IRAs and 401(k)s: How to Pick the Best Plan

EXECUTIVE SUMMARY

RETIREMENT PLANS ARE OFFERED BY a variety of providers, including financial institutions, insurance companies and payroll service providers. But adherence to IRS regulations is the responsibility of the business owner. ANY BUSINESS WITH ONE EMPLOYEE that does not have any other type of retirement plan can set up a simplified employee pension-IRA plan. All contributions to SEPs come from the employer. SEPs are easy to set up and maintain, and do not require an annual tax return. THERE ARE TWO TYPES OF SAVING INCENTIVE match plans for employees: the SIMPLE IRA and the SIMPLE 401(k). They require little documentation and no annual tax filing. But employers must make annual contributions to employee accounts. Employer and employee contributions both are vested immediately. THE TRADITIONAL 401(k) PLAN carries the most reporting requirements and is the most costly to administer. It is better for employees because they can make contributions every year, even if the employer does not. Administration of 401(k) plans is complicated by annual compliance testing and a required annual tax return. SAFE HARBOR 401(k) PLANS are an attractive alternative for a business that wants a 401(k) plan, but does not want to or is not able to satisfy the annual discrimination testing required by traditional plans. The price to be paid is a safe harbor contribution made to all employee accounts.

CYNTHIA SCARINCI is assistant professor of accounting at the College of Staten Island, The City University of New York. Her e-mail address is cascarinci@aol.com .

PAs with small business clients—or those with decision-making responsibilities for smaller companies—often are called upon to evaluate pension plan options. This article will help by outlining the key features of retirement plans that can be implemented by small businesses: the simplified employee pension-IRA (SEP-IRA); the savings incentive match plan for employees (SIMPLE), IRA and 401(k); the traditional 401(k); and the safe harbor 401(k).

THE REGULATIONS
The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 offers tax credits to any business with 100 or fewer employees that establishes a pension plan. Such businesses are eligible for credit up to 50% of the first $1,000 spent on retirement education and administration, to a maximum of $500 per year for the first three years. Eligible employees must have received $5,000 in compensation, and there must be at least one “highly compensated” employee who owned more than a 5% interest in the business at any time during the previous year or who receives compensation of more than $95,000 in 2005 (increased from $90,000 for 2004).

The law also includes a provision enabling employees age 50 or older to “catch up” by making incremental contributions to compensate for any years in which they did not participate in a pension plan. Another provision offers a tax credit to low-income participants; they can receive a nonrefundable tax credit of up to 50% on up to $2000 in contributions to specified plans, for a maximum credit of $1,000. This credit is in addition to the tax deduction already associated with contributions to such plans.

In order to ensure that all retirement plans have a representative balance of participants and are not dominated by higher-paid employees, they are subject to annual top-heavy testing (IRC section 416(g)). (See “ Top-Heavy Testing and Key Employees. ”) If a plan becomes top-heavy, the employer must provide a minimum contribution to all nonkey employees, based on how much they have contributed to the plan—out of their own salaries or in the form of employer contributions—during the year. CPAs therefore should remind their small business clients that it’s up to the plan administrator to keep a keen eye on account values throughout the plan year and notify the employer if the plan is in danger of becoming top-heavy.

To make it less likely that a plan would be deemed top-heavy, the EGTRRA narrowed the definition of key employees by nearly doubling the compensation limit from $67,500 in 2000 to $130,000 in 2001. It also allowed companies to count matching contributions toward satisfying the minimum contribution requirements.

The top-heavy rules are particularly harsh on small businesses that employ family members; they discriminate by treating all family members as key employees, regardless of salary level and percentage of ownership (IRC section 318). This makes it difficult for family-based small businesses to pass top-heavy testing and continues to be a major deterrent to their implementing pension plans.

ONE SIZE DOESN’T FIT ALL
In recommending and researching retirement plan options, CPAs should pay special attention to the unique needs of the small business employer. (See “ The CPA’s Retirement Plan Checklist. ”) In addition to size constraints, individual businesses face varying earnings, profit levels, number and age of employees, industry, business location, employee turnover, regulations, etc. A major concern is the uncertainty of future revenues. Without reliable, consistent earnings, a business cannot support a plan that requires an annual commitment to contributions by the employer. Pension plans are far from a “one-size-fits-all” product. CPAs should ensure that any plan selected is well-suited for the individual needs of the employer under its current circumstances and that it is flexible enough to remain effective if circumstances should change.

RETIREMENT PLAN OPTIONS
To give CPAs some insight into the challenge facing their small business clients, we asked six pension plan providers (financial institutions, insurance companies and payroll service providers) for recommendations in selecting a plan for a business with 10 full-time employees and an estimated annual payroll of $450,000 to $600,000. We used 10 employees because it was representative of employers that statistically have not provided plans. We selected the payroll total by using average annual earnings of small business employees of $30,000, and a supplement of approximately $150,000 for one or two more highly compensated owner/executives.

Five of the providers recommended a SEP-IRA, SIMPLE IRA or SIMPLE 401(k) and one suggested either a safe harbor or traditional 401(k) plan. Although pensions are usually implemented and maintained by plan providers, CPAs can assist their clients or employers in the selection process.

Here’s a rundown of the options:

The SEP-IRA
Best suited for: Small businesses that do not have any other type of retirement plan, have a small part-time staff and are comfortable completely funding the company pension plan.

Plan details. Small businesses can set up a SEP-IRA plan by completing IRS form 5305-SEP, or its equivalent, which may be obtained from any retirement plan provider. The IRS form requires a calendar-year plan while non-IRS forms permit businesses to opt for a fiscal-year plan instead.

A SEP-IRA is based only on employer contributions. The 2004 maximum annual contribution was 25% of the employee’s compensation or a maximum of $41,000 ($42,000 for 2005). Vesting is immediate. Any employer with one or more employees may establish a SEP-IRA. Any employee who is at least 21, has been employed for three of the five preceding years and has earned a minimum of $450 in the current year is eligible to participate.

There are three formulas that may be used to allocate contributions to a SEP-IRA: a flat dollar amount, a specified percentage of eligible compensation or a Social Security integration formula. With the first formula each employee receives a contribution of the same dollar amount. Under the second formula, every employee receives a contribution of the same percentage of eligible compensation. If the employer decides on 10%, then all employees receive a contribution amounting to 10% of their eligible compensation, not to exceed the IRS limitation of $41,000.

Using the Social Security integration formula, the employer assigns to the plan a percentage of the accumulated total of all eligible employees’ compensation, then, using a special formula, allocates a percentage to each eligible employee. The allocation must be made according to specific IRS-provided requirements or the SEP may be disqualified. Social Security integration provides the higher-paid employees with a larger percentage of the contribution.

Plan advantages. SEP-IRAs are easy to set up and maintain and no annual tax return is required. The employer contribution is optional, which eliminates the problem of required contributions in years when cash flow is a problem.

Plan disadvantages. Employee accounts are completely funded, or not, by the employer. Part-time employees and those who have earned only $450 in annual compensation and met other minimal requirements must be included.

SIMPLE Plans
Best suited for: Small businesses that have a consistent, reliable, positive earnings stream.

Plan details. There are two types of SIMPLE plans: a SIMPLE IRA and a SIMPLE 401(k). For both types, employees may contribute up to $9,000 for 2004 and $10,000 for 2005; the catch-up contribution for employees age 50 and older is $1,500 for 2004 and $2,000 for 2005. In SIMPLE IRA plans the employer must match up to 3% of employee pay or make a 2% nonelective contribution. In SIMPLE 401(k) plans the employer also must match the first 3% of deferred compensation.

Plan advantages. SIMPLE plans require little documentation and no annual tax filing. A plan is established by completing IRS form 5305-SIMPLE or an equivalent obtained from a retirement plan provider. Again, the non-IRS form permits a fiscal-year plan while the IRS form requires a calendar year. Employer and employee contributions are both vested immediately.

Plan disadvantages. Because of the annual mandatory employer contribution to employee accounts, employers who have concerns about irregular earnings streams must be wary of SIMPLE plans. It is possible to reduce the contribution percentage in designated years, but not to zero.

Traditional 401(k) Plans
Best suited for: Small business clients with irregular earnings streams that cannot support a plan with required contributions.

Plan details. Established about 20 years ago, the traditional 401(k) carries the most reporting requirements among the plans discussed here and is the most costly to administer. Employees make contributions to their 401(k) plans from pretax earnings. Employers can offer matching contributions but are not required to do so unless there is an imbalance in the plan that favors highly compensated employees. Employers may contribute a flat dollar amount, a share of the profits or a matching contribution.

Both SIMPLE and 401(k) plans are free from federal taxation but are subject to FICA and Medicare contributions. The traditional 401(k) plan is better for employees because it allows them to control the amount being set aside for retirement. Even if the employer chooses not to contribute in any particular year, employees still can. Employees also can contribute more to a 401(k) plan than they can to a SIMPLE plan. For 2004, 401(k) plan participants can contribute up to $13,000, plus an additional $3,000 per year catch-up contribution if they are 50 or older and meet additional requirements. For 2005, the maximum contribution is $14,000 plus a $4,000 catch-up. Employee contributions are vested immediately, while employer contributions may vest over time, according to plan schedules. If required contributions are made because the plan is top-heavy, the plan must adhere to an accelerated vesting schedule outlined by the IRS, unless the plan’s vesting schedule is more liberal.

401(k) costs. Administration of a 401(k) plan is complicated by the need for an annual tax return and annual compliance testing. Many small business employers turn the administrative duties over to the plan provider, but even if they do the IRS says it is the employer’s responsibility to ensure that the plan is administered properly and fairly.

The plan providers we contacted said a 401(k) plan for a 10-employee company costs approximately $2,000 per year to administer, not including initial set-up costs or the cost of loan features. Some providers charge a per employee fee for administration in addition to monthly, quarterly or annual fees. Internet-based providers charge lower fees, and they predicted that fees will continue to fall as administration becomes more and more Internet-based.

The 401(k) plan was not a very popular choice for small business owners in the past because of its higher administration cost and the complexity of annual testing and filing of form 5500. Several plan providers we contacted suggested that small businesses consider outsourcing retirement plans to their payroll plan administrator, who already has access to the necessary payroll data. This reduces the cost to the employer and allows the employer and employees to deal with only one entity for both services.

Another way to keep costs down is to offer only a few carefully selected mutual funds as investment vehicles instead of a large variety. A study by the Pension Research Council showed that retirement plan participation was higher in plans that offered a handful of options, as opposed to 10 or more choices.

401(k) compliance tests. 401(k) plans are subject to top-heavy tests in addition to others specified by the IRS to ensure they maintain a balanced participation of highly compensated and non-highly compensated employees. IRC section 415 limits the annual amount that can be added to a participant’s account from all sources for 2005 to the lesser of their entire earnings or $42,000; for 2004 it was the lesser of their entire earnings or $41,000. IRC section 404 limits the maximum an employer can contribute to 25% of the company’s payroll.

Compliance tests such as the actual deferral percentage test (ADP test—IRC section 401(k)(3)) and the actual contribution percentage test (ACP tests—IRC section 401(m)(2)) prevent employers from designing 401(k) plans that benefit only highly paid personnel. The ADP test compares the percentage of salaries the different classes of employees have contributed to the plan. The ACP test compares the percentage of employer contributions in the 401(k) accounts for the different classes of employees. If contributions for highly compensated employees are more than the test limits, the employer may have to pay a 10% excise tax (see IRC section 4979).

IRS publications 4224 and 4050 provide information on correcting plans that are not in compliance so they maintain their tax-favored status.

Plan advantages. Employers are not required to contribute to the plan unless it is top-heavy. Employers wishing to contribute have the choice of making a matching contribution, profit sharing or a flat dollar contribution. Employees have the advantage of contributing pretax dollars to their accounts, which are vested immediately. The 401(k) plan allows for the highest permissible employee deferral of income and the highest catch-up contributions of all the plans.

Plan disadvantages. Administration costs are the highest of all the plans and require the most complex testing. In addition, the employer must file an annual tax return for the plan.

The Safe Harbor 401(k)
Best suited for: Employers with consistent earnings streams that can support a plan with annual required contributions. This is an attractive alternative for the business that wants the benefits of a 401(k) plan but does not want to or is not able to satisfy the required annual compliance testing. It’s a very good option for family-based businesses that can meet the required criteria.

Plan details. The safe harbor plan is a means provided by the IRS to permit employers to achieve balanced participation in a 401(k) plan without the need for compliance tests. Rather, employers must make matching contributions to employee retirement accounts, or nonelective contributions (which are immediately vested) equal to 3% of each employee’s annual compensation. The contributions are nonelective because they are made to all eligible employees, regardless of whether they participate in the company’s 401(k) plan.

Matching contributions are made only to the accounts of active 401(k) plan participants. A dollar-for-dollar match must be made on salary deferrals up to 3% of compensation for each non-highly compensated employee, and a 50-cent-on-the-dollar match must be made on salary deferrals from 3% to 5% of compensation. The rate of any matching contributions being made to highly compensated employees cannot exceed that being made to non-highly compensated employees.

Employers choosing to make nonelective contributions can decide as late as 30 days before the end of each plan year whether to take the safe harbor route. Employers opting for the matching contributions must inform employees no later than 30 days before the beginning of the plan year, so they have time to determine their contribution rate.

Plan advantage. Offers all the benefits of traditional 401(k) plans but does not require mandated testing. Can be set up just 30 days in advance of the new plan year.

Plan disadvantage. Required annual contributions are the premise of this plan, so it is not a good option for CPAs to recommend to employers that do not have consistent earnings.

THE ROLE OF THE CPA
Since most people focus on the short term, it’s easy to lose sight of the future benefits that retirement planning yields until it’s too late. CPAs have a responsibility to educate small business employers and employees of the benefits of joining a retirement plan to the company and its employees.

CPAs should remember when advising small business clients that the best way to present information is in a brief and simple fashion. Small business owners often are bound by strict time constraints because of their limited staff. The key is to inform these clients without overwhelming them. The involvement and support of employers is imperative for promoting confidence in the plan and its sponsor.

Small Business Retirement Plan Options