Learn about the various IRA based employer retirement plans.
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Simplified Employee Pensions (SEPs)
Simplified Employee Pension (SEP) plans can provide a relatively simple and easy was for business owners to set aside money in retirement accounts for themselves and their employees.
A SEP does not have the start-up and operating costs of a conventional retirement plan and allows for a contribution of up to 25 percent of each employee’s pay.
Contributions are made to each plan participant’s Traditional IRA. A new Traditional IRA can be set up for each participant or the employer can make contributions to a participant’s existing Traditional IRA. Some, including the IRS, often refer to participant’s Traditional IRA to which SEP contributions are made as a SEP-IRA, but it is really just a Traditional IRA. A Traditional IRA can receive both SEP contributions from the employer and regular individual contributions from the IRA account owner.
Advantages of SEPs:
- Easy to set up and operate
- Can be established after the end of the employer’s tax year
- Low administrative costs
- Flexible annual contributions – good plan if cash flow is an issue
- Available to any size business
- Easily established. The IRS has provided a model document Form 5305-SEP .*
- No filing requirement for the employer (such as Form 5500)
- Only the employer contributes (no employee contributions required or permitted)
- Contributions are made to each employee’s Traditional IRA (sometimes referred to as a SEP-IRA)
- Employees make their own investment decisions and are always 100% vested in (or, has ownership of) all SEP-IRA money
- In-service withdrawals are permissible, but are included in income and subject to a 10% additional tax if under age 59 1/2.
* If Form 5305-SEP is used, the employer cannot have leased employees or have any other retirement plan (except another SEP). Special rules apply if the employer is a member of a controlled group or affiliated service group. A SEP prototype or an individually designed SEP plan document can also be used.
Disadvantages of SEPs:
- Employees are not permitted to contribute
- Employer must contribute equally for all eligible employees.
- Total contributions to each employee’s SEP-IRA are limited.
- Participant Loans are not permitted. The assets may not be used as collateral.
What is involved in establishing and administering a SEP?
Remember, a SEP is an employer sponsored retirement plan. Only a business can establish a SEP.
There are three steps to establishing a SEP. The employer must
- Adopt a SEP plan (a written formal agreement between the employer and the employees).
- IRS Model SEP Form 5305-SEP
- IRS approved prototype (offered by banks, trust companies and other financial institutions)
- Individually designed SEP, usually prepared by an attorney
- Notify the employees that the SEP plan has been adopted. (If Form 5305-SEP was used, see the instructions to the form.
- Verify that each employee has a Traditional IRA (existing or new) to which the employer will make contributions.
In administering a SEP, the employer must
- Determine which employees are eligible participants.
- Determine the contribution that must be made to each participant’s IRA
- Make the contribution to each participant’s IRA
How does a SEP work?
Jed works for the Rambling RV Company. Rambling RV decides to establish a SEP for its employees. Rambling RV has chosen a SEP because the RV industry is cyclical in nature, with good times and down times. In good years, Rambling RV can make larger contributions for its employees and in down times it can reduce the amount. Rambling RV’s contribution rate (whether large or small) must be uniform for all employees. Jed, an employee, cannot contribute because SEPs only permit employer contributions.
Savings Incentive Match Plans (SIMPLEs)
Savings Incentive Match Plans (SIMPLEs) can provide a relatively simple and easy was for business owners to set aside money in retirement accounts for themselves and their employees. SIMPLE plans do not have the start-up and operating costs of a conventional retirement plan.
- Available to any small business – generally with 100 or fewer employees
- Easily established by adopting Form 5304-SIMPLE, 5305-SIMPLE, a SIMPLE prototype or an individually designed plan document
- Employer cannot have any other retirement plan
- No filing requirement for the employer
- Employer is required to contribute each year either a:
- Matching contribution up to 3% of compensation (not limited by the annual compensation limit), or
- 2% nonelective contribution for each eligible employee
- Under the “nonelective” contribution formula, even if an eligible employee doesn’t contribute to his or her SIMPLE IRA, that employee must still receive an employer contribution to his or her SIMPLE IRA equal to 2% of his or her compensation up to the annual limit of $255,000 for 2013 (subject to cost-of-living adjustments in later years)
- Employees may make contributions (deferrals) through a salary reduction agreement with the employer
- Employer is required to contribute each year either a:
- Employee is always 100% vested in (or, has ownership of) all SIMPLE IRA money
Advantages of SIMPLEs:
- Inexpensive to set up and operate
- Employees may contribute (through a salary reduction agreement with the employer)
- Employees share responsibility for their retirement
- No discrimination testing required
- Somewhat flexible employer contributions
- An employer generally has no filing requirements.
- In-service withdrawals are permissible, but are included in income and subject to a 10% additional tax if under age 59-1/2. Also, if withdrawals are made within the first two years of participation, the 10% additional tax is increased to 25%.
Disadvantages of SIMPLEs:
- Although the acronym would imply that operating the plan is simple, SIMPLEs have more complicated rules than a SEP. The employer should consider seeking help from a tax or benefits expert when considering a SIMPLE.
- The employer may not have any other plans.
- Employer must contribute and employees may contribute.
- Total contributions to each employee’s SIMPLE IRA are limited.
- Participant loans are not permitted. The assets may not be used as collateral.
- Lower contribution limits than some other retirement plans
- Employees may not make contributions to their SIMPLE IRAs.
How does a SIMPLE plan plan work?
Elizabeth works for the Rockland Quarry Company, a small business with 50 employees. Rockland has decided to establish a SIMPLE plan for its employees and will match its employees’ contributions dollar-for-dollar up to 3% of each employee’s compensation. Under this option, if a Rockland employee does not contribute to his or her SIMPLE IRA (through a salary reduction agreement), then that employee does not receive any matching employer contribution.
Elizabeth has a yearly compensation of $50,000 and completes a salary reduction agreement under which her employer reduces her compensation by 5% ($2,500) and contributes $2,500 to her SIMPLE IRA. The Rockland matching contribution is $1,500 (3% of $50,000). Therefore, the total contribution to Elizabeth’s SIMPLE IRA that year is $4,000 (her $2,500 contribution plus Rockland’s $1,500 contribution). The financial institution holding Elizabeth’s SIMPLE IRA has several investment choices and she is free to choose which ones suit her best.
Austin works for the Skidmore Tire Company, a small business with 75 employees. Skidmore has a SIMPLE IRA plan for its employees and will make a 2% nonelective contribution for each of them. Under this option, even if a Skidmore employee does not contribute to his or her SIMPLE IRA, that employee would still receive an employer contribution to his or her SIMPLE IRA equal to 2% of compensation.
Austin’s annual compensation is $40,000. Even if Austin does not contribute this year, Skidmore must still make a contribution of $800 (2% of $40,000).