Lesson 5 - How to set up a retirement plan for yourself and your employees
Retirement plans? I just started my business. Why do I need to start thinking about a retirement plan? I already have too many things to think about, Braces, summer camp, college. Then there's the mortgage, and I was hoping to buy a boat. Besides, I just started my business, and it's taking every extra penny I have. I don't have the money to set aside for retirement. But maybe if I don't start now, I won't be able to retire at all. What's the use of a boat if I'm still working and never able to use it? But even if I wanted to set up a retirement plan for myself-- and my employees if I ever have any-- how do I go about it?
Welcome to How to Set Up a Retirement Plan for You and Your Employees.
In this lesson, we'll help Mark, and you, navigate your way through some of the various retirement plan options. And, as always, we'll provide you with IRS resources for more information so you can make the best informed decision for your situation. Mark had some good reasons for not wanting to think about retirement plans at this stage of his business, but he thought of even better reasons why a retirement plan would be a good investment-- both for him and for any potential employees.
Just like Mark, you may not have thought yet about taking steps to set up a retirement plan, so consider this: experts say that to maintain the same lifestyle during your retirement years, you'll need an income of at least 60 to 80 percent of the income you earned while working. And, the lower your income now, the higher percentage of it you'll need in retirement. And here's another thought: unlike Mark wanting some time on his boat, sometimes when we retire isn't as much a choice as a necessity. Health issues, family issues-- or other issues beyond your control-- may require you to cut back on your working hours or even force you to sell or shut down your business. But you'll still need an income.
To have a retirement savings plan separate from your business investment will not only benefit you, but your employees as well: if you have a plan that allows employee contributions, those contributions can reduce your employees' current taxable incomes. That means that what employees pay into the plan isn't taxed until it is withdrawn. Plus, contributions can be made through employees' payroll deductions. Finally, just like you, employees will have the opportunity to improve their financial security in retirement. Now that we've convinced Mark, and you, about the benefits of setting up a business retirement plan, let's get started.
Selecting a Plan for You and Your Business
The first step is selecting a plan that makes sense for you and your business. The IRS Publication 3998, Choosing a Retirement Solution for Your Small Business, will give you a quick course in many of the available types of retirement plans-- there's at least one for every business, even yours.
SEP and SIMPLE Plans
In this lesson, we'll be focusing on Simplified Employee Pension-- or SEP-- plans, and Savings Incentive Match Plan for Employees-- also known as SIMPLE-- plans. While SEP plans are always Individual Retirement Accounts, or IRAs, SIMPLE plans may be an IRA or a 401(k). For the purpose of this lesson, though, we will be discussing SEP plans and SIMPLE IRA plans, both of which are easy and inexpensive for small business owners to set up and operate.
There's even a tax credit many businesses can claim that helps pay the start up and operating costs for new retirement plans. Both SEP and SIMPLE IRA plans hold participants retirement assets in traditional IRAs, but there is a difference in how they are funded. SEP plans are funded with employer contributions while SIMPLE IRA plans allow employee contributions and require employer contributions.
SEP or SIMPLE?
Before we continue our discussion, we want to give you the opportunity to skip a section that may not apply to you.
If you're interested in a plan that allows only employer contributions, click on the SEP plan icon. If you're interested in a retirement plan that allows both employer and employee contributions, click on the SIMPLE IRA plan icon.
If you're interested in a plan that allows only employer contributions, click on the SEP plan icon.
If you're interested in a retirement plan click on the SIMPLE IRA plan icon.
Let's talk about SEP plans. In SEP plans, the SEP IRA is owned and controlled by the employee, and the employer makes contributions to the financial institution where the SEP IRA is maintained. Any size business, even self-employed individuals, can establish a SEP.
Setting up a SEP plan
To set up a SEP plan, you'll need to take three actions: 1) sign a written agreement; 2) notify your employees; and 3) establish traditional IRAs for your employees. There must be more to it than that. What about the paperwork-- that written agreement you mentioned? The only paperwork you'll need is... IRS Form 5305 SEP; the form and its instructions fit on a single sheet of paper. Fill out the top part here, add your signature, title, and date here, and you have your SEP plan document. Make a copy of the completed form and give a copy of it and its instructions to each of your eligible employees. There are a couple of other items that you'll need to tell your employees and these are listed in the instructions section of Form 5305 SEP. When that's finished, you've met the employee notification requirements.
Not everyone can use Form 5305 SEP
Can everyone use this form and process?
No, some employers cannot use Form 5305 SEP to set up their plan. IRS Publication 560, Retirement Plans for Small Business, explains who falls into this category. Instead of using Form 5305 SEP, an employer can use what's called a prototype document-- usually from mutual funds, insurance companies, banks, or other qualified institutions.
Establishing IRAs for Employees
What about that last step-- establishing IRAs for the employees?
To finish the process of setting up the SEP plan, you'll need IRAs for each eligible employee. Here are a few things to remember: Generally, any employee who is at least age 21 and has performed services for your business in three of the last five years is an eligible employee. SEP IRAs must be traditional IRAs and not Roth IRAs. You can set up a SEP IRA for any year as late as the due date of your income tax return, including the time for an extension.
Employer contributions to an employee's SEP IRA
Employer contributions to an employee's SEP IRA need to be a uniform percentage of pay and cannot be more than 25 percent of the employee's annual compensation or the annual dollar limit, whichever is less. Contributions under a SEP plan must be made for each eligible participant, even if that participant is over age 70 and a half. This also includes employees who die or terminate employment before the end of the year.
If you are self-employed
If you are self-employed, you can also make contributions under the SEP plan for yourself even if you are over 70 and a half. In this case, however, you must still take minimum distributions. Only certain amounts of compensation can be considered when contributing to your own account as an employer. You can find these limitations in IRS Publication 560 or on our Website at www.irs.gov/retirement.
If you have more than one retirement plan
If you have more than one retirement plan, or if you're self-employed, review IRS Publication 560 or the IRS Website at www.irs.gov for information about additional limits on SEP plan contributions.
Is there anything else an employer needs to do?
Your financial institution will give participating employees an annual statement showing the amount contributed to their SEP account for the year. You can deduct the amount you contributed to eligible employees' SEP IRAs on your business tax return.
What about deductions if you are a sole proprietor?
If you are a sole proprietor, you can deduct contributions you make to the plan for yourself. When calculating the deduction for contributions made to your own SEP IRA, compensation is your net earnings from self-employment, which takes into account the deduction for the deductible part of your self-employment tax as well as the deduction for contributions to your own SEP IRA. IRS Publication 560 has more information on how to calculate your deduction.
Let's talk about SIMPLE IRA plans. Again, SIMPLE stands for Savings Incentive Match Plan for Employees. These plans are a great option for small businesses with 100 or fewer employees who received $5,000 or more in compensation from the employer for the preceding year. Also, the business does not maintain another retirement plan to which it contributes, other than a collectively bargained plan that covers only union employees. You can set up this type of plan easily with one of two IRS forms. Which form you choose depends on whether you want to choose the financial institution that first receives the plan contributions or if you want to let your employees make that choice.
If you are choosing the financial institution
If you are choosing the financial institution, you can set up the plan using the IRS Form 5305 SIMPLE. Fill in the sections to say who is eligible to participate in the plan, what employees must do to elect to defer a portion of their salary to the plan, and which formula you'll use to make employer contributions. Don't forget to sign and date it here. Next, make copies of the form and instructions and give them to your employees. Remember to tell your employees that they can make changes in their salary reduction agreement or make a new agreement just before November 2nd-- that's 60 days prior to the beginning of the new plan year. When that's done, a selected financial institution must set up a SIMPLE IRA for each eligible employee. Then, you'll have met the requirements for the summary description of the plan and the information regarding transfers and withdrawals.
If you want employees to choose their financial institutions
What if you want employees to choose their own financial institutions?
If you do want your employees to choose their own financial institution for their SIMPLE IRAs, you can use IRS Form 5304 SIMPLE to establish the plan. Then, your SIMPLE IRA plan operates much the same: you have a written agreement, you've notified your employees, and there are IRAs ready to receive contributions.
Employer Contribution Choices
What about the contribution choices that can be made with SIMPLE IRAs?
Essentially, there are two employer contribution choices: nonelective and matching contributions, and you can use one method one year and the other one the next year.
In a nonelective contribution, you make a contribution of 2 percent of compensation for each eligible employee-- even if they choose not to defer a part of their salary.
In a matching contribution, you can elect to match employees' salary reduction contributions on a dollar-for-dollar basis, up to 3 percent of compensation-- but only for those employees making salary reduction contributions. What if I, as the employer, can't afford a 3 percent match? An employer can reduce the 3 percent matching contribution to a lower percentage, but no lower than 1 percent for up to two of the five year period that ends with the reduction year. Let's look at some examples:
Nonelective contribution example
Hi, I'm Ann. I work for XYZ Company where I earned 20 thousand dollars this year. The XYZ Company told me I'm eligible for its SIMPLE IRA plan, but I didn't think I could afford to put anything into a SIMPLE IRA. But because XYZ chose to make a 2 percent nonelective contribution, it will make a contribution of 400 dollars to my SIMPLE IRA account. This is an example of a nonelective contribution. Ann's employer, XYZ Company, contributed 2 percent of compensation for her as well as all other eligible employees. This happens whether or not the employee chooses to make salary reduction contributions.
Now let's look at an example of a matching contribution:
Matching contribution example
Hi, I'm Shirley. I own ABC Company and chose to make 3 percent matching contributions to the company's SIMPLE IRA plan for each of my eligible employees. One of my employees, Jeff, earns 30 thousand dollars and chooses to defer 10 percent of his salary, or 3 thousand dollars. My company matches the first 3 percent of Jeff's deferral and contributes 9 hundred dollars to his SIMPLE IRA.
Changing the employer contribution formula
ABC Company can't make any other employer contributions to the SIMPLE IRA plan for Jeff, but it can change the formula for making employer contributions each year if it gives employees notice of the change by November 2nd before the new calendar year. The company also gets to take a deduction for those contributions.
Annual updates before November 2nd
So now that an employer has signed a written agreement, notified employees, and set up IRAs for participants, what's next? Before November 2nd each year, you'll tell employees how the plan will operate in the upcoming year, give them an opportunity to make or to change their salary reduction agreements, provide them with a summary description provided by the financial institution, and provide written notice that their balance can be transferred without cost or penalty if they use a designated financial institution.
Rules for if you start the plan during the year
If you start the plan during the year, there are slightly different rules. These rules can be found in IRS Publication 560.
Employee contribution choices
What choices do employees have regarding increasing, decreasing, or stopping their salary reduction contributions?
Employees can stop a salary reduction contribution at any time during the year, and you can allow employees to add to the amount they are contributing at any time. The 60-day election period from November 2 to December 31 is the minimum required for giving employees the opportunity to make salary reduction choices for the upcoming year.
Be sure to keep records of salary reduction agreements. You'll cap the amounts of salary reduction contributions at the limit in effect for the year. This usually changes each year because it's adjusted for increases in the cost-of-living. There are also catch-up contributions available for employees age 50 and over. You can find more information about the election period-- as well as contribution limits-- in IRS Publication 560 or on our Website, www.irs.gov/retirement. Remember, the limits may change from year to year. In another lesson from this workshop you'll learn how to handle the payroll withholding for SIMPLE IRA contributions. IRS Publication 560 also contains information for you and your employees on deducting contributions.
Rules that are common to SEP and SIMPLE IRA Plans
Before we finish this lesson, let's talk about some rules that are common to both SEP and SIMPLE IRA plans.
Tax credit for business owners
There's a tax credit for business owners of up to 5 hundred dollars per year for the first three years of a SEP or SIMPLE IRA plan for the ordinary and necessary costs of starting the plan and educating employees about the new plan. To claim this credit, you'll file Form 8881, Credit for Small Employer Pension Plan Startup Costs.
Employee rollover from SEP or SIMPLE IRA
Employees may roll over their SEP or SIMPLE IRA into another plan; however, a rollover from a SIMPLE IRA to a non-SIMPLE IRA can be made tax free only after a 2 year participation in the SIMPLE IRA plan. For more information, review IRS Publication 590, Individual Retirement Arrangements.
Employees are fully vested
Also, contributions to SEP and SIMPLE IRAs are always 100 percent vested; that is, owned, by the employee.
Employees can take withdrawals
Employees can take a withdrawal from their SEP or SIMPLE IRAs at any time, but generally there is a 10 percent additional tax on early withdrawals that are taken before the age of 59 and a half; that tax is increased to 25 percent if the withdrawal is made in the first two years of participation in the plan. And remember, no one can borrow from an IRA. Generally, you and your employees must begin to receive distributions from your SEP or SIMPLE IRA by April 1 of the first year after the calendar year in which you or your employees reach age 70 and a half.
No Annual Report to the IRS
Finally, you generally do not need to file an annual report to the IRS for a SEP or SIMPLE IRA plan. The financial institution that holds the SIMPLE IRAs handles most of any other paperwork.
By now, I hope you're convinced of the benefits and the ease of setting up and running a SEP or SIMPLE IRA plan for you and your employees. You can find more information on SEP and SIMPLE IRA plans in IRS Publications 560 and 590 as well as by visiting our Website at www.irs.gov/retirement and selecting Types of Retirement Plans.
Additionally, whether you have employees or not, we'd like to invite you to subscribe to our free electronic newsletter, Retirement News for Employers.
You've certainly convinced me. I'm going to take a look at those materials and get started on setting up my own retirement plan.
Glad we could be of help, Mark. Thanks for joining us to learn more about retirement plans. Best wishes for a successful business and a well-deserved retirement.