Sunday, February 8, 2004
 

Getting started

Small-business retirement plans made simple

By Sue Stevens
Morningstar.com

It's easy to neglect setting up a retirement plan when you own your own business. With so many administrative tasks — payroll taxes, health-insurance benefits, bookkeeping — adding one more benefit may seem overwhelming. But retirement creeps up on you much faster than you'd expect. Setting up a retirement plan is essential — and the sooner, the better. Tax incentives for setting up a plan Thanks to EGTRRA, if you set up a plan after Dec. 31, 2001, you may be eligible for a tax credit for 50 percent of the cost of setting up the plan and educating your employees. The maximum credit is $500 per year for up to three years. For additional information, see IRS Publication 560. What are your options? The first step is understanding the pros and cons of the different plans available to you. A lot has changed since the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Details on these plans can be found in IRS Publication 560. Think about your own situation as you consider the following: What is it? A retirement plan that uses an IRA as a funding vehicle. How do you set one up? Either you or your employee opens an account with a fund company, brokerage, bank or other financial institution. You have until the due date of your tax return (including extensions) to set up the accounts. How much can the employer and employee contribute? The employer can contribute up to the lesser of 25 percent of employee compensation (up to a compensation maximum of $200,000) or $40,000 to each participant account. The employer can deduct a maximum of 25 percent of the total compensation paid or accrued during the year to eligible participants in the plan. The employee also can contribute subject to the regular rules regarding IRAs. As an employer, you are not required to make a contribution every year. When you do make a contribution, it can't discriminate in favor of highly compensated employees. Pros: Easy and cost-efficient to set up and maintain. Annual employer contributions are discretionary. No annual IRS forms to file. Contributions can be made after year end (up until tax-filing deadline). Employee has investment responsibility for his or her own account. Cons: Must cover all employees, even part time. No loans allowed. Can contribute more through other types of plans. What is it? A qualified retirement plan that allows an employer to make flexible, discretionary contributions on behalf of employees. How do you set one up? You need a written plan. You can get one from an outside administrator or you can adopt a prototype plan at most mutual-fund companies, banks or brokerages. The plan has to be in place by the end of the calendar year. How much can the employer and employee contribute? The employer can contribute up to 100 percent of compensation (up to a max of $200,000) or $40,000 (whichever is less) to each participant account. The employer can deduct a maximum of 25 percent of the total compensation paid or accrued during the year to eligible participants in the plan. The employee cannot make his or her own contributions to the plan. Pros: Flexible employer contributions — you don't have to contribute every year. Employee has investment responsibility for his or her own account. Cons: More filing requirements for employer. No employee contributions. Can contribute more in other types of plans. Plan has to be set up by year-end. What is it? A qualified plan that sets a fixed percentage contribution that must be met every year. How do you set one up? You need a written plan. You can get one from an outside administrator or you can adopt a prototype plan at most mutual-fund companies, banks, or brokerages. The plan has to be in place by the end of the calendar year. How much can the employer and employee contribute? The employer can contribute up to 100 percent of compensation (up to a max of $200,000) or $40,000 (whichever is less) to each participant account. The employer can deduct a maximum of 25 percent of the total compensation paid or accrued during the year to eligible participants in the plan. Employees cannot make their own contributions to the plan. Pros: There's not much reason to set up this type of plan anymore. It used to be that you needed this plan (paired with a profit-sharing plan) to be able to get to a 25 percent contribution of compensation. Since EGTRRA, you can get to 25 percent with just a profit-sharing plan or a SEP-IRA. Cons: Required employer contributions. Once you set your contribution percentage, you must make contributions. More filing requirements for employer. No employee funding. Can contribute more through other types of plans.

What is it? A qualified retirement plan that allows for salary deductions for employees and matching contributions for employers. How do you set one up? Traditional third-party plan administrators can design a plan or you can go to one of the newer online providers such as Fidelity's e401(k). How much can the employer and employee contribute? Employees can defer up to $12,000 in 2003, with an additional catch-up contribution of $2,000 if they are over age 50. The employer may match a portion of the employee contribution. The match is in addition to the employee contribution, so for example, if you contribute $14,000 in 2003, your employer can add a match on top of that. What is a one-person 401(k)? This is just a traditional 401(k) that avoids some of the problems of nondiscrimination testing by having only one participant. Pros: Employee contributes part of salary. Less financial burden on the employer. Can offer features such as employee loans. Employee has investment responsibility for his or her own account. Cons: More administrative work. More expensive to set up. Can contribute more through other types of plans. What is it? A profit-sharing plan combined with an elective salary deferral, or 401(k), plan. Employer makes the profit-sharing contributions. Employees can defer part of their salary into a 401(k) plan. Employers also can choose to match part of the employee salary deferral. How do you set one up? See rules for profit-sharing and 401(k) plans above. How much can the employer and employee contribute? Employer contributions can go up to the lesser of 100 percent of compensation (up to a compensation limit of $200,000) or $40,000. In addition, the employee can put up to $12,000 into the plan ($14,000 if participant is over age 50). Pros: Allows employees to make contributions through salary deferral, or 401(k), as well as employers to make contributions to the profit-sharing plan. Employee has investment responsibility for his or her own account. Cons: More administrative work by combining the plans. More expense in having two plans. Can contribute more through other types of plans. What is it? A Savings Incentive Match Plan for Employees is a retirement plan available to employers with 100 or fewer employees who received $5,000 or more in compensation for the preceding year. Employees contribute using salary deferral. Employers must contribute a match for all eligible employees. How do you set one up? There are two types of Simple plans: Simple IRAs and Simple 401(k)s. Use IRS Form 5304-Simple or 5305-Simple to set up a plan. Most people set up the Simple IRA because it is less expensive to maintain and has fewer reporting requirements. How much can the employer and employee contribute? Employees can contribute up to 100 percent of compensation up to a maximum of $8,000. Employees can also make catch-up contributions of $1,000 per year. Employers must match contributions from 1 to 3 percent of compensation. Pros: Minimal reporting requirements for the employer. Works well in companies where salaries are relatively low. Inexpensive to set up and maintain. Employee has investment responsibility for his or her own account. Cons: Can't put away as much as with other plans. What is it? A qualified retirement plan where the employer makes contributions based on an actuarial formula. Employer has funding and investment responsibility for the plan. How do you set one up? First you adopt a written plan. Your administrator figures out how much you should contribute each year. The plan must be in place by year-end. The employer chooses how this money is invested within a trust or custodial account. How much can the employer and employee contribute? The employer contributes the actuarially determined amount to provide a benefit that's the lesser of 100 percent of the participant's average compensation for his or her highest-paid three consecutive calendar years or $160,000. You must make quarterly installment payments subject to minimum funding requirements. Pros: Employers can put away more money for employees. Cons: More expensive to set up and maintain. More administrative burden. Employer is responsible for investment choices. What is it? A combination of a pension plan and a defined contribution plan, such as a 401(k) or profit-sharing plan. How do you set one up? See above for each type of plan. How much can the employer and employee contribute? If you contribute to both a defined benefit plan and a defined contribution plan, your deduction is limited to the greater of 25 percent of compensation paid (for the defined contribution plan) or no more than the amount needed to meet the year's minimum funding standard (for the defined benefit plan). If you are self-employed, the rules are even more complicated (see IRS Publication 560). Pros: Allows maximum contributions. Cons: Expensive to set up and maintain. More administrative burden. Note: If you are considering this type of plan arrangement, you also should consider a cross-tested defined benefit cash-balance plan (which is beyond the scope of this article).