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Salary Reduction Arrangement A SEP may include a salary reduction arrangement. Under the arrangement, you can elect to have your employer contribute part of your pay to your SEP-IRA. Only the remaining portion of your pay is currently taxable. The tax on the contribution is deferred. This choice is called an elective deferral. Form 5305A-SEP can be used by an employer to set up such an arrangement. An employer cannot start a new simplified employee pension (SEP) that includes a salary reduction arrangement. Only SEPs that allowed employees to choose elective deferrals as of December 31, 1996, can include salary reduction arrangements. Restrictions on election. You can choose elective deferrals only if all three of the following conditions exist. At least 50% of employees eligible to participate choose elective deferrals. There were no more than 25 eligible employees at any time during the preceding year. The amount deferred each year by each eligible highly compensated employee as a percentage of pay is no more than 125% of the average deferral percentage of all other eligible employees (ADP test). Generally, compensation that is more than $160,000 cannot be considered in figuring an employee's deferral percentage. An elective deferral arrangement is not available for a SEP maintained by a state or local government, any of their political subdivisions, agencies, or instrumentalities, or a tax-exempt organization. Limits on deferrals. In general, the total income you can defer under a salary reduction arrangement included in your SEP and certain other elective deferral arrangements, for 1998, is limited to $10,000. This limit applies only to the amounts that represent a reduction from your salary, not to any contributions from employer funds. Elective deferrals, not exceeding the ADP test (see Restrictions on election, earlier), are excluded from your income in the year of deferral, but are included in wages for social security, Medicare, and unemployment (FUTA) tax purposes. Overall limits on SEP contributions. Contributions, including elective deferrals (salary reductions), made by your employer to the SEP-IRA are subject to the overall limit of 15% of your compensation (generally up to $160,000 for 1998) or $30,000, whichever is less.

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