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If you’re like most small business owners, you consider your business to be anything but small. After all, it took a significant investment to start and you’ve devoted a lot of time to working on it. Your business may be your primary source of income and — on some days — your biggest headache.
When considering a qualified retirement plan for your employees, you may want to consider two plan types that are designed specifically for small businesses: a Simplified Employee Pension (SEP) and a Savings Incentive Match Plan for Employees (SIMPLE).
SEP and SIMPLE plans are attractive employer-sponsored retirement plans because they're easy to set up and inexpensive to administer. There is no complicated paperwork or filing with the Internal Revenue Service (IRS) required. Both SEP and SIMPLE are qualified retirement plans, which means that they can provide significant tax advantages for both you and your employees. (Related: State-mandated retirement plans gain traction)
Let’s take a closer look at each type of arrangement.
SEP IRA plan
A SEP is a written plan designed to allow your company to make contributions toward retirement for you and your eligible employees. SEP-IRAs are individually owned and controlled. Any type of business can establish a SEP-IRA plan, including sole proprietorships, corporations (including S-corporations) and non-profit organizations.
Contributions are made directly into individual retirement accounts that are set up by, or for, each participant. Employer contributions are sent directly to the financial institutions where the IRAs are maintained.
Setting up a SEP-IRA plan is easy and involves a few basic steps:
Step 1 – Create a formal written agreement. A SEP-IRA plan is adopted when a business creates a written agreement authorizing the plan and eligible employees are informed about the plan. IRS Model Agreement Form 5305-SEP can be used and is available from the IRS.
Step 2 – Give all eligible employees information about the plan. Information about the plan must be provided to each eligible employee and all eligible employees of a business with a SEP-IRA plan must participate. Sample forms and communications are available from financial institutions.
Step 3 – Make sure a SEP-IRA is established for each eligible employee. If an eligible employee does not set up a SEP-IRA, you will need to set one up on his or her behalf.
Although the individual retirement accounts are owned and controlled by each employee, the plans are funded with employer contributions only; employee contributions are not allowed.
Key SEP features include:
- Tax advantages – There are a variety of tax benefits with a SEP plan. For the employer, contributions within IRS limits are tax-deductible as a business expense — provided they’re made by the business’s tax filing deadline. Eligible employees benefit because contributions are not included in their gross income for federal income tax purposes. All plan participants benefit because any earnings can accumulate on a tax-deferred basis.
- Contribution flexibility – You don’t have to make contributions to the plan each year and can vary the amount you contribute from year to year. So if your business income fluctuates, you can decide whether — and how much — to contribute. The IRS has special rules for determining the maximum deductible contribution. IRS Publication 560 has complete details.
- Limited financial responsibility – Because each plan participant controls asset distribution and the risk level of their individual accounts, your financial responsibility for the plan is limited.
- Uniform contributions – The employer determines the amount that will be contributed to the SEP-IRAs. Contributions must be uniform (i.e., the same percentage of compensation) for every eligible employee — including the owner(s).
SIMPLE IRA
A SIMPLE IRA plan is designed for employers with fewer than 100 employees. Like a SEP Plan, a SIMPLE IRA plan is not subject to complex discrimination testing or annual reporting requirements. A SIMPLE IRA is a written salary reduction arrangement that allows employees of small businesses to make elective contributions into individual retirement arrangements (IRAs) that are set up for the benefit of each eligible employee.
IRS Form 5304-SIMPLE can be used and will help ensure that your plan is in compliance. It is available from the IRS on their website at irs.gov or by calling the IRS.
Key SIMPLE features include:
- Employee contributions (salary deferral) – All employees, including highly compensated employees, can participate in the plan and defer up to the maximum dollar limits or 100 percent of their compensation, whichever is less for the corresponding year. In addition, individuals age 50 and above may make “catch-up contributions” to their SIMPLE IRA Plan.
- Tax advantages – Employer contributions and employee salary deferral contributions made to an employee’s SIMPLE IRA are tax deductible as a business expense. The amount employees contribute through salary reduction to their SIMPLE IRAs will help reduce their taxable income each year. The money contributed to a SIMPLE IRA accumulates tax deferred until it is withdrawn.
- Flexible employer contributions – You can choose to match employee contributions, dollar-for-dollar, up to three percent of their compensation. Or, you can choose a non-elective contribution equal to two percent of compensation for each eligible employee (whether they participate or not), within IRS limits. The employer contribution election may change each year. Employer contributions are invested directly into each eligible employee’s IRA.
- Limited financial responsibility – Because each plan participant controls asset distribution and the risk level of their individual accounts, your financial responsibility for the plan is limited.
Making Your Decision
While there are other types of retirement plans your small business can establish, SEP and SIMPLE IRAs are compelling options to consider. Both types of plan offer tax advantages and both can help you attract and retain the talent your business needs to keep growing.
Both SEP and SIMPLE IRAs can be funded through a wide range of financial tools, including deferred annuities. A financial professional can help you decide which type of plan works best for your business.
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This article was originally published in November 2016. It has been updated.
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