The annual limits on your contributions to a common-law employee's SEP-IRA also apply to contributions you make to your own SEP-IRA. However, special rules apply when figuring your maximum deductible contribution. See Deduction Limit for Self-Employed Individuals, later.

You cannot consider the part of an employee's compensation over $210,000 when figuring your contribution limit for that employee. However, $42,000 is the maximum contribution for an eligible employee. The annual compensation limit of $210,000 increases to $220,000 for 2006.)

If you contribute to a defined contribution plan (defined in chapter 4), annual additions to an account are limited to the lesser of $42,000 or 100% of the participant's compensation. When you figure this limit, you must add your contributions to all defined contribution plans. Because a SEP is considered a defined contribution plan for this limit, your contributions to a SEP must be added to your contributions to other defined contribution plans.

Excess contributions are your contributions to an employee's SEP-IRA (or to your own SEP-IRA) for 2005 that exceed the lesser of the following amounts.

Do not include SEP contributions on your employee's Form W-2 unless contributions were made under a salary reduction arrangement (discussed later).

If you also contribute to a qualified defined contribution plan, you must reduce the 25% deduction limit for that plan by the allowable deduction for contributions to the SEP-IRAs of those participating in both the SEP plan and the defined contribution plan.

If you made nondeductible (excess) contributions to a SEP, you may be subject to a 10% excise tax. For information about the excise tax, see Excise Tax for Nondeductible (Excess) Contributions under Employer Deduction in chapter 4.

A SARSEP can permit participants who are age 50 or over at the end of the calendar year to also make catch-up contributions. The catch-up contribution limit for 2005 is $4,000 ($5,000 for 2006). Elective deferrals are not treated as catch-up contributions for 2005 until they exceed the elective deferral limit (the lesser of 25% of compensation or $14,000), the SARSEP ADP test limit discussed earlier, or the plan limit (if any). However, the catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts.

Catch-up contributions are not subject to the elective deferral limit (the lesser of 25% of compensation or $14,000).

If you also make nonelective contributions to a SEP-IRA, the total of the nonelective and elective contributions to that SEP-IRA cannot exceed the lesser of 25% of the employee's compensation or $42,000 ($44,000 for 2006). The same rule applies to contributions you make to your own SEP-IRA. See Contribution Limits, earlier.

For figuring the 25% limit on elective deferrals, compensation does not include SEP contributions, including elective deferrals or other amounts deferred in certain employee benefit plans.

For 2005, excess deferrals are the elective deferrals for the year that are more than the $14,000 limit discussed earlier. For a participant who is eligible to make catch-up contributions, excess deferrals are the elective deferrals that are more than $18,000. The treatment of excess deferrals made under a SARSEP is similar to the treatment of excess deferrals made under a qualified plan. See Treatment of Excess Deferrals under Elective Deferrals (401(k) Plans) in chapter 4.

Excess SEP contributions are elective deferrals of highly compensated employees that are more than the amount permitted under the SARSEP ADP test. You must notify your highly compensated employees within 2 months after the end of the plan year of their excess SEP contributions. If you do not notify them within this time period, you must pay a 10% tax on the excess. For an explanation of the notification requirements, see Revenue Procedure 91-44 in Cumulative Bulletin 1991-2. If you adopted a SARSEP using Form 5305A-SEP, the notification requirements are explained in the instructions for that form.

Do not include elective deferrals in the Wages, tips, other compensation box of Form W-2. You must, however, include them in the Social security wages and Medicare wages and tips boxes. You must also include them in box 12. Mark the Retirement plan checkbox in box 13. For more information, see the Form W-2 instructions.

You can set up a SIMPLE IRA plan only if you had 100 or fewer employees who received $5,000 or more in compensation from you for the preceding year. Under this rule, you must take into account all employees employed at any time during the calendar year regardless of whether they are eligible to participate. Employees include self-employed individuals who received earned income and leased employees (defined in chapter 1).

Once you set up a SIMPLE IRA plan, you must continue to meet the 100-employee limit each year you maintain the plan.

The SIMPLE IRA plan generally must be the only retirement plan to which you make contributions, or to which benefits accrue, for service in any year beginning with the year the SIMPLE IRA plan becomes effective.

Any employee who received at least $5,000 in compensation during any 2 years preceding the current calendar year and is reasonably expected to receive at least $5,000 during the current calendar year is eligible to participate. The term employee includes a self-employed individual who received earned income.

You can use less restrictive eligibility requirements (but not more restrictive ones) by eliminating or reducing the prior year compensation requirements, the current year compensation requirements, or both. For example, you can allow participation for employees who received at least $3,000 in compensation during any preceding calendar year. However, you cannot impose any other conditions for participating in a SIMPLE IRA plan.

The following employees do not need to be covered under a SIMPLE IRA plan.

Compensation for employees is the total wages, tips, and other compensation from the employer subject to federal income tax withholding and the amounts paid for domestic service in a private home, local college club, or local chapter of a college fraternity or sorority. Compensation also includes the employee's salary reduction contributions made under this plan and, if applicable, elective deferrals under a section 401(k) plan, a SARSEP, or section 403(b) annuity contract and compensation deferred under a section 457 plan required to be reported by the employer on Form W-2. If you are self-employed, compensation is your net earnings from self-employment (line 4, Section A, or line 6, Section B, of Schedule SE (Form 1040)) before subtracting any contributions made to the SIMPLE IRA plan for yourself.

If you set up a SIMPLE IRA plan using Form 5304-SIMPLE or Form 5305-SIMPLE, you can use the form to satisfy other requirements, including the following.

You can set up a SIMPLE IRA plan effective on any date from January 1 thru October 1 of a year, provided you did not previously maintain a SIMPLE IRA plan. This requirement does not apply if you are a new employer that comes into existence after October 1 of the year the SIMPLE IRA plan is set up and you set up a SIMPLE IRA plan as soon as administratively feasible after your business comes into existence. If you previously maintained a SIMPLE IRA plan, you can set up a SIMPLE IRA plan effective only on January 1 of a year. A SIMPLE IRA plan cannot have an effective date that is before the date you actually adopt the plan.

SIMPLE IRAs are the individual retirement accounts or annuities into which the contributions are deposited. A SIMPLE IRA must be set up for each eligible employee. Forms 5305-S, Form: 5305–SSIMPLE Individual Retirement Trust Account, and 5305-SA, Form: 5305–SASIMPLE Individual Retirement Custodial Account, are model trust and custodial account documents the participant and the trustee (or custodian) can use for this purpose.

A SIMPLE IRA cannot be designated as a Roth IRA. Contributions to a SIMPLE IRA will not affect the amount an individual can contribute to a Roth IRA.

You may be able to claim a tax credit for part of the ordinary and necessary costs of starting a SIMPLE IRA plan that first became effective in 2005. For more information, see Credit for startup costs under Reminders, earlier.

The election period is generally the 60-day period immediately preceding January 1 of a calendar year (November 2 to December 31 of the preceding calendar year). However, the dates of this period are modified if you set up a SIMPLE IRA plan in mid-year (for example, on July 1) or if the 60-day period falls before the first day an employee becomes eligible to participate in the SIMPLE IRA plan.

A SIMPLE IRA plan can provide longer periods for permitting employees to enter into salary reduction agreements or to modify prior agreements. For example, a SIMPLE IRA plan can provide a 90-day election period instead of the 60-day period. Similarly, in addition to the 60-day period, a SIMPLE IRA plan can provide quarterly election periods during the 30 days before each calendar quarter, other than the first quarter of each year.

The amount the employee chooses to have you contribute to a SIMPLE IRA on his or her behalf cannot be more than $10,000 for 2005. These contributions must be expressed as a percentage of the employee's compensation unless you permit the employee to express them as a specific dollar amount. You cannot place restrictions on the contribution amount (such as limiting the contribution percentage), except to comply with the $10,000 limit.

If an employee is a participant in any other employer plan during the year and has elective salary reductions or deferred compensation under those plans, the salary reduction contributions under a SIMPLE IRA plan also are elective deferrals that count toward the overall annual limit ($14,000 for 2005) on exclusion of salary reduction contributions and other elective deferrals.

You are generally required to match each employee's salary reduction contributions on a dollar-for-dollar basis up to 3% of the employee's compensation. This requirement does not apply if you make nonelective contributions as discussed later.

Instead of matching contributions, you can choose to make nonelective contributions of 2% of compensation on behalf of each eligible employee who has at least $5,000 (or some lower amount you select) of compensation from you for the year. If you make this choice, you must make nonelective contributions whether or not the employee chooses to make salary reduction contributions. Only $210,000 of the employee's compensation can be taken into account to figure the contribution limit.

If you choose this 2% contribution formula, you must notify the employees within a reasonable period of time before the 60-day election period (discussed earlier) for the calendar year.

You must make the salary reduction contributions to the SIMPLE IRA within 30 days after the end of the month in which the amounts would otherwise have been payable to the employee in cash. You must make matching contributions or nonelective contributions by the due date (including extensions) for filing your federal income tax return for the year.

Do not include SIMPLE IRA plan contributions in the Wages, tips, other compensation box of Form W-2. However, salary reduction contributions must be included in the boxes for social security and Medicare wages. Also include the proper code in box 12. For more information, see the instructions for Forms W-2 and W-3.

See Publication 590, Individual Retirement Arrangements, for information about IRA rules, including those on the tax treatment of distributions, rollovers, required distributions, and income tax withholding.

This notice contains questions and answers about the implementation and operation of SIMPLE IRA plans, including the election and notice requirements for these plans. Notice 98-4 is in Cumulative Bulletin 1998-1.

A profit-sharing plan is a plan for sharing your business profits with your employees. However, you do not have to make contributions out of net profits to have a profit-sharing plan.

The plan does not need to provide a definite formula for figuring the profits to be shared. But, if there is no formula, there must be systematic and substantial contributions.

The plan must provide a definite formula for allocating the contribution among the participants and for distributing the accumulated funds to the employees after they reach a certain age, after a fixed number of years, or upon certain other occurrences.

In general, you can be more flexible in making contributions to a profit-sharing plan than to a money purchase pension plan (discussed next) or a defined benefit plan (discussed later).

Forfeitures under a profit-sharing plan can be allocated to the accounts of remaining participants in a nondiscriminatory way or they can be used to reduce your contributions.

Contributions to a money purchase pension plan are fixed and are not based on your business profits. For example, if the plan requires that contributions be 10% of the participants' compensation without regard to whether you have profits (or the self-employed person has earned income), the plan is a money purchase pension plan. This applies even though the compensation of a self-employed individual as a participant is based on earned income derived from business profits.

To qualify, the plan you set up must be in writing and must be communicated to your employees. The plan's provisions must be stated in the plan. It is not sufficient for the plan to merely refer to a requirement of the Internal Revenue Code.

Most qualified plans follow a standard form of plan (a master or prototype plan) approved by the IRS. Master and prototype plans are plans made available by plan providers for adoption by employers (including self-employed individuals). Under a master plan, a single trust or custodial account is established, as part of the plan, for the joint use of all adopting employers. Under a prototype plan, a separate trust or custodial account is established for each employer.

If you prefer, you can set up an individually designed plan to meet specific needs. Although advance IRS approval is not required, you can apply for approval by paying a fee and requesting a determination letter. You may need professional help for this. Revenue Procedure 2006-6 in Internal Revenue Bulletin 2006-1 may help you decide whether to apply for approval.

For information on other important plan requirements, see Qualification Rules, later.

Your promissory note made out to the plan is not a payment that qualifies for the deduction. Also, issuing this note is a prohibited transaction subject to tax. See Prohibited Transactions, later.

The deduction for contributions to a defined contribution plan (profit-sharing plan or money purchase pension plan) cannot be more than 25% of the compensation paid (or accrued) during the year to your eligible employees participating in the plan. If you are self-employed, you must reduce this limit in figuring the deduction for contributions you make for your own account. See Deduction Limit for Self-Employed Individuals, later.

When figuring the deduction limit, the following rules apply.

The deduction for contributions to a defined benefit plan is based on actuarial assumptions and computations. Consequently, an actuary must figure your deduction limit.

If you contribute to both a defined contribution plan and a defined benefit plan and at least one employee is covered by both plans, your deduction for those contributions is limited. Your deduction cannot be more than the greater of the following amounts.

This limit does not apply if contributions to the defined contribution plan consist only of elective deferrals.

The deduction limit for multiple plans (discussed earlier) also applies to contributions you make as an employer on your own behalf.

The 10% excise tax does not apply to any contribution made to meet the minimum funding requirements in a money purchase pension plan or a defined benefit plan. Even if that contribution is more than your earned income from the trade or business for which the plan is set up, the difference is not subject to this excise tax. See Minimum Funding Requirement, earlier.

If you maintain a defined benefit plan, the following exceptions may enable you to choose not to take certain nondeductible contributions into account when figuring the 10% excise tax.

You must report the tax on your nondeductible contributions on Form 5330. Form 5330 includes a computation of the tax. See the separate instructions for completing the form.

A 401(k) plan can permit participants who are age 50 or over at the end of the calendar year to also make catch-up contributions. The catch-up contribution limit for 2005 is $4,000 ($5,000 for 2006). Elective deferrals are not treated as catch-up contributions for 2005 until they exceed the $14,000 limit, the ADP test limit of Internal Revenue Code section 401(k)(3), or the plan limit (if any). However, the catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts.

Your contributions to a 401(k) plan are generally deductible by you and tax free to participating employees until distributed from the plan. Participating employees have a nonforfeitable right to the accrued benefit resulting from these contributions. Deferrals are included in wages for social security, Medicare, and federal unemployment (FUTA) tax.

You must report the total amount deferred in boxes 3, 5, and 12 of your employee's Form: W-2 Form W-2. See the Form W-2 instructions.

If the employee takes out the excess deferral by April 15, 2006, it is not reported again by including it in the employee's gross income for 2006. However, any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. The distribution is not subject to the additional 10% tax on early distributions.

If the employee takes out part of the excess deferral and the income on it, the distribution is treated as made proportionately from the excess deferral and the income.

Even if the employee takes out the excess deferral by April 15, the amount is considered contributed for satisfying (or not satisfying) the nondiscrimination requirements of the plan, unless the distributed amount is for a non-highly compensated employee who participates in only one employer's 401(k) plan or plans. See Contributions or benefits must not discriminate, later, under Qualification Rules.

If the employee does not take out the excess deferral by April 15, 2006, the excess, though taxable in 2005, is not included in the employee's cost basis in figuring the taxable amount of any eventual benefits or distributions under the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.

Report corrective distributions of excess deferrals (including any earnings) on Form 1099-R. For specific information about reporting corrective distributions, see the Instructions for Forms 1099, 1098, 5498, and W-2G.

The law provides tests to detect discrimination in a plan. If tests, such as the actual deferral percentage test (ADP test) (see section 401(k)(3)) and the actual contribution percentage test (ACP test) (see section 401(m)(2)), show that contributions for highly compensated employees are more than the test limits for these contributions, the employer may have to pay a 10% excise tax. Report the tax on Form 5330. Form: 5330The ADP and ACP tests do not apply to safe harbor 401(k) plans.

The tax for the year is 10% of the excess contributions for the plan year ending in your tax year. Excess contributions are elective deferrals, employee contributions, or employer matching or nonelective contributions that are more than the amount permitted under the ADP test or the ACP test.

See Regulations sections 1.401(k)-2 and 1.401(m)-2 for further guidance relating to the nondiscrimination rules under sections 401(k) and 401(m).

If the account balance of a qualified plan participant is to be distributed (other than as an annuity), the plan administrator must figure the minimum amount required to be distributed each distribution calendar year. This minimum is figured by dividing the account balance by the applicable life expectancy. For details on figuring the minimum distribution, see Tax on Excess Accumulation in Publication 575.

Generally, each participant must receive his or her entire benefits in the plan or begin to receive periodic distributions of benefits from the plan by the required beginning date.

A participant must begin to receive distributions from his or her qualified retirement plan by April 1 of the first year after the later of the following years.

These distribution restrictions do not apply if the distribution is to an alternate payee under the terms of a QDRO, which is defined in Publication 575.

The recipient of an eligible rollover distribution from a qualified plan can defer the tax on it by rolling it over into a traditional IRA or another eligible retirement plan. However, it may be subject to withholding as discussed under Withholding requirement, later.

If, during a year, a qualified plan pays to a participant one or more eligible rollover distributions (defined earlier) that are reasonably expected to total $200 or more, the payor must withhold 20% of each distribution for federal income tax.

The 10% tax will not apply if distributions before age 59 are made in any of the following circumstances.

To report the tax on early distributions, file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. See the form instructions for additional information about this tax.

You are a 5% owner if you meet either of the following conditions at any time during the 5 plan years immediately before the plan year that ends within the tax year you receive the distribution.

Include on Form 1040, line 63, any tax you owe for an excess benefit. On the dotted line next to the total, write Sec. 72(m)(5) and write in the amount.

The amount subject to the additional tax is not eligible for the optional methods of figuring income tax on a lump-sum distribution. The optional methods are discussed under Lump-Sum Distributions in Publication 575.

The amount involved in a prohibited transaction is the greater of the following amounts.

If services are performed, the amount involved is any excess compensation given or received.

The taxable period starts on the transaction date and ends on the earliest of the following days.

Pay the 15% tax with Form 5330.

If you are a disqualified person who participated in a prohibited transaction, you can avoid the 100% tax by correcting the transaction as soon as possible. Correcting the transaction means undoing it as much as you can without putting the plan in a worse financial position than if you had acted under the highest fiduciary standards.