Retirement Plans for Small Business Owners

Choosing between the SEP and the Simple

CPAs often advise small business on establishing retirement plans. In many cases, small business owners seek a plan that offers tax-deferred savings, deductible contributions, and the opportunity to provide maximum benefits to the owner in either a corporate or noncorporate entity; however, it can be difficult for small employers to offer retirement benefits that will qualify under the stringent rules for pension or profitsharing plans. Such plans can be both complex and costly to implement and maintain.

<p>The Simple Employee Pension (SEP) plan and the Savings Incentive Match Plan for Employees (Simple) present two lowcost alternatives for small employers. In both options, the employer establishes individual retirement accounts (IRA) for each participating employee and makes contributions to those accounts on behalf of each participant. These plans are easy to establish and inexpensive to maintain; unlike qualified plans, they do not require actuarial estimates or the submission of annual reports. In addition, no ongoing requirement exists for discrimination testing of coverage or benefits. In either of these plans, selfemployed owners can establish their own retirement account to be funded within the rules of the plan. (For the SEP plan tax rules, see Internal Revenue Code [IRC] section 408[k]; for the Simple, see IRC section 408[p].)

Although the SEP and Simple are similar in design, certain distinguishing factors will make one plan or the other a preferred choice in many circumstances. Financial advisors should review these factors, listed in the Exhibit, with small business owners when evaluating both plans.

The SEP Plan

As previously mentioned, this plan requires an employer to establish a separate IRA for each participating employee; however, these accounts have higher contribution limits than individual traditional IRAs. Under the current SEP rules, no employee contributions are permitted. (Prior to 1997, an alternative known as SARSEP, which permitted elective salary deferrals, was available; some of these plans were grandfathered in at the time and still exist today.)

Under this plan, an employer makes annual discretionary contributions. Unlike pension plan mies that require mandatory contributions or profit-sharing mies that require recurring or substantial contributions, the SEP plan has no mandate for an annual employer contribution. The SEP offers the employer the advantage of controlling contributions from year to year; this flexibility makes it an attractive option for businesses that tend to have significant variation in annual cash flows.

When a contribution is made, it must be tiie same percentage of compensation for all covered workers; this prevents the plan from skewing benefits to highly compensated employees or older workers. This mandatory equal treatment of participants allows employers to avoid the antidiscrimination testing required for qualified plans. Furthermore, a SEP plan may be integrated with Social Security, which allows an additional percentage contribution for employees with compensation that exceeds a specified integration level (typically the Social Security wage base). This additional percentage contribution is known as a "permitted disparity." There are specified limits on the additional percentage allowed, and the integration mle must be applied in a nondiscriminatory manner (IRC section 401 [I]).

The annual contributions to any individual employee's IRA are limited to the lesser of $52,000 (indexed annually) or 25% of the employee's compensation. This cap applies to the total contributions made to all of an employee's definedcontribution accounts within the tax year, including employer contributions, employee contributions, and forfeitures. The employer's deduction for a SEP contribution is limited to 25% of compensation (total payroll for participants), with individual employee compensation capped at $260,000 for 2014. If an employer offers a qualified defmed-contribution plan in addition to the SEP plan, the 25% deduction limit applies to the total of all contributions to all plans; thus, it is important to note that SEP contributions reduce the amount that can be deducted for other plan contributions.

In a noncorporate entity, the maximum deduction for a contribution to the SEP account of a self-employed owner must be calculated according to a specified formula. The deduction is subject to an overall limit of 20%; this may be lower than 20%, depending upon the percentage of compensation contributed for employees. The 1RS provides a "rate table for the selfemployed," which indicates the maximum deductible contribution rate for the owner, relative to the contribution rate for employees in the SEP plan. (For the rate table, see chapter 5 of 1RS Publication 560, Retirement Plans for Small Business.) For example, if the plan calls for a contribution of 15% of compensation to participating employees accounts, the owner's deductible contribution will be 13.0435% of net earnings. "Net earnings" is defined as the net profit reported on Schedule C (or Schedule F, or Schedule K-l for a partner), reduced by a deduction for half of the self-employment tax. This represents the maximum allowable deduction that is deducted "for AGI" on the owner's personal return. (The deduction for contributions to employees' accounts is taken on Schedule C or F, or, in the case of a partnership, on Form 1065, U.S. Return of Partnership Income.)

Example. Employer A offers a SEP that contributes 15% of each participating employee's compensation to the employee's SEP IRA. The employer's Schedule C net profit is $250,000; this is reduced by the $10,173 deduction for half of the self-employment tax and yields net earnings of $239,827. Based on the 1RS rate table, this employer may deduct a maximum of 13.0435% in this plan. Thus, the employer will be allowed to deduct up to $31,282 for his own SEP contributions within this tax year (13.0435% of $239,827). If owners choose to maximize the contribution to employees' accounts at 25%, or if no employees and owners wish to maximize the contribution to their own account, they can contribute the maximum 20% allowed. As in all cases, the contribution limit of $52,000 applies to the selfemployed owner.

The rules that govern traditional IRAs, with respect to investments and prohibited transactions, also apply to SEP IRAs. All funds in the account are fully vested at all times. Employees are not permitted to take loans from the IRA or use it as collateral; however, rollovers and in-service withdrawals are allowed. Withdrawals will be taxed as ordinary income and are subject to the 10% early distribution penalty (with the usual exceptions) if the employee is under age 59%. Rollovers are permitted at any time if the employee chooses to move the assets from the SEP account to another IRA. Employees must begin withdrawals at age 70% under the required minimum distribution (RMD) mies.

A SEP plan must cover any employee who is 21 years of age and has earned $550 in three of the last five years. This might be the least popular feature of the plan because it requires coverage for many parttime employees. (The employer must make the requisite contribution for all employees, including those who are over age 70% and those who are no longer employed on the date of contribution because of death or termination during that plan year, according to Treasury Regulations section 1.408-7[d] [3].) This three-year requirement does, however, avoid coverage of transient employees. In addition, employees who belong to a collective bargaining unit that bargains for retirement benefits can be excluded from a SEP plan.

An attractive feature of the SEP plan is the simplicity with which employers can implement and maintain it. For employers who do not offer any other qualified plan, a prototype SEP plan can be established by using Form 5305-SEP, Simplified Employee Pension-Individual Retirement Accounts Contribution Agreement; however, this form does not have to be filed with the 1RS. It provides the pertinent details of the employer's plan, along with an appropriate signature. There are no annual filing requirements and administrative costs are low, because the primary cost is simply establishing the employee IRAs.

Employers must provide certain information to eligible employees, including a copy of the Form 5305-SEP or prototype document. They must give notice of any amendments to the SEP plan and any change in the requirements for receiving contributions; they must also provide each participating employee with an annual contribution statement.

The Simple

Similar to the SEP plan, the Simple calls for the creation of an IRA for each individual participant. In contrast with the SEP plan, however, the Simple offers employees an opportunity to make an elective salary deferral contribution to their account. The employer is required to make a matching contribution, subject to explicit mies. The Simple is only available to employers with 100 or fewer employees. In addition, the employer is not permitted to offer a Simple if another qualified plan is maintained. One exception to this rule is if another plan covers only union employees and is collectively bargained for; in this case, the plan does not prevent an employer from offering a Simple to nonunion employees. The plan must cover any employee who earned $5,000 in any two previous years and will earn $5,000 again in the current year. Employees who are members of a collective bargaining unit are not required to be covered under the plan, but they will count toward the 100-employee limit.

The Simple provides two options for employer contributions. Under the first option, the employer must provide a dollar-for-dollar match with the employee's deferrals on the first 3% of compensation. The employer can periodically lower the rate of matching to not less than 1% of compensation and must notify participants of this reduction at least 60 days before the plan year starts. The lower match can only be applied in two years out of any five-year period. The second option is for the employer to provide a 2% nonelective contribution for all eligible employees; this means that even if an eligible employee does not contribute to the Simple IRA, that employee must still receive an employer contribution equal to 2% of compensation. If this second option is elected, no employer matching contributions are allowed. The employee may still make an elective salary-deferral contribution. The $260,000 compensation limit is applicable to the nonelective contribution option; it does not apply under the matching contribution option. Because the compensation limit does not apply to the matching formula, the 3% (and match) could be applied to compensation up to $400,000 before reaching the current employee contribution limit of $12,000 for Simple IRAs.

The employer claims a deduction for contributions made under either option. No Federal Insurance Contributions Act (FICA), Medicare, or Federal Unemployment Tax Act (FUTA) taxes are required on employer contributions; however, employee contributions are subject to all payroll taxes. Contributions must be made by the due date of the employer's tax return (including extensions) for the plan year.

As mentioned, elective salary deferrals contributed to an employee's Simple IRA are limited to $12,000 (indexed to inflation) per year, with a catch-up contribution of $2,500 for participants age 50 and older. (Although employers are required to match salary deferrals up to 3%, they are not required to match catch-up contributions.) It should be noted that if the participant is employed elsewhere and contributes to a 401 (k), the Simple contribution applies toward the $17,500 limit on elective deferrals. Employees must decide on the amount of their elective salary deferral during a 60day period immediately preceding the beginning of the plan year or the beginning date of their participation in the plan. An employee can terminate the elective deferral at any point during the plan year; however, plan rules will determine whether an employee can reinstate a deferral prior to the beginning of the next plan year. Certain information must be provided to the employee before the 60-day election period begins.

Employees are fully and immediately vested in all contributions made to the account-both from the employer and the employee. Funds may be withdrawn at any time and will be subject to income tax. Early withdrawals (before age 5 9 Vi) will be subject to a 25% early distribution penalty if the withdrawal occurs during the first two years of participation. After the first two years, the 25% penalty is superseded by the 10% early distribution penalty generally applicable to all IRAs.

Establishing the plan is easy. A prototype plan can be established by completing a Form 5305-SIMPLE (Savings Incentive Match Plan for Employees of Small Employers [SIMPLE]-for Use with a Designated Financial Institution) if the employer will choose the trustee or financial institution, or a Form 5304-SIMPLE (Savings Incentive Match Plan for Employees of Small Employers [SIMPLE]-Not for Use with a Designated Financial Institution) if the employee will be allowed to choose the trustee or financial institution. It is not necessary to file the form with the 1RS; it becomes valid when both the employer and the trustee or financial institution have signed it. Financial institutions authorized to hold and invest Simple IRA contributions include banks, savings and loan associations, insurance companies, certain regulated investment companies, federally insured credit unions, and brokerage firms.

All Simple plans are maintained on a calendar-year basis, and certain notifications must be provided to each employee in a timely manner. The plan must provide a 60-day election period that immediately precedes January 1 (i.e., November 2 to December 31). If the plan is established and begins during the year, the 60-day period occurs before the first day an employee becomes eligible to participate in the Simple IRA plan. Employees must be notified prior to this election period of their right to make or change an elective salary deferral and of the employer's intention to make a matching or nonelective contribution; in addition, they must receive a summary plan description (provided by the trustee financial institution).

Automatic enrollment is a plan feature that allows employers to automatically deduct an elective deferral from employees' paychecks to be contributed to their account. The percentage or amount of the automatic deduction is stated in the plan. Employees can opt out or change the amount of the automatic deduction at their discretion. The plan may allow an employee to withdraw automatic contributions and earnings within 90 days of the first automatic contribution (1RS Notice 2009-66, Automatic Enrollment in Simple IRAs).

An employer sponsoring a Simple may choose to use a 401 (k) plan as a savings vehicle in place of an IRA. These plans are subject to additional administrative burdens and are very rare in practice. The contribution limit of $12,000, with a catch-up contribution of $2,500, is applicable to either a Simple IRA account or Simple 401(k) account. This is above the traditional IRA limit of $5,500 with a catchup of $1,000, and it is lower than the $17,500 limit and catch-up of $5,500 for traditional 401 (k) plans. Unlike Simple IRAs, a participating employee may take a loan from a Simple 401 (k). The contribution and deduction limits applicable to the employer are the same as those for the Simple IRA plan.

Which Plan Is More Appropriate?

Although both the SEP and Simple are easy to establish and inexpensive to maintain, certain distinguishing features might lead a small business owner to choose one over the other. Moreover, certain preexisting conditions might prevent an employer from choosing one of these plan types-for example, an employer with more than 100 employees would have to choose a SEP. For companies that pass the 100-employee limit after establishing a Simple, tax mies allow for a two-year grace period to reduce the workforce below the limit; however, this might not be optimal for a growing business and would require the employer to terminate the plan. This might be the appropriate time to choose a SEP plan. The Simple rules also prevent an employer from having another plan, aside from one covering members of a collective bargaining unit; thus, an employer wishing to offer more than one plan would prefer the SEP plan.

Self-employed owners contributing to their personal retirement account might prefer to have the higher contribution limits provided by the SEP. There is currently a $40,000 difference between the SEP contribution limit of $52,000 and the $12,000 limit on Simple contributions. This not only reduces the amount that can be contributed; it also affects the amount that self-employed owners can contribute to their own retirement account. In addition, the opportunity to use integration in the SEP plan might allow owners to increase the percentage of compensation contributed to their own account, as compared to employees with compensation below the integration level. Integration is not available for a Simple; thus, employers wishing to maximize their own contributions will prefer the SEP plan.

An additional disadvantage of the Simple is the mandatory contribution requirement. In contrast with the SEP, which gives the employer complete discretion regarding the timing and amount of employer contributions to the plan, the Simple requires an annual contribution from the employer, who must provide the required matching or nonelective contribution every year that the plan is in effect. Given this, a business with significant variability in cash flows will prefer the flexibility of a SEP plan.

The Simple is more restrictive on several factors, but the SEP forces employers to provide more generous coverage mies. The SEP employer must cover any employee who has earned more than $550 in three out of the last five years, whereas the Simple must only cover employees who have earned $5,000 or more in any two previous years and are expected to earn $5,000 in the current year. Although the lower compensation limit may force the SEP employer to include many part-time employees, the longer service period does avoid including shortterm employees.

The pivotal difference between these two plans is the source of contributions-whether they will be entirely from the employer (under the SEP) or will include the employee (under the Simple). Although many factors favor the choice of a SEP plan, it is clear that employers who wish to have employees participate in the retirement savings process will prefer a Simple. The Simple might also be preferable when part-time employees are forced into a SEP plan due to the low compensation limit for eligibility.

Other factors might also play a role in determining an employer's preference for one of these plans. As mentioned above, the Exhibit provides a comparison of the most poignant plan features. A review of these factors will help small businesses owners and their advisor choose and implement a suitable retirement plan. ?

Self-employed owners contributing to their personal retirement account might prefer to have the higher contribution limits provided by the SEP.

Although many factors favor the choice of a SEP plan, it Is clear that employers who wish to have employees participate in the retirement savings process will prefer a Simple.

Linda Burilovich, PhD, CPA, and Howard Bunsis, JD, PhD, CPA, are professors in the department of accounting and finance at Eastern Michigan University, Ypsilanti, Mich.