Handling SEP and SIMPLE Plan Excess Contributions
By Agatha Schmidt, CISP, SDIP, CHSP
Are excess contributions in simplified employee pension (SEP) plans and savings incentive match plan for employees of small employers (SIMPLE) IRA plans handled in the same way as excess contributions in Traditional IRAs and Roth IRAs?
No. There are fundamental differences between correcting SEP and SIMPLE plan excesses, which are generally created by employer contributions, and correcting Traditional and Roth IRA excesses, which are created by the account owner.
Under a SEP plan, the maximum SEP contribution an employer may make to an employee’s IRA is 25 percent of the employee’s eligible compensation. This contribution is also capped at $61,000 for 2022. SEP contributions are made to an employee’s Traditional IRA, which is sometimes referred to as a “SEP IRA.” Employees may also contribute to a Traditional or Roth IRA if they are eligible. But these IRA contributions are independent from SEP plan contributions, and any excesses are handled differently from SEP excesses.
Under a SIMPLE plan, eligible employees may defer no more than $14,000 of their salary into a SIMPLE IRA (plus $3,000 in catch-up deferrals for employees at least 50 years old) for 2022. Generally, employers must make either a three percent matching contribution or a two percent nonelective contribution.
Contributions over these SEP and SIMPLE limits are considered excess contributions. But an employer who makes an excess contribution to an employee’s IRA cannot simply tell a financial organization to remove the excess amount; the IRA owner must authorize the distribution. So correcting an excess should involve both the employer and the employee: the employer must notify the employee that an excess exists, and the employee should authorize the excess removal before the financial organization takes any action.
How do you fix excess employer contributions and excess employee salary deferrals?
Recent guidance outlined in Revenue Procedure 2021-30 provides that corrections for SEP and SIMPLE plans must be made under the Employee Plans Compliance Resolution System (EPCRS). Under this system, both SEP and SIMPLE plan corrections are eligible for the self-correction program (SCP), the voluntary correction with Service approval program (VCP), and the audit closing agreement program (Audit CAP).
An employer has two options under EPCRS: remove the excess or retain the excess in the SEP or SIMPLE IRA.
Fixing SEP Excesses
Remove the Excess
The earnings attributed to the excess amount must also be removed. The distribution is returned to the employer and is not included in the employee’s income. The employer may not receive a deduction for the excess contribution.
The financial organization reports the distribution on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc. The entry in Box 1, Gross distribution, must include the excess employer contribution and earnings. The entry in Box 2a, Taxable amount, should be zero, and the entry in Box 7, Distribution code(s), should contain code E, Distributions under Employee Plans Compliance Resolution System (EPCRS).
There is no need to adjust Form 5498, IRA Contribution Information—it must show the full contribution originally made, including the excess amount. The employee does not have any additional taxable income or tax consequences.
Retain the Excess
Guidance in Revenue Procedure 2022-4 provides that the employer will owe a VCP fee plus a sanction of at least 10 percent of the excess amount, not including earnings.
For SEP plans, if the excess exceeds the annual limit of $61,000 for 2022, the employee’s limit for the following year (and subsequent years, if applicable) must be reduced by the amount of the excess until the excess is eliminated. The employer must notify the employee of the retained excess.
Fixing SIMPLE Excesses
There are two types of SIMPLE plan excesses: Employer contribution excesses and employee salary deferral excesses.
SIMPLE Plan Employer Contribution Excesses
The same options and handling instructions above that apply to SEP plan employer contribution excesses also apply to SIMPLE plan employer contribution excesses.
SIMPLE Plan Employee Salary Deferral Excesses
Remove the Excess
The earnings attributed to the excess deferral amount must also be removed. The distribution is returned to the employee and is not eligible for tax-free rollover treatment. Because the excess amount is taxed to the employee on Form 1099-R, the employer should not show the excess amount as employee income on Form W-2, Wage and Tax Statement, in either the current year or previous year. The employee should include the excess deferral amount plus earnings as income for the year of the distribution on Form 1040, U.S. Individual Income Tax Return.
The financial organization reports the distribution on Form 1099-R. The entry in both Box 1 and Box 2a must include the excess amount and earnings. The entry in Box 7 should contain code E. The financial organization should not adjust Form 5498.
Retain the Excess
The employer will owe a VCP fee plus a sanction of at least 10 percent of the excess amount, not including earnings (Rev. Proc. 2022-4). The EPCRS does not indicate whether a penalty is assessed to the employee or whether the excess must be removed. The employer should not adjust the employee’s Form W-2, and the employee should include the excess deferrals as income in the year of the deferral on Form 1040.
Is there a deadline for correcting a SEP or SIMPLE excess?
There may or may not be, depending on whether the cause of the excess was due to a significant or insignificant failure, as well as the correction program that is used under the EPCRS. Generally, self-correction can be used for “insignificant failures” or for significant failures that are corrected within three years after the year for which they arose.
