Tax Tips
Small Business Retirement Plans - June 2000
Richard Scrivanich - Partner
Most small business owners don't think of retirement plans when thinking about deductions and their yearly tax bill. This is unfortunate, since contributions to retirement plans are one of the best tax breaks available to small business owners. If you visualize yourself enjoying retirement life, the uncertainties and risks that come with running your own business make it imperative that you save for retirement. You can personally deduct contributions to your own account, and your company gets to deduct contributions you make on behalf of your employees. In addition to the tax benefits you receive, a company-sponsored retirement plan is a great way to attract and retain valuable employees.
There are a number of retirement plan options in place for small business owners. SIMPLEs, SEPs, Keoghs, and IRAs all offer significant tax advantages. Depending on the type of plan you choose and your earnings, you may be able to shield as much as $30,000 of your earned income.
SIMPLE plan.
If you are looking for a plan that is relatively easy to open and administer, you might want to consider the new SIMPLE retirement plan. The acronym stands for Savings Incentive Match Plan for Employees, and it was created by the Taxpayer Relief Act of 1997. Under a SIMPLE plan, employees make deductible contributions and employers follow specified formulas for matching employee contributions. True to their name, SIMPLEs lack most of the reporting requirements of some other tax-favored plans. They can be set up as IRAs or as 401(k)s. SIMPLE retirement plans may be opened only by employers with no more than 100 employees. The maximum annual contribution to a SIMPLE IRA is $12,000 or total compensation, if less. The maximum contribution will be lower if the net self-employment income is less than $200,000. In some cases, the maximum allowed contribution to a SIMPLE IRA may be more than that under a SEP or Keogh Plan. This is because the elective contribution to a SIMPLE IRA is limited by the amount of the taxpayer's income, while SEP and Keogh contributions are limited to a percentage of income.
SEP plan.
A simplified employee pension (SEP) plan allows an employer to make contributions toward his or her own retirement and that of his or her employees. SEPs are basically IRAs you set up for yourself and your employees. If you set up a SEP for yourself, you generally must cover all employees who meet an age and service test. The maximum contribution and deduction for employees is 15% or $30,000, whichever is less. As the owner, your maximum contribution works out to be 13.0435% of net self-employment income. Net self-employment income is defined as self-employment income less related expenses and 50% of the self-employment tax paid. Employee contributions to a SEP are not allowed. You can make a contribution to a SEP IRA even if you participate in an employer qualified retirement plan. A SEP IRA can usually be established at a financial institution using IRS-approved plan documents. Administrative costs are low, because unlike Keoghs, the IRS does not impose annual filing requirements on SEP IRAs. The account must be established and contributions have to be made before the due date of the individual's tax return. (This includes extensions.)
Keoghs.
Keoghs offer more flexibility and higher contribution limits than many other retirement plans, but at the price of greater complexity. Since Keoghs must cover employees on a non-discriminating basis, they are primarily used in businesses with few or no workers other than the owner.
A Keogh is a qualified retirement plan, and there are two basic types of plans: a defined contribution plan and a defined benefit plan. Generally, defined contribution plans are either profit sharing arrangements or money purchase plans. Annual contributions to a profit sharing plan are not mandatory, and contributions are deductible up to 13.04348% of net self-employment income (not exceeding $160,000). For a money purchase plan, annual contributions are mandatory, and an excise tax is imposed if the contributions are not made. The maximum contribution is the lesser of $30,000 or a fixed percentage (up to 25%) of net self-employment income.
A profit sharing plan (or SEP IRA) can be combined with a money purchase plan. A combination plan provides the maximum allowable annual contribution (20% of net self-employment income), while giving some flexibility by having a discretionary portion for contribution. For example, 13.04348% could be contributed on a discretionary basis to a SEP IRA, with the remaining amount being a fixed contribution to a money purchase plan.
Under a defined benefit plan, a fixed benefit will be paid from the plan in the future. Contributions to defined benefit plans are based on an actuarially determined amount designed to provide sufficient funds for the fixed benefit at a specified retirement age. For 1999, the annual retirement benefit cannot exceed the lesser of: 1) $130,000 or 2) the average of the participant's earned income for the three consecutive highest years.
Other alternatives.
While 401(k) plans are popular with large corporations, substantial reporting requirements make them too expensive for small businesses with just an owner and a few employees.
IRAs are an alternative for small business owners who find the cost of covering employees prohibitive. Although the contribution limits are low, you can establish and contribute to an IRA without respect to your employees.
If you have any questions concerning retirement plans, I would be happy to provide you additional information on what type of plan is best suited to your individual circumstances. You can reach me at (562) 698-9891.
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