Types of plans

There are basically three different types of retirement plans for small businesses that have been designated by the Internal Revenue Service (IRS) to receive special tax treatment:

• SEP (Simplified Employee Pension) plans
• SIMPLE (Savings Incentive Match Plan for Employees) plans
  • SIMPLE IRA plans
  • SIMPLE 401(k) plans
• Qualified plans (including Keogh or H.R. 10 plans)

Tax benefits

The potential tax benefits that can be gained by setting up one of these plans are:

• Your business can take a tax deduction for qualified contributions to the retirement plan.
• By making elective contributions to their retirement accounts, your employees can defer part of their taxable compensation, lowering their income tax in the current year.
• You personally can also defer part of your net earnings from self-employment by contributing to your own retirement account.
• Earnings on the contributions are generally tax free until you or your employees receive distributions from the plan.
• Your business can take a tax credit for part of the cost of setting up the plan.

How each type of plan works

With a SEP plan, you can make contributions directly to individual retirement accounts set up for each of your employees. These can be the employees’ traditional Individual Retirement Accounts (IRA), or Individual Retirement Annuities (SEP-IRA) that you set up for each eligible employee.

Under a SIMPLE plan, employees can choose to contribute part of their salary to a retirment account rather than receiving it as part of their pay. You, as their employer, then make matching or nonelective contributions. There are two types of SIMPLE plans: the SIMPLE IRA plan and the SIMPLE 401(k) plan.

Qualified plans are more complex than the SEP and SIMPLE plans, but they are generally more flexibile and there may be increased contribution and deduction limits in some cases. These plans are sometimes referred to as Keogh or H.R.10 plans. There are two basic kinds of qualified plans: defined contribution plans and defined benefit plans. In a defined contribution plan, a certain amount is contributed to the employee’s retirement account and benefits are based on the amount contributed and accumulated in the employee’s retirement account. In a defined benefit plan, the benefits are pre-determined, and contributions are made based on what is needed to provide those benefits.

What type of plan to set up

In determining which type of plan to set up, you may want to consider how many employees you have, whether all or most of your employees already have an IRA set up, how you want to contribute to your own retirement account, whether your employees would be interested in deferring part of their salaries into a retirement account, how much your business intends to contribute to the employees’ retirement accounts, and how complex it is for your business to set up a particular plan. You should also consider that the different plans have different maximum allowable contributions and different maximum deductions that your business can take for its contributions.

SEP (Simplified Employee Pension)

How to set up a SEP plan

You will need a written plan that allows your business, as the employer, to make contributions toward your own retirement account (as a self-employed individual) and toward all your eligible employees’ retirement accounts. Most banks and other financial institutions can help you with this plan.

For a SEP, the written plan allows your business to make contributions to the financial institution where each eligible employee has his or her IRA. Eligible employees are all individuals who are 21 years of age or older, have worked for you in at least 3 of the last 5 years, and have received at least $450 in compensation. If an employee does not have an IRA, a SEP-IRA can be set up. SEP-IRAs can be set up for employees at banks, insurance companies, or other qualified financial institutions. Roth IRA’s are not eligible to receive contributions from a SEP plan.

You can satisfy the written plan requirement for a SEP by completing IRS Form 5305-SEP. Once you complete this form, you should keep it for your records. It does not need to be filed with the IRS. Form 5305-SEP can be downloaded from the IRS website at www.irs.gov.

Once you complete and sign the written plan, each eligible employee should be given information about the plan. If you use Form 5305-SEP, give each employee a copy.

How much you can contribute to a SEP plan and claim as a deduction

You are not required to make contributions every year, but when you do, the percentage of compensation that you contribute must be the same for all employees, and must not be more than 25% of the employee’s compensation, up to a certain maximum limit. Annual limits on the amount of compensation for which you can make contributions may change from year to year and are published by the IRS.

The contributions you make under a SEP are generally are not taxable to the plan participants. You do not need to report your SEP contributions on the employees’ W-2 statements. But, if you contribute more than the maximum amount allowable, the excess must be included in the employees’s taxable compensation, and you may be subject to a 10% excess tax.

Your business contributions to your own SEP-IRA, as a self-employed individual are also subject to annual limits, but special rules apply. Your deduction for contributions to your own SEP-IRA, as a percentage of your net earnings, and your net earnings themselves, depend on each other. So you have to do a special calculation to determine your maximum deduction. You can do this by completing the Rate Table for Self-Employed or the Rate Worksheet for Self-Employed that can be found in Publication 560 – Retirement Plans for Small Business.

SIMPLE (Savings Incentive Match Plan for Employees) IRA Plan

How to set up a SIMPLE IRA plan

You can set up a SIMPLE IRA plan for your business if you had 100 or fewer employees who received at least $5,000 in compensation for the preceding year. Once established, the employees eligible to participate in the plan are those who received at least $5,000 in compensation during any 2 years preceding establishment of the plan, and who are reasonably expected to receive at least $5,000 in compensation during the current year. These are the most restrictive conditions you can apply. You can establish less restrictive requirements to allow more employees to participate, for example by setting the compensation level at less than $5,000.

Like the SEP plan, a SIMPLE plan must be a written arrangement. Financial institutions can help you set up the plan. You can also use the IRS model on Form Form 5304-SIMPLE or Form 5305-SIMPLE. Which form you use depends on whether you select one financial institution where the business will make all the contributions, or you let your employees select their own financial institution where they want to receive the contributions. Use Form 5304-SIMPLE if you allow each plan participant to select the financial institution for receiving his or her plan contributions, and Form 5305-SIMPLE if you require that all contributions be deposited initially at a financial institution that you, as the employer, designate. The SIMPLE IRA plan is adopted when you have completed the form and you as the employer and the designated financial institution, if applicable, have signed it. Keep the original form for your records. You do not need to file it with the IRS.

All employees will need to have SIMPLE IRAs set up for them. The IRS provides model formats that can be used for this purpose: Forms 5305-S, SIMPLE Individual Retirement Trust Account, and 5305-SA, SIMPLE Individual Retirement Custodial Account. Roth IRAs set up by employees do not qualify to receive contributions under a SIMPLE plan.

When you adopt a SIMPLE IRA plan, you need to notify the employees of the following:

1. The employees’ option to decide how much of their salary they want contributed to the plan, and to change that amount
2. Your choice, as employer, whether you make matching contributions or nonelective contributions that you determine
3. A summary description of the plan
4. Written notice that employees can transfer their balances from a financial insitution that you designate, without incurring any cost or penalty

How much you can contribute to a SIMPLE IRA plan and claim as a deduction

Contributions to the employees’ SIMPLE IRA plan accounts consist of the amounts the employees contribute through salary reductions, and the amounts you contribute as matching or nonelective contributions. Employees can choose to contribute a percentage of their compensation, or a fixed amount, up to a maximum per year. These annual limits are published by the IRS and can be found in IRS Publication 560, Retirement Plans for Small Business.

As the employer, you are generally required to match each employee’s contribution on a dollar-for-dollar basis up to 3% of the employee’s compensation. If you decide to make nonelective contributions, you contribute 2% of each eligible employee’s compensation, whether or not they make their own contributions.

The contributions you make to your own SIMPLE IRA as a self-employed individual consist of the percentage of your net earnings from self-employment that you choose to contribute, plus either the matching contribution of up to 3% of your net earnings, or the nonelective contribution of 2% of your net earnings. In other words, your own contribution is treated the same as for other employees, except that your contribution is based on your net earnings rather than on compensation.

Employees are not subject to federal income tax on the amounts they elect to contribute to the SIMPLE IRA plan, or on the contributions you make as the employer. Salary reduction contributions are subject to Social Security, Medicare and federal unemployment taxes, but the matching or nonelective contributions you make as the employer are not subject to these taxes.

SIMPLE 401(k) plan

How to set up a SIMPLE 401(k) plan

A SIMPLE 401(k) plan has to meet two basic qualification requirements. First, you must have a written plan, which can be an IRS prototype or an individually designed plan. Banks, insurance companies, mututal funds and other financial institutions can help with the plan. Second, the plan’s assets will need to be invested in a trust or custodial account. This is set up by a legal instrument, and you may need to ask for legal assistance with this. Once the plan is established, the notifications that you must give to your employees are the same as those that apply for a SIMPLE IRA plan.

How much you can contribute to a SIMPLE 401(k) plan and claim as a deduction

Contributions to a SIMPLE 401(k) plan are made through employees’ salary deductions, and matching or nonelective contributions by you as the employer, just as they are under a SIMPLE IRA plan.

Qualified Plans – Keogh or H.R. 10 Plans

How to set up a Qualified Plan

As in the case of a SIMPLE plan, there are two different types of qualified plans, in terms of how contributions are made - defined contribution plans and defined benefit plans. A defined contribution plan can be either a profit-sharing plan or a money purchase pension plan.

A profit-sharing plan is for sharing your business profits with your employees, but you can still have a profit-sharing plan even if contributions to the plan do not come out of your business profits. There does not have to be a definite formula for determining the profits to be shared, but there must be a formula for systematically allocating contributiions among the employees and for distributing accumulated funds to the employees. There is more flexibility in making contributions under a profit-sharing plan than there is under a money purchase pension plan or a defined benefit plan.

In a money purchase pension plan, contributions are fixed, for example as a percentage of employee compensation, regrdless of whether your business has a profit. This includes contributions to your own pension fund as a self-employed individual, in which case your contribution is based on your net earnings from the business.

In a defined benefit plan, contributions are based on what is needed to provide certain pre-determined benefits to plan participants. This requires actuarial assumptions and calculations, and you may need ongoing assistance to maintain this type of plan.

A qualified plan, just like a SIMPLE 401(k) plan, has to meet two basic qualification requirements. First, you must have a written plan, and second, the plan’s assets will need to be invested in a trust or custodial account.

If your plan is a money purchase pension plan or a defined benefit plan, there are minimum funding requirements. You will have to make quarterly installment payments to cover the amount needed to fund the defined benefits, calculated based on the actuarial assumptions.

How much you can contribute to a Qualified Plan and claim as a deduction

There are limits on the amount you can contribute to the plan each year, and there are also limits on the amount of benefits that can be paid.

In a defined benefit plan, annual benefits cannot exceed the greater of 100% of the the participant’s average compensation for his or her highest 3 consecutive calendar years, or a fixed dollar amount for the year. This amount generally changes each year and is published by the IRS.

In a defined contribution plan, the annual contributions cannot exceed the greater of 100% of the employee’s compensation, or a fixed dollar amount (also published by the IRS each year, but different from the amount for a defined benefit plan).

Under a qualified plan, participants can make their own contributions, but they are not tax-deductible. Even though the contributions are not deductible, earnings on the contributions can accumulate tax-free until they are distributed.

You can usually deduct contributions you make to a qualified plan, including those you make for your own retirement, subject to certain limits. The contributions (and the earnings on them) are generally tax free until they are distributed. The deduction limit for your contributions to a qualified plan depends on the kind of plan you have.

For a defined contribution plan, either a profit-sharing plan or a money purchase pension plan, your deduction for contributions cannot be more than 25% of the compensation paid to your eligible employees during the year.

For a defined benefit plan, the deduction for contributions is based on the actuarial assumptions made and the calculations done in order to determine the amount of contributions required to cover the pre-determined benefits. In order to determine the deductible contributions you make for your own retirement as a self-employed individual, you need to make a special calculation. You can do this by using either the Rate Table for Self-Employed or the Rate Worksheet for Self-Employed in IRS Publication 560 - Retirement Plans for Small Business, and then figuring your maximum deduction on the Deduction Worksheet for Self-Employed.

How do you claim the deduction for contributions to small business pension plans

The way you report and claim the deduction is the same for all three types of plans. If you are a sole proprietor, you deduct the contributions as a business expense on Schedule C - Profit or Loss from Business, or on Schedule F - Profit or Loss from Farming. You can deduct your business contribution for your own retirement as an adjustment to income in determining your adjusted gross income on Form 1040.

Tax Credit for Pension Plan Startup Costs

You may also claim a tax credit of 50% of the costs involved in setting up and administering a SEP, SIMPLE, or qualified plan, and educating employees about the plan, up to a maximum of $500 per year for each of the first 3 years of the plan. To take the credit you need to complete and file Form 8881 - Credit for Small Employer Pension Plan Startup Costs.

Final Note

Setting up a retirement plan for your small business does not have to be a complex process. You can choose the type of plan that most closely fits the needs of your business. By setting up a retirement plan, you will be providing an important benefit to your employees, and you can use the tax breaks available, which are intended to encourage saving for retirement by small business owners and their employees.