed for setting up aKeogh plan. See Publication 595, Tax High-lights for Commercial Fishermen, for thespecial rules that apply.

Sole proprietor. A sole proprietor is an in-dividual who owns an unincorporated busi-ness by himself or herself. For retirementplans, a sole proprietor is treated as both anemployer and an employee.

Simplified EmployeePension (SEP)A simplified employee pension (SEP) is awritten plan that allows you to make contri-butions toward your own (if you are self-employed) and your employees' retirementwithout getting involved in the more complexKeogh plan. But, some advantages availableto Keogh plans, such as the special taxtreatment that may apply to Keogh planlump-sum distributions, do not apply to SEPs.

Under a SEP, you make the contributionsto an individual retirement arrangement(called a SEP-IRA) established by or for eacheligible employee. SEP-IRAs are owned andcontrolled by the employee, and you makecontributions to the financial institution wherethe SEP-IRA is maintained.

SEP-IRAs are set up for, at a minimum,

each eligible employee (defined later). ASEP-IRA may have to be set up for a leasedemployee (defined earlier under DefinitionsYou Need To Know), but does not need tobe set up for excludable employees (definedlater).

Eligible employee. An eligible employee isan individual who has:

1) Reached age 21,

2) Worked for you in at least 3 of the last5 years, and

3) Received at least $400 in compensationfrom you for 1998.

TIP

You can establish less restrictiveparticipation requirements than thoselisted, but not more restrictive ones.

Excludable employees. The following em-ployees can be excluded from coverage un-der a SEP.

1) Employees who are covered by a unionagreement and whose retirement bene-fits were bargained for in good faith bytheir union and you.

2) Nonresident alien employees who haveno U.S. source wages, salaries, or otherpersonal services compensation fromyou. For more information about non-resident aliens, see Publication 519,U.S. Tax Guide for Aliens.

Setting Up a SEPThere are three basic steps in setting up aSEP.

1) You must execute a formal writtenagreement to provide benefits to all eli-gible employees.

2) You must give each eligible employeecertain information about the SEP.

3) An IRA account must be established byor for each eligible employee.

TIP

Many financial institutions will helpyou set up a SEP.

Formal written agreement. You must exe-cute a formal written agreement to providebenefits to all eligible employees under aSEP. You can satisfy the written agreementrequirement by adopting an IRS model SEPusing Form 5305SEP. However, see Whennot to use Form 5305SEP, later.

If you adopt an IRS model SEP usingForm 5305SEP, no prior IRS approval ordetermination letter is required. Keep the ori-

ginal form. Do not file it with the IRS. Also,using Form 5305SEP will usually relieve youfrom filing annual retirement plan informationreturns with the IRS and the Department ofLabor. See the Form 5305SEP instructionsfor details.

When not to use Form 5305SEP. Youcannot use Form 5305SEP if any of the fol-lowing apply.

You currently maintain any other qualifiedretirement plan. This does not preventyou from maintaining another SEP.

You have maintained a defined benefitplan (defined later under Keogh Plans),even if it is now terminated.

You have any eligible employees for

whom IRAs have not been established.

You use the services of leased employ-ees(as described earlier under Defi-nitions You Need to Know).

You are a member of an affiliated servicegroup (as described in section 414(m)),a controlled group of corporations (asdescribed in section 414(b)), or trades orbusinesses under common control (asdescribed in section 414(c)), unless alleligible employees of all the members ofthese groups, trades, or businesses par-ticipate under the SEP.

You do not pay the cost of the SEP con-tributions.

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Information you must give to employees.You must give each eligible employee a copyof Form 5305SEP, its instructions, and theother information listed in the Form5305SEP instructions. An IRS model SEPis not considered adopted until you give eachemployee this information.

Establishing IRA accounts. An IRA accountmust be established by or for each eligibleemployee. IRA accounts can be establishedwith banks, insurance companies, or otherqualified financial institutions. You send SEPcontributions to the financial institution wherethe IRA is maintained.

How MuchCan You Contribute?The SEP rules permit you to contribute alimited amount of money each year to eachemployee's SEP-IRA. If you are self-employed, you can contribute to your ownSEP-IRA. Contributions must be in the formof money (cash, check, or money order). Youcannot contribute property. However, youmay be able to transfer or roll over certainproperty from one retirement plan to another.See Publication 590 for more information

about rollovers.You do not have to make contributionsevery year. But if you make contributions,they must be based on a written allocationformula and must not discriminate in favor ofhighly compensated employees (defined ear-lier under Definitions You Need To Know).When you contribute, you must contribute tothe SEP-IRAs of all participants who actuallyperformed personal services during the yearfor which the contributions are made, evenemployees who die or terminate employmentbefore the contributions are made.

The contributions you make under a SEPare treated as if made to a qualified pension,stock bonus, profit-sharing, or annuity plan.Consequently, contributions are deductiblewithin limits, as discussed later, and generally

are not taxable to the plan participants.A SEP-IRA cannot be designated as a

Roth IRA. Contributions to a SEP-IRA will notaffect the amount that an individual can con-tribute to a Roth IRA.

Time limit for making contributions. Todeduct contributions for a year, you mustmake the contributions by the due date (in-cluding extensions) of your tax return for theyear.

Contribution LimitsContributions that you make for a year to acommon-law employee's SEP-IRA cannot bemore than the smaller of 15% of the employ-

ee's compensation or $30,000. Compen-sation generally does not include your contri-butions to the SEP. However, if you have asalary reduction agreement, discussed later,see Employee compensation under SalaryReduction Simplified Employee Pension(SARSEP), later.

Example. Your employee, Mary Plant,earned $21,000 for 1998. The maximumcontribution that you can make to herSEP-IRA is $3,150 (15% x $21,000).

Contributions for yourself. The annuallimits on your contributions to a common-lawemployee's SEP-IRA also apply to contribu-tions you make to your own SEP-IRA. How-

ever, special rules apply when figuring yourmaximum deductible contribution. See De-duction Limit for Self-Employed Individuals,later.

Annual compensation limit. You generallycannot consider the part of compensation ofan employee that is over $160,000 when fig-uring your contribution limit for that employee.Therefore, the maximum contribution amountfor an eligible employee for which the$160,000 limit applies is $24,000.

More than one plan. If you contribute to adefined contribution plan (defined later underKeogh Plans), annual additions to an accountare limited to the lesser of (1) $30,000 or (2)25% of the participant's compensation. Whenyou figure these limits, you must add yourcontributions to all defined contribution plans.Since a SEP is considered a defined contri-bution plan for these limits, your contributionsto a SEP must be added to your contributionsto other defined contribution plans.

Tax treatment of excess contributions.Excess contributions are your contributions toan employee's SEP-IRA (or to your ownSEP-IRA) for a year that are more than thesmaller of:

15% of the employee's compensation (or,for you, 13.0435% of your net earningsfrom self-employment), or

$30,000.

Excess contributions are included in the em-ployee's income for the year and are treatedas contributions by the employee to his or herSEP-IRA. For more information on employeetax treatment of excess contributions, seechapter 4 in Publication 590.

Reporting on Form W2. Do not includeSEP contributions on your employee's FormW2, Wage and Tax Statement, unless con-tributions were made under a salary reduction

arrangement (discussed later).

How Much Can You Deduct?Generally, you can deduct the contributionsyou make each year to each employee'sSEP-IRA. If you are self-employed, you candeduct the contributions you make each yearto your own SEP-IRA.

Deduction Limitfor Your Contributionson Behalf of EmployeesThe most you can deduct for your contribu-tions for participants is the lesser of:

1) Your contributions (including any elective

deferrals and excess contributionscarryover), or

2) 15% of the compensation (limited to$160,000 per participant) paid to themduring the year from the business thathas the plan.

Deduction Limit forSelf-Employed IndividualsIf you contribute to your own SEP-IRA, youneed to make a special computation to figureyour maximum deduction for these contribu-tions. When figuring the deduction for contri-butions made to your own SEP-IRA, com-pensation is your net earnings from

self-employment (defined under DefinitionsYou Need To Know), which takes into ac-count:

1) The deduction for one-half of your self-employment tax, and

2) The deduction for contributions to yourown SEP-IRA.

The deduction for contributions to yourown SEP-IRA and your net earnings dependon each other. For this reason, you determinethe deduction for contributions to your ownSEP-IRA indirectly by reducing the contribu-tion rate called for in your plan. To do this,use either the Rate Table for Self-Employedor the Rate Worksheet for Self-Employed inAppendix A. Then figure your maximum de-duction by using the Deduction Worksheet forSelf-Employedin Appendix A.

Deduction Limitsfor Multiple PlansFor the deduction limits, treat all of yourqualified defined contribution plans and all ofyour qualified defined benefit plans as a sin-gle plan. See Kinds of Plans, later underKeogh Plans for the definitions of definedcontribution plans and defined benefit plans.

If you have both kinds of plans, a SEP istreated as a separate profit-sharing (definedcontribution) plan. A qualified plan is a planthat meets the requirements discussed laterunder Keogh Plan Qualification Rules.

SEP and profit-sharing plans. If you alsocontribute to a qualified profit-sharing plan,you must reduce the 15% deduction limit forthat profit-sharing plan by the allowable de-duction for contributions to the SEP-IRAs ofthose participating in both the SEP plan andthe profit-sharing plan.

Defined contribution and defined benefitplans. If you contribute to one or more de-fined contribution plans (including a SEP) and

one or more defined benefit plans, specialdeduction limits may apply. For informationabout the special deduction limits, see De-duction limit for multiple plans under KeoghPlans, later.

Carryover ofExcess SEP ContributionsIf you made SEP contributions in excess ofthe deduction limit (nondeductible contribu-tions), you can carry over and deduct the ex-cess in later years. However, the excesscontributions carryover, when combined withthe contribution for the later year, cannot bemore than the deduction limit for that year. Ifyou also contributed to a defined benefit planor defined contribution plan, see Carryover

of Excess Contributions, later under KeoghPlansfor the carryover limit.

Excise tax. If you made nondeductible (ex-cess) contributions to a SEP, you may besubject to a 10% excise tax. For informationabout the excise tax, see Excise Tax forNondeductible (Excess) Contributions underKeogh Plans, later.

When To Deduct ContributionsWhen you can deduct contributions made fora year depends on the tax year on which theSEP is maintained.

If the SEP is maintained on a calendar

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year basis, you deduct contributionsmade for a year on your tax return for theyear with or within which the calendaryear ends.

If you file your tax return and maintain theSEP using a fiscal year or short tax year,you deduct contributions made for a yearon your tax return for that year.

Where To Deduct Contributions

Deduct contributions for yourself on line 29of Form 1040. You deduct contributions foryour employees on Schedule C (Form 1040),on Schedule F (Form 1040), on Form 1120S,or on Form 1065, whichever applies to you.

If you are a partner, the partnershippasses its deduction to you for the contribu-tions it made for you. The partnership will re-port these contributions on Schedule K1(Form 1065). You deduct the contributionson line 29 of Form 1040.

Salary ReductionSimplified EmployeePension (SARSEP)A SARSEP is a SEP established before 1997that includes a salary reduction arrangement.(See the Caution, next). Under a SARSEP,your employees can elect to have you con-tribute part of their compensation to theirSEP-IRAs. The income tax on the part con-tributed is deferred. This choice is called anelective deferral, which remains tax free untildistributed (withdrawn).

CAUTION

!You are not allowed to establish aSARSEP after 1996. However, par-ticipants (including employees hired

after 1996) in a SARSEP that was establishedbefore 1997 can continue to elect to have youcontribute part of their pay to the plan. If youare interested in a retirement plan that in-

cludes a salary reduction arrangement, seeSIMPLE Plans, later.

Who can have a SARSEP? A SARSEP thatwas established before 1997 is available toyou and your eligible employees only if:

1) At least 50% of your employees eligibleto participate choose the salary re-duction arrangement,

2) You have 25 or fewer employees whowere eligible to participate in the SEP (orwould have been eligible to participate ifyou had maintained a SEP) at any time

during the preceding year, and

3) The SEP meets the ADP test.

ADP test. Under the ADP test, theamount deferred each year by each eligiblehighly compensated employee as a percent-age of pay (the deferral percentage) cannotbe more than 125% of the average deferralpercentage (ADP) of all other employees eli-gible to participate. A highly compensatedemployee is defined earlier under DefinitionsYou Need To Know.

Deferral percentage. The deferral per-centage for an employee for a year is figuredusing the following ratio.

The amount of elective employercontributions paid to the SEP for the

employee for the year

The employees compensation(limited to $160,000)

Who cannot have a SARSEP. A SEPthat is maintained by a state or local govern-ment or any of its political subdivisions,agencies, or instrumentalities, or by a tax-exempt organization cannot include a salaryreduction arrangement.

Limits on Elective DeferralsThe most compensation a participant canelect to defer for calendar year 1998 is thesmaller of:

15% of the participant's compensation(limited to $160,000 of the participant'scompensation), or

$10,000.

The $10,000 limit applies to the totalelective deferrals the employee makes for theyear to a SEP and any of the following.

Cash or deferred arrangement (section

401(k) plan). Salary reduction arrangement under a

tax-sheltered annuity plan (section 403(b)plan).

SIMPLE IRA plan.

Overall limit on SEP contributions. If youalso make nonelective contributions to aSEP-IRA, the total of the nonelective andelective contributions to that SEP-IRA cannotbe more than the smaller of $30,000 or 15%of the employee's compensation. The samerule applies to contributions you make to yourown SEP-IRA. See Contribution Limits, ear-lier.

Employee compensation. For figuring theelective deferral amount, compensation isgenerally the amount you pay to the em-ployee for the year. Compensation includesthe elective deferral amount and otheramounts deferred in certain employee benefitplans. See Compensation, earlier under De-finitions You Need To Know. These amountsare included in figuring your employees' totalcontributions even though they are not in-cluded in the income of your employees forincome tax purposes.

TIP

You can choose not to treat thedeferral amount as compensation, asdiscussed later.

When figuring the deferral amount, youmultiply the employee's compensation by thedeferral contribution rate. However, the re-duced rate method must always be used todetermine the maximum deductible contribu-tion (13.0435% of unreduced compensation).This is the same method you use to figureyour deduction for contributions you make toyour own SEP-IRA.

Example 1. Jim's SARSEP calls for adeferral contribution rate of 10% of his salary.Jim's salary for the year is $30,000 (beforereduction for the deferral). You multiply Jim'ssalary by 10% to get his deferral amount of$3,000. Your maximum deduction for elective

deferrals and any nonelective contributionswould be $3,913.05 ($30,000 .130435).

On Jim's Form W2, you show his totalwages as $27,000 ($30,000 $3,000). Socialsecurity wages and Medicare wages will eachbe $30,000. Jim will report $27,000 as wageson his individual income tax return.

Election not to treat deferrals as com-pensation. You can choose not to treatelective deferrals (and other amounts de-ferred in certain employee benefit plans) fora year as compensation under your SARSEP.

This method may be used for calculatingdeferral percentages for the ADP test.

The deferral amount and the compen-sation (minus the deferral) depend on eachother. For this reason, the deferral amount isfigured indirectly by reducing the contributionrate for deferrals called for under the salaryreduction arrangement. This method is thesame one that you use to figure your de-duction for contributions you make to yourown SEP-IRA. The reduced rate methodmust also be used to determine the maximumdeductible contribution (13.0435% of unre-duced compensation).

To figure the deferral amount, use eitherthe rate table or rate worksheet in AppendixA. Use the rate table if the deferral contribu-

tion rate called for under the SARSEP is awhole number. Otherwise, use the rate work-sheet. When using the rate table, first locatethe deferral contribution rate in Column A.Then read across to find the reduced rate inColumn B. Multiply the reduced rate by youremployee's compensation to get the deferralamount.

Example 2. The facts are the same as inExample 1 except that you elected not to treatdeferrals as compensation under the ar-rangement. To figure the deferral amount,you multiply Jim's salary of $30,000 by0.090909 (the reduced rate equivalent of10%) to get the deferral amount of $2,727.27.Your maximum deduction for elective defer-rals and any nonelective contributions would

be $3,913.05 ($30,000 .130435).On Jim's Form W2, you show his total

wages as $27,272.73 ($30,000 minus$2,727.27). Social security wages and Medi-care wages will each be $30,000. Jim will re-port $27,272.73 as wages on his individualincome tax return.

Alternative definitions of compen-sation. In addition to the general definitionof compensation under Definitions You NeedTo Know and the election described in thepreceding paragraphs, you can use any defi-nition of compensation that:

Is reasonable,

Is not designed to favor highly compen-sated employees, and

Provides that the average percentage oftotal compensation used for highly com-pensated employees as a group for theyear is not more than minimally higherthan the average percentage of totalcompensation used for all other employ-ees as a group.

Compensation of self-employed indi-viduals. If you are self-employed, compen-sation is your net earnings from self-employment as defined earlier underDefinitions You Need To Know.

To figure the deferral amount, you mustuse a reduced rate instead of the deferral

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contribution rate called for under theSARSEP. Use either the rate table or rateworksheet in Appendix A to get the reducedrate. Then use the deduction worksheet tofigure the deferral amount.

Compensation for this purpose does notinclude tax-free items (or deductions relatedto them) other than foreign earned incomeand housing cost amounts.

Compensation of disabled participants.You may be able to elect to use special rulesto determine compensation for a participantwho is permanently and totally disabled. Un-der these rules, compensation means thecompensation the participant would have re-ceived if paid at the rate of compensation paidimmediately before becoming permanentlyand totally disabled. See Internal RevenueCode section 415(c)(3)(C) for details.

Tax treatment of deferrals. You can deductyour deferrals that, when added to your otherSEP contributions, are not more than thelimits under How Much Can You Deduct,earlier.

Elective deferrals that are not more thanthe limit discussed earlier are excluded fromyour employees' wages subject to federal in-come tax in the year of deferral. However,

these deferrals are included in wages for so-cial security, Medicare, and federal unem-ployment (FUTA) tax.

Excess deferrals. For 1998, excessdeferrals are the elective deferrals for theyear that are more than the $10,000 limit (orthe limit figured under ADP test in the caseof a highly compensated employee) dis-cussed earlier. The treatment of excessdeferrals made under a SARSEP is similar tothe treatment of excess deferrals made undera Keogh plan. See Treatment of ExcessDeferralsunder Keogh Plans, later.

You must notify your highly compensatedemployees of their deferrals that are morethan the ADP limit within 21/2 months after theend of the plan year. If you do not notify them

within this time period, you must pay a 10%tax on the excess deferrals. For an explana-tion of the notification requirements, seeRevenue Procedure 9144, printed on page733 of Cumulative Bulletin 19912. If youadopted a SARSEP using Form 5305ASEP,the notification requirements are explained inthe instructions for that form.

Reporting on Form W2. Do not includeelective deferrals in the Wages, tips, andother compensation box of Form W2. Youmust, however, include them in the Socialsecurity wages and Medicare wages andtips boxes. You must also include them inbox 13. Mark the Deferred compensationcheckbox in box 15. For more information,

see the Form W2 instructions.

Distributions (Withdrawals)As an employer, you cannot prohibit distribu-tions from a SEP-IRA. Also, you cannot makeyour contributions on the condition that anypart of them must be kept in the account.

Distributions are subject to IRA rules. Forinformation about IRA rules, including the taxtreatment of distributions, rollovers, required

distributions, and income tax withholding, seePublication 590.

Additional TaxesThe tax advantages of using SEP-IRAs forretirement savings can be offset by additionaltaxes. There are additional taxes for:

Making excess contributions,

Making early withdrawals (taking prema-ture distributions), and

Allowing excess amounts to accumulate(not making required withdrawals).

For information about these taxes, seechapter 1 in Publication 590. Also, a SEP-IRAmay be disqualified, or an excise tax mayapply if the account is involved in a prohibitedtransaction, discussed next.

Prohibited transaction. If an employee im-properly uses his or her SEP-IRA, such asby borrowing money from it, the employeehas engaged in a prohibited transaction. Inthat case, the SEP-IRA will no longer qualifyas an IRA. For a list of prohibited trans-actions, see Prohibited Transactions underKeogh Plans, later.

Effect on employee. If a SEP-IRA isdisqualified because of a prohibited trans-action, the assets in the account will betreated as having been distributed to the em-ployee of that SEP-IRA on the first day of theyear in which the transaction occurred. Theemployee must include in income the excessof the assets' fair market value (on the firstday of the year) over any cost basis in theaccount. Also, the employee may have to paythe additional tax on premature distributions.For more information, see Tax on ProhibitedTransactionsunder Keogh Plans, later.

Reporting andDisclosure RequirementsIf you set up a SEP using Form 5305SEPor Form 5305ASEP (see the Cautionbelow),you must give your eligible employees certaininformation about the SEP at the time you setit up. See Setting Up a SEP, earlier. Also, youmust give your eligible employees a state-ment each year showing any contributions totheir SEP-IRAs. If you set up a salary re-duction SEP, you must also give them noticeof any excess contributions. For details aboutother information you must give them, see theinstructions for either of these forms.

Even if you did notuse Form 5305SEPor Form 5305ASEP to set up your SEP, youmust give your employees information similarto that described above. For more informa-tion, see the instructions for either Form5305SEP or Form 5305ASEP.

CAUTION

!Form 5305ASEP is used to set upa SEP that includes a salary reductionarrangement. SEPs that include a

salary reduction arrangement cannotbe setup after 1996. However, eligible employeeshired after 1996 can elect to have you con-tribute part of their pay to a SARSEP estab-lished before 1997. See Salary ReductionSimplified Employee Pension (SARSEP),earlier.

SIMPLE PlansA Savings Incentive Match Plan for Employ-ees (SIMPLE plan) is a written arrangementthat provides you and your employees with asimplified way to make contributions to pro-vide retirement income. Under a SIMPLEplan, employees can choose to make salaryreduction contributions rather than receivingthese amounts as part of their regular com-pensation. In addition, you will contribute

matching or nonelective contributions.SIMPLE plans can only be maintained ona calendar-year basis.

A SIMPLE plan can be set up:

Using IRAs (SIMPLE IRA plan), or

As part of a 401(k) plan (SIMPLE 401(k)plan).

SIMPLE IRA PlanA SIMPLE IRA plan is a retirement plan thatuses SIMPLE IRAs for each eligible em-ployee. SIMPLE IRAs are the individual re-tirement accounts or annuities into which thecontributions must be deposited. Under a

SIMPLE IRA plan, a SIMPLE IRA must be setup for each eligible employee. For the defi-nition of an eligible employee, see Who CanParticipate in a SIMPLE IRA Plan?, later.

Who Can Set Upa SIMPLE IRA Plan?You can set up a SIMPLE IRA plan if youmeet both of the following requirements.

You meet the 100-employee limit.

You do not maintain another qualifiedplan unless the other plan is for collectivebargaining employees.

100-employee limit. You can set up aSIMPLE IRA plan only if you had 100 or feweremployees who earned $5,000 or more incompensation during the preceding year.Under this rule, you must take into accountall employees employed at any time duringthe calendar year, regardless of whether theyare eligible to participate. Employees includeself-employed individuals who receivedearned income and leased employees (de-fined earlier under Definitions You Need ToKnow).

Once you establish a SIMPLE IRA plan,you must continue to meet the 100-employeelimit each year that you maintain the plan.

Grace period for employers who ceaseto meet the 100-employee limit. If youmaintain the SIMPLE IRA plan for at least oneyear and you cease to meet the100-employee limit in a later year, you will betreated as meeting it for the 2 calendar yearsimmediately following the calendar year forwhich you last met it.

A different rule applies if you do not meetthe 100-employee limit because of an acqui-sition, disposition, or similar transaction. Un-der this rule, the SIMPLE IRA plan will betreated as meeting the 100-employee limit forthe year of the transaction and the 2 followingyears if:

Coverage under the plan has not signif-icantly changed during the grace period,and

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Lower percentage elected. If you electa matching contribution that is less than 3%,the percentage must not be less than 1%.You must notify the employees of the lowermatch within a reasonable period of time be-fore the employee's 60-day election period(discussed earlier) for the calendar year. You

cannot elect a percentage less than 3% formore than 2 years during the 5-year periodthat ends with (and includes) the year forwhich the election is effective.

2% nonelective contributions. Instead ofmatching contributions, you can elect to makenonelective contributions of 2% of compen-sation on behalf of each eligible employeewho has at least $5,000 of compensationfrom you for the year. Only $160,000 of theemployee's compensation can be taken intoaccount to figure the contribution limit.

If you elect this 2% contribution formula,you must notify the employees within a rea-sonable period of time before the employee's60-day election period (discussed earlier) for

the calendar year.

Example 1. In 1998, your employee,Jane Wood, earned $36,000 and elected tohave you contribute 10% of her salary. Youmake a 2% nonelective contribution. The totalcontributions you can make for her are$4,320, figured as follows.

Example 2. Using the same facts as inExample 1, above, the maximum contributionyou can make for Jane if she earned $75,000

is $7,500, figured as follows.

Time limits for contributing funds. Youmust make the salary reduction contributionsto the SIMPLE IRA within 30 days after theend of the month in which the amounts wouldotherwise have been payable to the employeein cash. You must make matching contribu-tions or nonelective contributions by the duedate (including extensions) for filing your fed-eral income tax return for the year.

When to deduct contributions. You candeduct contributions under a SIMPLE IRAplan in the tax year with or within which thecalendar year for which contributions weremade ends. Contributions will be treated asmade for a particular tax year if they are madefor that tax year and are made by the duedate (including extensions) of your federalincome tax return for that year.

Example. Your tax year is the fiscal yearending June 30. Contributions under theSIMPLE IRA plan for the calendar year 1998(including contributions made in 1998 beforeJune 30, 1998) are deductible in the tax yearending June 30, 1999.

Salary reduction contributions($25,000 .05) ............................................ $1,250

Tax treatment of contributions. You candeduct your contributions and your employ-ees can exclude these contributions from theirgross income. SIMPLE IRA contributions arenot subject to federal income tax withholding.However, salary reduction contributions aresubject to social security, Medicare, and fed-eral unemployment (FUTA) taxes. Matchingand nonelective contributions are not subjectto these taxes.

Reporting on Form W2. Do not includeSIMPLE IRA contributions in the Wages, tips,and other compensation box of Form W2.However, salary reduction contributions mustbe included in the boxes for social securityand Medicare wages. Also include the propercode in Box 13. For more information, seethe Instructionsfor Form W2.

Distributions (Withdrawals)Distributions from a SIMPLE IRA are subjectto IRA rules and generally are includible inincome for the year received. Tax-freerollovers can be made from one SIMPLE IRAinto another SIMPLE IRA. Early withdrawalsgenerally are subject to a 10% (or 25%) ad-ditional tax.

A rollover from a SIMPLE IRA to anotherIRA can be made tax free only after a 2-year

participation in the SIMPLE IRA plan. A 25%additional tax for early withdrawals applies iffunds are withdrawn within 2 years of begin-ning participation.

More information. See Publication 590 forinformation about IRA rules, including thoseon the tax treatment of distributions, rollovers,required distributions, and income tax with-holding.

More Informationon SIMPLE IRA PlansIf you need additional guidance to establishand maintain SIMPLE IRA plans, see the fol-lowing IRS notice and revenue procedure.

Notice 984. This notice (printed on page25 of Internal Revenue Bulletin 19982) con-tains questions and answers relating to theimplementation and operation of SIMPLE IRAplans, including the election and notice re-quirements regarding these plans.

Revenue Procedure 9729. This revenueprocedure (printed on page 698 of CumulativeBulletin 19971) provides guidance on ob-taining opinion letters to drafters of prototypeSIMPLE IRAs.

SIMPLE 401(k) PlanYou can adopt a SIMPLE plan as part of a401(k) plan if you meet the 100-employee

limit as discussed earlier under SIMPLE IRAplans. A SIMPLE 401(k) plan generally mustsatisfy the rules that apply to a 401(k) plan,as discussed in Keogh Plan QualificationRules under Keogh Plans, later. However,contributions and benefits under a SIMPLEplan will be considered not to discriminate infavor of highly compensated employees pro-vided the plan meets the conditions listedbelow.

1) Under the plan, an employee can electto have you make salary reduction con-tributions for the year to a trust in anamount expressed as a percentage ofthe employee's compensation, but not toexceed $6,000 for 1998.

2) You are required to make either:

a) A matching contribution not morethan 3% of compensation for theyear, or

b) Nonelective contributions of 2% ofcompensation on behalf of each el-igible employee who has at least$5,000 of compensation from youfor the year.

3) No other contributions can be made tothe trust.

4) No contributions are made, and no ben-efits accrue, for services during the yearunder any other qualified retirement planof the employer on behalf of any em-ployee eligible to participate in theSIMPLE 401(k) plan.

5) The employee's rights to any contribu-tions are nonforfeitable.

No more than $160,000 of the employee'scompensation can be taken into account infiguring salary reduction contributions,matching contributions, and nonelective con-tributions.

Top-heavy plan exception. A SIMPLE

401(k) plan that allows only contributionsmeeting the conditions listed above will notbe treated as a top-heavy plan. Top-heavyKeogh plans are discussed in Top-heavy planrequirementsunder Keogh Plans, later.

Employee notification. The notificationrules that apply to SIMPLE IRA plans alsoapply to SIMPLE 401(k) plans. See Notifica-tion Requirements, earlier.

More Information onSIMPLE 401(k) PlansIf you need additional guidance to establishand maintain SIMPLE 401(k) plans, seeRevenue Procedure 979, printed on page

624 of Cumulative Bulletin 19971. This rev-enue procedure provides a model amend-ment that you can use to adopt a plan withSIMPLE 401(k) provisions. This modelamendment provides guidance to plan spon-sors for incorporating 401(k) SIMPLE pro-visions in plans containing cash or deferredarrangements.

Keogh PlansA qualified employer plan set up by a self-employed individual is sometimes called aKeogh or HR10 plan. A sole proprietor or apartnership can establish a Keogh plan. Acommon-law employee or a partner cannotestablish a Keogh plan. The plans describedhere can also be established and maintainedby employers that are corporations, and allthe rules discussed here apply to corpo-rations, except where specifically limited tothe self-employed.

The plan must be for the exclusive benefitof employees or their beneficiaries. A Keoghplan includes coverage for a self-employedindividual. For Keogh plan purposes, a self-employed individual is both an employer andan employee.

As an employer, you can usually deduct,subject to limits, contributions you make to aKeogh plan, including those made for yourown retirement. The contributions (and

Employer matching contribution($25,000 .03) ............................................ 750Total contributions ....................................... $2,000

Salary reduction contributions($36,000 .10) ............................................ $3,6002% nonelective contributions($36,000 .02) ............................................ 720Total contributions ....................................... $4,320

Salary reduction contributions(maximum amount) ...................................... $6,0002% nonelective contributions($75,000 .02) ............................................ 1,500Total contributions ....................................... $7,500

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earnings and gains on them) are generally taxfree until distributed by the plan.

Kinds of PlansThere are two basic kinds of Keogh plans

defined contribution plans and definedbenefit plans and different rules apply toeach. You can have more than one Keoghplan, but your contributions to all the plansmust not total more than the overall limitsdiscussed under Contributionsand Employer

Deduction, later.

Defined Contribution PlanA defined contribution plan provides an indi-vidual account for each participant in the plan.It provides benefits to a participant largelybased on the amount contributed to that par-ticipant's account. Benefits are also affectedby any income, expenses, gains, losses, andany forfeitures of other accounts that may beallocated to an account. A defined contribu-tion plan can be either a profit-sharing or amoney purchase pension plan.

Profit-sharing plan. A profit-sharing plan isa plan for sharing your business profits withyour employees. However, you do not haveto make contributions out of net profits tohave a profit-sharing plan.

The plan does not need to provide a defi-nite formula for figuring the profits to beshared. But, if there is no formula, there mustbe systematic and substantial contributions.

The plan must provide a definite formulafor allocating the contribution among the par-ticipants, and for distributing the accumulatedfunds to the employees after they reach acertain age, after a fixed number of years, orupon certain other occurrences.

In general, you can be more flexible inmaking contributions to a profit-sharing planthan to a money purchase pension plan (dis-cussed next) or a defined benefit plan (dis-

cussed later). But the maximum deductiblecontribution may be less under a profit-sharing plan (see Limits on Contributions andBenefits, later).

Forfeitures under a profit-sharing plan canbe allocated to the accounts of remainingparticipants in a nondiscriminatory way, orthey can be used to reduce your contribu-tions.

Money purchase pension plan. Contribu-tions to a money purchase pension plan arefixed and are not based on your businessprofits. For example, if the plan requires thatcontributions be 10% of the participants'compensation without regard to whether youhave profits (or the self-employed person has

earned income), the plan is a money pur-chase pension plan. This applies even thoughthe compensation of a self-employed individ-ual as a participant is based on earned in-come derived from business profits.

Defined Benefit PlanA defined benefit plan is any plan that is nota defined contribution plan. Contributions toa defined benefit plan are based on a com-putation of what contributions are needed toprovide definitely determinable benefits toplan participants. Actuarial assumptions andcomputations are required to figure thesecontributions. Generally, you will need con-

tinuing professional help to have a definedbenefit plan.

Forfeitures under a defined benefit plancannot be used to increase the benefits anyemployee would otherwise receive under theplan. Forfeitures must be used instead to re-duce employer contributions.

Setting Up a Keogh PlanThere are two basic steps in setting up aKeogh plan. First you adopt a written plan.

Then you invest the plan assets.You, the employer, are responsible forestablishing and maintaining the plan.

TIP

If you are self-employed, it is notnecessary to have employees be-sides yourself to sponsor and set up

a Keogh plan. If you have employees, seeEligible Employees, later.

Set-up deadline. To take a deduction forcontributions for a tax year, your plan mustbe set up (adopted) by the last day of thatyear (December 31 for calendar-year em-ployers).

Adopting a Written PlanYou must adopt a written plan. The plan canbe an IRS-approved prototype or master planoffered by a sponsoring organization. Or itcan be an individually designed plan.

Written plan requirement. To qualify, theplan you establish must be in writing and mustbe communicated to your employees. Theplan's provisions must be stated in the plan.It is not sufficient for the plan to merely referto a requirement of the Internal RevenueCode.

Master or prototype plans. Most Keoghplans follow a standard form of plan (a masteror prototype plan) approved by the IRS.

Master and prototype plans are plans that aremade available by plan providers for adoptionby employers (including self-employed indi-viduals). Under a master plan, a single trustor custodial account is established, as partof the plan, for the joint use of all adoptingemployers. Under a prototype plan, a sepa-rate trust or custodial account is establishedfor each employer.

Plan providers. The following organiza-tions generally can provide IRS-approvedmaster or prototype plans.

Banks (including some savings and loanassociations and federally insured creditunions).

Trade or professional organizations.

Insurance companies.

Mutual funds.

Individually designed plans. If you prefer,you can set up an individually designed planto meet specific needs. Although advanceIRS approval is not required, you can applyfor approval by paying a fee and requestinga determination letter. You may need profes-sional assistance for this. Revenue Procedure994, printed on page 115 of Internal Reve-nue Bulletin 19991, may help you decidewhether to apply for approval of your plan. Itis available at most IRS offices and at somelibraries.

Investing Plan AssetsIn setting up a Keogh plan, you arrange howthe plan's funds will be used to build its as-sets.

You can establish a trust or custodialaccount to invest the funds.

You, the trust, or the custodial accountcan buy an annuity contract from an in-surance company. Life insurance can beincluded only if it is incidental to the re-tirement benefits.

You, the trust, or the custodial accountcan buy face-amount certificates from aninsurance company. These certificatesare treated like annuity contracts.

You establish a trust by a legal instrument(written document). You may need profes-sional assistance to do this.

You can establish a custodial account witha bank, savings and loan association, creditunion, or other person who can act as theplan trustee.

You do not need a trust or custodial ac-count, although you can have one, to investthe plan's funds in annuity contracts or face-amount certificates. If anyone other than atrustee holds them, however, the contracts

or certificates must state that they are nottransferable.

Eligible EmployeesAn employee must be allowed to participatein your plan if he or she:

Has reached age 21, and

Has at least 1 year of service (2 years ifthe plan is not a 401(k) plan and providesthat after not more than 2 years of servicethe employee has a nonforfeitable rightto all of his or her accrued benefit).

CAUTION

!A plan cannot exclude an employeebecause he or she has reached aspecified age.

Other plan requirements. For informationon other important plan requirements, seeKeogh Plan Qualification Rules, later.

Minimum FundingRequirementsIn general, if your Keogh plan is a moneypurchase pension plan or a defined benefitplan, you must actually pay enough into theplan to satisfy the minimum funding standardfor each year. Determining the amountneeded to satisfy the minimum fundingstandard is complicated. The determination isbased on what should be contributed underthe plan formula using actuarial assumptionsand formulas. For information on this fundingrequirement, see section 412 and its regu-lations.

Quarterly installments of required contri-butions. If your Keogh plan is a definedbenefit plan subject to the minimum fundingrequirements, you must make quarterly in-stallment payments of the required contribu-tions. If you do not pay the full installmentstimely, you may have to pay interest on anyunderpayment for the period of the under-payment.

Due dates. The due dates for the install-ments are 15 days after the end of eachquarter. For a calendar-year plan, the install-

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ments are due April 15, July 15, October 15,and January 15 (of the following year).

Installment percentage. Each quarterlyinstallment must be 25% of the required an-nual payment.

Extended period for making contribu-tions. Additional contributions required tosatisfy the minimum funding requirement fora plan year will be considered timely if madeby 81/2 months after the end of that year.

ContributionsA Keogh plan is generally funded by yourcontributions. However, employees partic-ipating in the plan may be permitted to makecontributions.

Contribution deadline. You can makedeductible contributions for a tax year up tothe due date of your return (plus extensions)for that year.

Self-employed individual. You can makecontributions on behalf of yourself only if youhave net earnings (compensation) from self-employment in the trade or business for whichthe plan was established. Your net earningsmust be from your personal services, not from

your investments. If you have a net loss fromself-employment, you cannot make contribu-tions for yourself for the year, even if you cancontribute for common-law employees basedon their compensation.

When ContributionsAre Considered MadeYou generally apply your Keogh plan contri-butions to the year in which you make them.But you can apply them to the previous yearif all of the following requirements are met.

1) You make them by the due date of yourtax return for the previous year (plusextensions).

2) The plan was established by the end ofthe previous year.

3) The plan treats the contributions asthough it had received them on the lastday of the previous year.

4) You do either of the following:

a) You specify in writing to the planadministrator or trustee that thecontributions apply to the previousyear, or

b) You deduct the contributions onyour tax return for the previousyear. (A partnership shows contri-butions for partners on Schedule K

(Form 1065)).

Employer's promissory note. Yourpromissory note made out to the plan is nota payment for the Keogh deduction. Also, is-suing this note is a prohibited transactionsubject to tax. See Prohibited Transactions,later.

Employer ContributionsThere are certain limits on the contributionsand other annual additions you can makeeach year for plan participants. There arealso limits on the amount you can deduct. SeeDeduction Limits, later.

Limits onContributions and BenefitsYour plan must provide that contributions orbenefits cannot exceed certain limits. Thelimits differ depending on whether your Keoghplan is a defined contribution plan or a definedbenefit plan.

Defined benefit plan. For 1998, the annualbenefit for a participant under a defined ben-efit plan cannot be more than the smaller of:

1) $130,000, or2) 100% of the participant's average com-

pensation for his or her highest 3 con-secutive calendar years.

Defined contribution plan. For 1998, a de-fined contribution plan's annual contributionsand other additions (excluding earnings) tothe account of a participant cannot exceedthe smaller of:

1) $30,000, or

2) 25% of the compensation actually paidto the participant.

The maximum compensation that can betaken into account for this limit is generally$160,000.

Excess annual additions. Excess annualadditions are the amounts contributed thatexceed the limits discussed previously. A plancan correct excess annual additions becauseof:

A reasonable error in estimating a par-ticipant's compensation,

A reasonable error in determining theamount of elective deferrals permitted(discussed later), or

Forfeitures allocated to participants' ac-counts.

Correcting excess annual additions. Aplan can provide for the correction of excesscontributions in the following ways:

1) Allocate and reallocate the excess toother participants in the plan to the ex-tent of their unused limits for the year,or

2) If these limits are exceeded:

a) Hold the excess in a separate ac-count and allocate (and reallocate)it to participants' accounts in thefollowing year (or years) beforemaking any contributions for thatyear (see also Carryover of ExcessContributions, later), or

b) Return employee after-tax contri-butions or elective deferrals (seeEmployee Contributionsand Elec-tive Deferrals (401(k) Plans), later).

Tax treatment of returned contributionsor distributed elective deferrals. The returnof employee after-tax contributions or thedistribution of elective deferrals to correct ex-cess annual additions is considered a cor-rective payment rather than a distribution ofaccrued benefits. The penalties for premature(early) distributions and excess distributionsdo not apply.

These disbursements are not wages re-portable on Form W2. You must report themon a separate Form 1099R as follows.

Report the total amount of the distribu-tion, including employee contributions, inbox 1. If the distribution includes any gainfrom the contribution, report the gain inbox 2a. Report the return of employeecontributions in box 5. Enter Code E inbox 7.

Report a distribution of an elective defer-ral in boxes 1 and 2a. Include any gainfrom the contribution. Leave box 5 blankand enter Code E in box 7.

Participants must report these amountson the line for Total pensions and annuitieson Form 1040 or Form 1040A.

Employee ContributionsParticipants may be permitted to make non-deductible contributions to a plan in additionto your contributions. Even though these em-ployee contributions are not deductible, theearnings on them are tax free until distributedin later years. Also, these contributions mustsatisfy the nondiscrimination test of section401(m). See Notice 981, printed on page 42of Internal Revenue Bulletin 19983, for fur-ther guidance and transition relief relating torecent statutory amendments to the nondis-

crimination rules under sections 401(k) and401(m).

Employer DeductionYou can usually deduct, subject to limits,contributions you make to a Keogh plan, in-cluding those made for your own retirement.The contributions (and earnings and gains onthem) are generally tax free until distributedby the plan.

Deduction LimitsThe deduction limit for your contributions toa Keogh plan depends on the kind of plan youhave.

Defined contribution plans. The deductionlimit for a defined contribution plan dependson whether it is a profit-sharing plan or amoney purchase pension plan.

Profit-sharing plan. Your deduction forcontributions to a profit-sharing plan cannotbe more than 15%of the compensation paid(or accrued) during the year to your eligibleemployees participating in the plan. You mustreduce this 15% limit in figuring the deductionfor contributions you make for your own ac-count. See Deduction Limit for Self-Employed Individuals, later.

Money purchase pension plan. Yourdeduction for contributions to a money pur-chase pension plan is generally limited to25% of the compensation paid (or accrued)during the year to your eligible employees.You must reduce this 25% limit in figuring thededuction for contributions you make foryourself, as discussed later.

Defined benefit plans. The deduction forcontributions to a defined benefit plan isbased on actuarial assumptions and compu-tations. Consequently, an actuary must figureyour deduction limit.

CAUTION

!In figuring the deduction for contribu-tions, you cannot take into accountany contributions or benefits that ex-

ceed the limits discussed earlier underLimitson Contributions and Benefits.

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Deduction limit for multiple plans. If youcontribute to both a defined contribution planand a defined benefit plan, and at least oneemployee is covered by both plans, your de-duction for those contributions is limited. Yourdeduction cannot exceed the greater of thefollowing amounts.

25% of the compensation paid (or ac-crued) during the year to your eligibleemployees participating in the plan. Youmust reduce this 25% limit in figuring thededuction for contributions you make foryour own account.

Your contributions to the defined benefitplans, but not more than the amountneeded to meet the year's minimumfunding standard for any of these plans.

CAUTION

!For this rule, a Simplified EmployeePension (SEP) plan is treated as aseparate profit-sharing (defined con-

tribution) plan.

Deduction Limit forSelf-Employed IndividualsIf you make contributions for yourself, youneed to make a special computation to figure

your maximum deduction for these contribu-tions. Compensation is your net earnings fromself-employment, defined earlier under Defi-nitions You Need To Know, which takes intoaccount:

1) One-half of your self-employment tax,and

2) The deduction for contributions on behalfof yourself to the plan.

The deduction for your own contributionsand your net earnings depend on each other.For this reason, you determine the deductionfor your own contributions indirectly by re-ducing the contribution rate called for in yourplan. To do this, use either the Rate Table for

Self-Employed or the Rate Worksheet forSelf-Employed in Appendix A. Then figureyour maximum deduction by using the De-duction Worksheet for Self-Employed in Ap-pendix A.

Multiple plans. The deduction limit for mul-tiple plans (discussed earlier) also applies tocontributions you make as an employer onyour own behalf.

Where To Deduct ContributionsDeduct the contributions you make for

your common-law employees on Schedule C(Form 1040), on Schedule F (Form 1040), oron Form 1065, whichever applies to you.

You take the deduction for contributionsfor yourself on line 29 of Form 1040.

If you are a partner, the partnershippasses its deduction to you for the contribu-tions it made for you. The partnership will re-port these contributions on Schedule K1(Form 1065). You deduct them on line 29 ofForm 1040.

Carryover ofExcess ContributionsIf you contribute more to the plans than youcan deduct for the year, you can carry overand deduct the excess in later years, com-bined with your deduction for those years.Your combined deduction in a later year is

limited to 25% of the participating employees'compensation for that year. The limit is 15%if you have only profit-sharing plans (includingSEPs). Remember that these percentagelimits must be reduced to figure your maxi-mum deduction for contributions you make foryourself. See Deduction Limit for Self-Employed Individuals, earlier. The excessyou carry over and deduct may be subject tothe excise tax discussed next.

Table 2illustrates the carryover of excesscontributions to a profit-sharing plan.

Excise Tax for Nondeductible(Excess) ContributionsIf you contribute more than your deductionlimit to a retirement plan, you have madenondeductible contributions and you may beliable for an excise tax. In general, a 10%excise tax applies to nondeductible contribu-tions made to qualified pension, profit-sharing, stock bonus, or annuity plans, andto simplified employee pension plans (SEPs).

Special rule for self-employed individuals.The 10% excise tax does not apply to anycontribution to meet the minimum funding re-quirements in a money purchase pensionplan or a defined benefit plan. Even if thatcontribution is more than your earned incomefrom the trade or business for which the planis set up, the excess is treated as a deductiblecontribution that is not subject to this excisetax. See Minimum Funding Requirementsearlier in this section.

Exception. The 10% excise tax does notapply to contributions to one or more definedcontribution plans that are not deductible onlybecause they exceed the combined plan de-duction limit, and then only to the extent theexcess is not more than the greater of:

6% of the participants' compensation forthe year, or

The sum of employer matching contribu-tions and the elective deferrals to a401(k) plan.

Reporting the tax. You must report the taxon your nondeductible contributions on Form5330. Form 5330 includes a computation ofthe tax. See the separate instructions forcompleting the form.

Elective Deferrals(401(k) Plans)Your Keogh plan can include a cash or de-ferred arrangement (401(k) plan) under whichparticipants can elect to have you contribute

part of their before-tax compensation to theplan rather than receive the compensation incash. (As a participant in the plan, you cancontribute part of your before-tax net earningsfrom the business.) This contribution, calledan elective deferral(and any earnings on it),remains tax free until it is distributed by theplan.

In general, a Keogh plan can include a401(k) plan only if the Keogh is:

A profit-sharing plan, or

A money purchase pension plan in exist-ence on June 27, 1974, that included asalary reduction arrangement on thatdate.

Partnership. A partnership can have a401(k) plan.

Restriction on conditions of participation.The plan may not require, as a condition ofparticipation, that an employee completemore than 1 year of service.

Matching contributions. If your plan per-mits, you can make additional (matching)contributions for an employee on account ofthe contributions on behalf of the employee

under the deferral election just discussed. Forexample, the plan might provide that you willcontribute 50 cents for each dollar your par-ticipating employees elect to defer under your401(k) plan.

Nonelective contributions. You can, undera qualified 401(k) plan, also make contribu-tions (other than matching contributions) foryour participating employees without givingthem the choice to take cash instead.

Employee compensation limit. No morethan $160,000 of the employee's compen-sation can be taken into account when figur-ing contributions.

Limit on Elective DeferralsThere is a limit on the amount that an em-ployee can defer each year under theseplans. This limit applies without regard tocommunity property laws. Your plan mustprovide that your employees cannot defermore than the limit that applies for a particularyear. For 1998, the basic limit on electivedeferrals is $10,000. This limit is subject toannual increases to reflect inflation (asmeasured by the Consumer Price Index). If,in conjunction with other plans, the deferrallimit is exceeded, the excess is included in theemployee's gross income.

Self-employed individual's matchingcontributions. Beginning in 1998, matchingcontributions to a 401(k) plan on behalf of aself-employed individual are no longer treatedas elective contributions subject to the limiton elective deferrals. Therefore, the matchingcontributions for partners and other self-employed individuals receive the same treat-ment as the matching contributions for otheremployees.

Treatment of contributions. Your contribu-tions to a 401(k) plan are generally deductibleby you and tax free to participating employeesuntil distributed from the plan. Participatingemployees have a nonforfeitable right to theaccrued benefit resulting from these contri-butions. Deferrals are included in wages forsocial security, Medicare, and federal unem-ployment (FUTA) tax.

Reporting on Form W2. You must reportthe total amount deferred in boxes 3, 5, and13 of your employee's Form W2. See theForm W2 instructions.

Treatment of Excess DeferralsIf the total of an employee's deferrals exceedsthe limit for 1998, the employee can have theexcess deferral paid out of any of the plansthat permit these distributions. He or shemust notify the plan by March 1, 1999, of theamount to be paid from each plan. The planmust then pay the employee that amount byApril 15, 1999.

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Table 2. Carryover of Excess Contributions IllustratedProfit-Sharing Plan (000s omitted)

YearParticipantscompensation

Participantsshare ofrequiredcontribution(10 percent ofannual profit) Contribution

Excesscontributioncarryoverused*

Totaldeductibleincludingcarryovers

Excesscontributioncarryoveravailable atend of year

199519961997

1998

$1,000400500

600

$10012550

100

$1506075

90

$10012550

100

$ 00

25

0

$1006075

90

$ 06540

50

Deductiblelimit for currentyear (15percent ofcompensation)

* There were no carryovers from years before 1995.

Excess withdrawn by April 15. If the em-ployee takes out the excess deferral by April15, 1999, it is not reported again by includingit in the employee's gross income for 1999.However, any income earned on the excessdeferral taken out is taxable in the tax year inwhich it is taken out. The distribution is notsubject to the additional 10% tax on prema-ture (early) distributions.

If the employee takes out partof the ex-cess deferral and the income on it, the distri-bution is treated as made proportionately fromthe excess deferral and the income.

Excess not withdrawn by April 15. If theemployee does not take out the excessdeferral by April 15, the excess, though taxa-ble in 1998, is not included in the employee'scost basis in figuring the taxable amount ofany eventual benefits or distributions underthe plan. In effect, an excess deferral left inthe plan is taxed twice, once when contrib-uted and again when distributed. Also, if theentire deferral is allowed to stay in the plan,the plan may not be a qualified plan.

Even if the employee takes out the excessdeferral by April 15, the amount is consideredcontributed for satisfying (or not satisfying)the nondiscrimination requirements of theplan. See Contributions or benefits must notdiscriminate later, under Keogh Plan Quali-fication Rules.

Reporting corrective distributions onForm 1099R. Report corrective distributionsof excess deferrals (including any earnings)on Form 1099R. If you need specific infor-mation about reporting corrective distribu-tions, see the 1998 Instructions for Forms1099, 1098, 5498, and W2G.

Tax on certain excess deferrals. The lawprovides tests to detect discrimination in aplan. If tests, such as the actual deferralpercentage test (ADP test) (see section401(k)(3) or 408(k)(6)(A) in the case ofSARSEPs) and the actual contribution per-centage test (ACP test) (see section401(m)(2)) show that contributions for highlycompensated employees exceed the testlimits for these contributions, the employermay have to pay a 10% excise tax. Reportthe tax on Form 5330.

The tax for the year is equal to 10% of theexcess contributions for the plan year endingin your tax year. Excess contributions areelective deferrals, employee contributions, oremployer matching or nonelective contribu-tions that exceed the amount permitted underthe ADP or ACP test.

See Notice 981, printed on page 42 ofInternal Revenue Bulletin 19983, for furtherguidance and transition relief relating to re-cent statutory amendments to the nondis-

crimination rules under sections 401(k) and401(m).

CAUTION

!The rule discussed earlier underSelf-employed individual's matchingcontributions does not apply to the

ADP test.

DistributionsAmounts paid to plan participants from aKeogh plan are called distributions. Distribu-

tions may be nonperiodic, such as lump-sumdistributions, or periodic, such as annuitypayments. Also, certain loans may be treatedas distributions. See Loans Treated as Dis-tributionsin Publication 575.

Required DistributionsA Keogh plan must provide that each partic-ipant will either:

1) Receive his or her entire interest (bene-fits) in the plan by the required begin-ning date(defined later), or

2) Begin receiving regular periodic distribu-tions by the required beginning date inannual amounts calculated to distribute

the participant's entire interest (benefits)over his or her life expectancy or overthe joint life expectancy of the participantand the designated beneficiary.

These distribution rules apply individuallyto each Keogh plan. You cannot satisfy therequirement for one plan by taking a distribu-tion from another. These rules may be incor-porated in the plan by reference. The planmust provide that these rules override anyinconsistent distribution options previouslyoffered.

Minimum distribution. If the account bal-ance of a Keogh plan participant is to be dis-tributed (other than as an annuity), the planadministrator must figure the minimumamount required to be distributed each distri-bution calendar year. This amount is figuredby dividing the account balance by the appli-cable life expectancy. For details on figuringthe minimum distribution, see Tax on ExcessAccumulationin Publication 575.

Minimum distribution incidental benefitrequirement. Minimum distributions mustalso meet the minimum distribution incidentalbenefit requirement. This requirement is toensure that the plan is used primarily to pro-vide retirement benefits to the employee. Af-ter the employee's death, only incidentalbenefits are expected to remain for distribu-tion to the employee's beneficiary (or benefi-ciaries). For more information about this and

other distribution requirements, see Publica-tion 575.

Required beginning date. Generally, eachparticipant must receive his or her entirebenefits in the plan or begin to receive peri-odic distributions of benefits from the plan bythe required beginning date.

A participant must begin to receive distri-butions from his or her qualified retirementplan by April 1 of the year that follows thelater of the:

1) Calendar year in which he or shereaches age 701/2, or

2) Calendar year in which he or she retires.

Before 1997, the law did not take into ac-count whether or not the participant had re-tired. A participant was required to begin re-ceiving distributions by April 1 of the yearfollowing the calendar year in which the par-ticipant reached age 701/2. This rule still ap-plies if the participant is a 5% owner or thedistribution is from an IRA. For more infor-mation, see Tax on Excess Accumulation inPublication 575.

Exception. A 5% owner must still beginto receive distributions on April 1 of the yearfollowing the calendar year in which he or shereaches age 701/2, regardless of when he orshe retires.

Distributions after the starting year.The distribution required to be made by April1 is treated as a distribution for the startingyear. (The starting year is the year in whichthe participant meets (1) or (2) above,whichever applies). After the starting year, theparticipant must receive the required distri-bution for each year by December 31 of thatyear. If no distribution is made in the startingyear, required distributions for 2 years mustbe made in the next year (one by April 1 andone by December 31).

Distributions after participant's death.See Publication 575 for the special rulescovering distributions made after the deathof a participant.

Distributions From 401(k) PlansGenerally, a distribution may not be madeuntil the employee:

Retires,

Dies,

Becomes disabled, or

Otherwise separates from service.

Also, a distribution may be made if the planends and no other defined contribution planis established or continued. In the case of a401(k) plan that is part of a profit-sharing plan,a distribution may be made if the employee

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reaches age 591/2 or suffers financial hard-ship.

CAUTION

!Some of the above distributions maybe subject to the tax on prematuredistributions discussed later.

Hardship distribution. For the rules onhardship distributions, including the limits onthem, see Treasury Regulation 1.401(k)1(d)(2).

Qualified domestic relations order(QDRO). These distribution restrictions donot apply if the distribution is to an alternatepayee under the terms of a QDRO. QDRO isdefined in Publication 575.

Tax Treatment of DistributionsDistributions from a Keogh plan minus a pro-rated part of any cost basis are subject to in-come tax in the year they are distributed.Since most recipients have no cost basis, adistribution is generally fully taxable. An ex-ception is a distribution that is properly rolledover as discussed next under Rollover.

The tax treatment of distributions dependson whether they are made periodically overseveral years or life (periodic payments), or

are nonperiodic distributions. See Taxationof Periodic Payments or Taxation of Nonpe-riodic Payments in Publication 575 for a de-tailed description of how distributions aretaxed, including the 5- or 10-year tax optionor capital gain treatment of a lump-sum dis-tribution.

Rollover. The recipient of an eligiblerollover distributionfrom a Keogh plan candefer the tax on it by rolling it over into an IRAor another eligible retirement plan. However,it may be subject to withholding as discussedunder Withholding requirements, later.

Eligible rollover distribution. This is adistribution of all (such as a lump-sum distri-bution) or any part of an employee's balancein a qualified retirement plan (such as aKeogh plan) that is not:

A required minimum distribution. SeeRequired Distributions, earlier.

An annual (or more frequent) paymentunder a long-term (10 years or more)annuity contract or as part of a similarlong-term series of substantially equalperiodic distributions.

The portion of a distribution that repre-sents the return of an employee's non-deductible contributions to the plan. SeeEmployee Contributions, earlier.

A corrective distribution of excess contri-butions or deferrals under a 401(k) plan

and any income allocable to the excess,or of excess annual additions and anyallocable gains. See Correcting excessannual additions, earlier, under Limits onContributions and Benefits.

CAUTION

!Hardship distributions from a 401(k)plan that occur after 1998 cannot berolled over into an IRA or other eligible

retirement plan. They are subject to the 10%additional tax on premature distributions.However, they are not subject to the 20%withholding tax that generally apply to eligiblerollover distributions that are not transferreddirectly to another retirement plan or IRA.

The IRS has made application of this newrule optional for 1999. For more information,

see Notice 995, printed on page 10 ofInternal Revenue Bulletin 19993.

More information. For more informationabout rollovers, see Rolloversin Publications575 and 590.

Withholding requirements. If, during ayear, a Keogh plan pays to a participant oneor more eligible rollover distributions(definedearlier) that are re

Documents

US Internal Revenue Service: p560--1998