Why Establish an Employee Retirement Plan?
Largely because it’s going to provide for security in retirement. People need income after their paychecks stop because I think we all probably realize that Social Security probably isn’t going to be enough so we need to have employer-sponsored retirement plans to fill this gap. Less than half of all Americans with small employers have a retirement plan at work, and about a third of all Americans have less than $1,000.00 in savings, so a retirement plan will be necessary. Also this is a good way to avoid taxes.
Best Reasons to use 401k Plan
For example, if you have something like a 401(k) plan, the taxes are going to be deferred until retirement, so you won’t pay taxes on the money you defer in 2015 but maybe in 20 or 30 years when you start taking the money out. That’s when you start paying taxes on it. And also, you have the value of compound earnings. Just small contributions that you make today can lead to significant savings over the years. And also, very importantly, the employees are going to thank you. You will be able to attract and keep the most qualified employees because those employees will think that you’re a real player since you have a retirement plan.
Tax Benefits of Retirement Plan for Employees and Employer
Besides having some security when you retire, a retirement plan has some tax benefits for both your business and your employees. For your business, at the most basic level, you can generally deduct the employer contributions you make to the retirement plan. For the employees, we mentioned the tax benefit of deferring income. When employees make salary deferrals and employers make contributions on an employee’s behalf, they aren’t included in employees’ current income so they aren’t taxed until the employee withdraws them later, usually during retirement. We also mentioned contributions in the plan have the benefit of compound earnings, we’re hoping for many years. And the earnings are also tax deferred. Of course, when you have Roth accounts, they’re taxed differently. When you make contributions to Roth accounts, you include them in current income and pay tax on them.
In exchange, when you later withdraw the money, it’s all tax free, even the earnings, if you meet certain requirements. So, considering the tax savings, employees might favor a retirement plan where the company makes contributions for them in the same amount of taxable salary.
Retirement Contribution Savings Credit
There are two credits related to retirement plans. The first one is for employees called the Retirement Contribution Savings Credit, or Savers Credit. This one is designed especially for workers in the low and moderate income range. They can get a credit for up to half the contributions they make to an IRA or a retirement plan. And depending on a person’s income and filing status, the employee can receive a credit of up to $2,000.00 in savings for joint filers.
Start Up Costs Credit
The next credit is for the business, the Start Up Costs Credit. You can claim a credit on your business tax return. It’s 50% of the cost to set up, administer and educate employees about the plan. There’s a maximum of $500.00 each year for the first three years. Learn more about these credits on at irs.gov/retirement, and you would just search for retirement savings contribution credit or startup cost credit.
Choosing a Small Business Retirement Plan
Something you always have to keep in mind that there’s always going to be a tradeoff between the cost of the plan and the flexibility that you’ll have with the plan. For example, any time you’re talking about IRA-based plans, like SIMPLE IRA plans, or SEP IRA plans, there’s always going to be a very low administrative burden, but there’s also going to be very few special features. Like, for example, if you have an IRA-based plan, it’s not going to allow for loans, it’s not going to allow for hardship distributions, it’s going to have inflexible vesting. All employer contributions will have to be 100% vested at all times.
Small Business 401k Plan Maintenance
Now on the flip side, if you have a 401(k) plan, it’s going to offer a lot more features, but there’s going to be more maintenance and there’s going to be more cost. You also have to consider does the plan require annual returns, which is going to be a Form 5500 for a pension plan. That’s a return you generally are going to file with the Department of Labor through their EFAST2 system.
You have to consider does the plan require annual testing, like you have discrimination tests, for example, 401(k) plans like the ADP test and the ACP test. There’s also topheavy tests you might have to consider or coverage tests you’ve got to consider, whereas in like IRA-based plans you don’t have to worry about those. But in the 401(k) plan you will.
The ADP and ACP tests, top heavy, all that stuff, is time consuming and it can be costly. Now you also need to consider the features that you want in the plan, you’ve got to consider the costs, and you’ve got to consider the time that you’re willing to put into the plan. That can help you determine the most appropriate type of plan for your employees.
Benefits of Using Traditional IRA for Small Business
You don’t formally adopt a retirement plan. And, to get started, notify your employees that you’re offering this option. It’s really up to your employees to decide whether and how much they’d like to contribute to their individual IRAs through payroll deductions. Your role is simply to collect the contributions and then send them to the IRA provider. You don’t have to file Form 5500. If you’d like to learn more about the basics of setting up a payroll deduction IRA, look for Publication Payroll Deduction IRAs, Publication 4587, and that’s on the IRS website irs.gov/retirement. You could find it a couple ways, either under the Types of Plans link or the Forms and Publications link.
The employees’ role in the payroll deduction IRA is fairly easy. They have to set up either a traditional or a Roth IRA. If they choose a traditional, their ability to deduct contribution depends on their filing status and their modified adjusted gross income. The maximum amount the employee can contribute is the same for traditional and Roth IRAs, and that’s $5,500.00 this year plus an additional $1,000.00 for employees age 50 and over.
Payroll deduction IRAs
It’s important to know that payroll deduction IRAs are not considered a plan under the law for reporting disclosure and fiduciary responsibilities. This keeps your role simple. They’re a good option if you think you can’t afford to contribute right now toward your employees’ retirement because employer contributions aren’t allowed. It’s strictly the employee deducting from his or her salary. This may also be good for you if you’re not sure about the future of your business because employees’ IRAs are separate assets. They control the investments, and even if your business closes, they could keep saving in their accounts. A downside to this type of arrangement is the most a person can contribute is the IRA limit, which is lower than the limits in retirement plans.
SEP Retirement Plans for Small Business
Let’s talk about SEP plans, Simplified Employee Pension plans. These are going to be funded by employer contributions. It works very similarly to a profit-sharing plan. Generally, there are going to be no employee contributions to these types of plans. The employers can decide how much money to put into the plan each year. And this works largely like a profit-sharing plan whereas the contributions can fluctuate from year to year. So like one year the employer can put in zero. It maybe they didn’t have a good year. And the next year they can put in, you know, maybe $20,000.00 or something. But when they do put money in, it has to be the same percentage of pay for everybody. So in other words, the owner just can’t give himself twenty-five percent and then give everybody else five percent. Also, the owner can’t establish a SEP plan only for himself and then not allow his ten employees to be in the plan. Everybody who is eligible to be in the arrangement has to be in the arrangement.
SEP IRA Plan
Now who is going to be included in a SEP plan? It’s got to be all employees who meet the following provisions. Basically, you’ve got to be age 21 and you have to have worked for the employer for three out of the last five years with compensation of at least $600.00 during the current year. Now that is the most stringent that an employer can be with those requirements. They can be more liberal. For example, they can say age 18, or they can have no age requirement at all, they can just say everybody is eligible to be in the plan as of their date of hire.
Pros and Cons of SEP plans
Well, it’s an IRA-based plan because all the money is going to IRAs, so it’s going to have very low administrative expenses. It’s going to be easy to set up with a Form 5305-SEP or a similar document that’s offered by a bank or financial institution. Basically, that document, you just download from the IRS’s website, and you have it. It virtually takes five or ten minutes to complete it, and once you complete it you have yourself a plan document. It’s very easy. But when you have a SEP, you’ve got to tell all the employees about it, you’ve got to tell all the employees you have a SEP IRA. It has to be established with each eligible employee. Again, you can’t just cover the owner.
Using a SEP IRA Plan
The SEP contributions are flexible, like a profit-sharing plan but, generally speaking the same percentage of compensation must go to everyone. There are no employee salary deferral contributions in a SEP. There’s no testing. There’s no coverage tests, there’s no top heavy tests, there’s no discrimination tests, you don’t have to worry about any of that. And there’s also no annual return that has to be filed. You wouldn’t have to file a 5500 with the Department of Labor or a 5500EZ with the IRS. And another really nice feature is that the contributions can be made as late as the due date of the taxable return including extensions. So like, for example, the contribution for 2015 wouldn’t actually have to be made until 2016, by the due date of the tax return.
Information about SIMPLE IRA Plans
If you’re willing to contribute to your employees’ accounts, a SIMPLE IRA plan might be right for you. SIMPLE stands for Savings Incentive Match PLan for Employees, and in this type of plan, employees can make salary deferrals through payroll deduction. So they’re contributing to the plan as soon as they are paid. And the annual limit this year is $12,500.00. Employees age 50 and over can contribute an additional $3,000.00. With the SIMPLE IRA plan, every year you have to decide which one of two formulas to use to make contributions. You could either match what the employee contributes dollar for dollar up to three percent of pay, or you can make a fixed contribution of two percent of pay for all eligible employees, even those employees who don’t make salary deferrals.
What to include in SEP IRA Plan?
Okay, so who do you have to include in a SIMPLE IRA plan? You must cover all employees who earned at least $5,000.00 in any two prior years and who you expect will earn that much in the current year. The eligibility requirements, as you can see, are very basic.
You cannot set an hours of service or age requirement to participate in a SIMPLE IRA plan. This doesn’t necessarily mean that Ben would have to include every part time worker in his retirement plan. For an example, if Ben hires students during the summer, it’s likely that they would earn less than $5,000.00 in the time they worked as a part time summer employee. And most students wouldn’t work for more than one year. However, if a student did earn more than $5,000.00 working for Ben for a third year, then Ben would have to include that student in the SIMPLE IRA plan. Not every company can adopt a SIMPLE IRA plan. Your business has to have 100 or fewer employees who made at least $5,000.00 in the prior year. And the other rule about SIMPLEs is called the Exclusive Plan Rule. You can’t have any other type of retirement plan such as a 401(k) or a SEP. The SIMPLE IRA plan has to be your only plan.
Advantages of using SIMPLE IRS versus SEP Plan
The key advantages of a SIMPLE IRA plan, like the SEP, are that there’s limited administration, you’re free from testing, and you don’t have to file Form 5500. Before you adopt this plan, though, understand that it does have that required employer contribution. So, you must make either a three percent match or a two percent fixed contribution every year regardless of your business profits. If you elect the matching contribution, you can reduce it to as low as one percent, but you could only do this for two out of five years, and you can’t reduce the contribution in the middle of the year. This is a good plan you can consider if you want to give employees the opportunity to make salary deferrals and you’re not going to have the added complexity of a 401(k) plan. A downside to a SIMPLE IRA plan is that the contribution limits are somewhat lower than 401(k)s. Also you can’t make employer contributions other than the required two percent fixed or the three percent matching.
Starting a SIMPLE IRA Plan
If you’d like to start a SIMPLE IRA plan, the IRS offers two model forms to help you. You would use Form 5305-SIMPLE if you want to choose the financial institution to receive the plan contributions. If you want to allow your employees to choose their own financial institution, use Form 5304-SIMPLE. You could also use a plan document approved by the IRS. One of the requirements in a SIMPLE IRA plan is that you have to notify employees before each year that they’re eligible to be in the plan, they can make salary deferrals, and you also have to let them know the contribution formula you will use. So your paperwork will largely be keeping track of who’s eligible, giving them required information, tracking their contributions, giving notices about the plan terms and elections that your employees have. One note here that if you’re using an outside administrator to help you with your plan, make sure that they have accurate compensation amounts for employees and that they’re including all employees in the plan.