Leimberg’s



Leimberg’s

Think About It

Think About It is written by

Stephan R. Leimberg, JD, CLU

and co-authored by Linas Sudzius

FEBRUARY 2010 # 408

Choosing the Best Qualified Retirement Plan

For a Closely Held Business

Introduction

Closely held business owners usually search hard to find tax-advantaged benefits for themselves and for their employees. Qualified retirement plans--pension plans--are usually high on the list of desirable strategies.

Why is that?

A qualified retirement plan allows the employer to take a tax deduction for amounts that it commits to the plan. The participating employee generally does not have to pay any income taxes on the amounts the employer puts in the plan. The employee only pays income taxes when receiving actual distributions—presumably at retirement.

So why doesn’t every business have a pension plan? Qualified retirement plans come with substantial baggage:

o All eligible employees must be included.

o The plan cannot discriminate in favor of certain employees.

o Related businesses must be aggregated together.

o A plan document must be implemented and kept up-to-date.

o Other strict administrative requirements must be observed.

Still, for many closely held business owners, the tax and practical rewards of a pension plan outweigh the hassle.

If a business owner is inclined to implement a pension plan, which is the best?

Large companies must usually choose pension plans that require full administration, like a defined benefit plan or a Section 401(k) plan.

For many smaller businesses, SEP and SIMPLE pension plans have the kind of simplified implementation and administrative rules that make them particularly attractive. Most of the other types of pension arrangements require full administration, which adds to their complexity and cost.

Each kind of pension plan has its own characteristics that can make it a perfect fit with the right business. This issue of Think About It will give a brief overview of the kinds of pension plans available to closely held businesses, the key characteristics of each, and describe the circumstances where each might be a good fit.

For more information about retirement plans for small businesses, IRS Publication 560 is an excellent resource.

Full Administration Pension Plans

There are two main types of full administration pension plans: defined benefit plans and defined contribution plans.  A defined benefit plan promises a specified monthly benefit at retirement.  The plan may calculate the promised benefit through a formula. The formula usually includes factors for salary, service or age.

Under a defined benefit plan, the company funds and pays its obligations from a common account that is not segregated for each of its employees.

Insurance professionals often work with a special kind of defined benefit plan called a Section 412(e)(3) plan (formerly known as a 412(i) plan). A Section 412(e)(3) plan is funded exclusively with guaranteed life insurance and annuity contracts.

A defined contribution plan does not promise a predictable monthly benefit at retirement.  Instead, the employer and sometimes the employee contribute to an individual sub-account within the plan.  The contributions are invested on the employee’s behalf, and the participant ultimately receives the balance in the account. 

Most of the pension plans that are referred to by name are really variations of the defined contribution plan, including:

• Profit sharing plan,

• Money purchase plan,

• Section 401(k) plan, and

• Employee stock ownership plan (ESOP).

Plan Setup and Administration

Setting up a full administration pension plan usually involves either creating a custom pension document and seeking IRS approval for it, or adopting a prototype plan that has been pre-approved by the Service.

Usually the sponsoring employer will also set up a custodial account in which it will invest the pension funds. The custodial account might be kept with a bank or other entity prepared to act as the pension plan’s fiduciary.

The employer sponsoring a full administration pension plan generally must also file IRS Form 5500 annually, reporting information about the status of the plan.

In general, employees older than 21 with at least one year of service must be included in a full administration pension plan. Full administration plans may delay a participating employee’s vesting in certain plan accounts or benefits until the employee meets certain conditions.

All pension plans are subject to ERISA requirements. ERISA requires that employers who sponsor pension plans must follow certain rules:

• The plan sponsor must provide participants with information about the plan including features and funding. 

• The employer must follow ERISA’s minimum standards for participation, vesting, benefit accrual and funding. 

• Plan fiduciaries, such as investment professionals, must follow certain rules of conduct, or otherwise may be liable for the financial losses of the plan.

• Participants must have the ability to sue for promised benefits, and if the sponsor or other fiduciary fails to follow the rules.

Defined Benefit Plan

A defined benefit plan is a type of pension plan in which the employer promises each eligible employee a specified monthly benefit at retirement. The retirement benefit is defined in that it is based on a formula that is set forth in the plan document.

The formula used might be based on the employee’s average earnings, or highest earnings. Generally, the defined retirement benefit begins at a specific age, and is paid until the employee’s death.

Defined benefit plans are typically funded only with employer contributions. Implementation requires adoption of a plan document.

Administration can be complex, often requiring the services of an actuary to calculate the employer’s potential pension liabilities, and determine the appropriate employer contributions to fund those liabilities.

Employee Access

A participating employee does not typically have access to a defined benefit plan’s value, except to receive retirement benefits at the date defined under the plan. In some cases, an employee who leaves employment prior to retirement may be entitled to a lump sum from the retirement plan.

Section 412(e)(3) Plan

Those employers who want to provide a defined benefit plan for employees without the administrative cost associated with most defined benefit plans might opt for a Section 412(e)(3) plan (formerly Section 412(i) plan). The Section 412(e)(3) plan is funded with fully guaranteed life and annuity contracts, which are designed to pay a guaranteed benefit at the participant’s retirement.

While administrative costs for a Section 412(e)(3) plan are lower than those for a traditional defined benefit plan, in general the employer plan contributions are higher. Because such plans are funded with guaranteed contracts, the interest rates used to meet retirement obligations are lower for Section 412(e)(3) plans.

BEST FITS

1. Companies that are more mature, wishing to implement retirement benefits for all employees that tend to favor the older, more highly compensated participants

2. Smaller companies that are very profitable, and want to provide significant retirement benefits to older members of the workforce in a relatively short period of time

Defined Contribution Plan

Under a defined contribution plan, pension deposits are made into a sub-account segregated for the participating employee. Some plans use only employee contributions, and some combine employer and employee contributions.

In general, the maximum contribution that may be made into a participant’s defined contribution plan account in 2010 is $49,000.

Section 401(k) Plan

A Section 401(k) savings plan allows an employee to save some of the employee’s wages for retirement and have the savings invested while deferring current income taxes on contribution and earnings until withdrawal. These contributions are referred to as elective deferrals.

The employer usually matches part or all of the employee's contribution by depositing additional amounts in the employee's 401(k) account. These are matching contributions. The employer may make additional nonelective contributions to employees accounts.

While Section 401(k) plans can be designed in a number of ways, usually the employee has the ability to direct his or her account’s investment choices. The plan fiduciary usually offers a small selection of pre-packaged mutual funds or other investments.

Most 401(k) contributions are pre-tax. However, for those Section 401(k) plans that offer designated Roth accounts, participants in 401(k) plans can make after-tax contributions to such accounts, commonly referred to as Roth 401(k) accounts.

The Section 401(k) plan document sets limits on the amount of elective deferrals an employee may make each year. Federal tax rules also impose an absolute limit on deferrals of $16,500 in 2010 for those younger than 50, and $22,000 for those older.

Employee Access

An employee’s access to his or her 401(k) plan account is restricted until

• The employee ends employment with the employer sponsoring the plan,

• The employee dies or becomes disabled,

• The plan is terminated by the employer,

• The employee reaches age 59 ½ or

• The employee suffers financial hardship.

An employer may permit an employee to have limited, indirect access to the Section 401(k) account through loans.

Best Fits

1. Larger companies where management favors having employees participate financially in their retirement programs

2. Larger, more mature companies, where employers want to supplement an existing defined contribution plan with supplemental employee-based savings

3. Younger companies that seek to add to employee satisfaction through a portable retirement plan that also offers access to the plan’s cash for employees

Profit Sharing Plan

Overview

A profit-sharing plan is funded by employer contributions. The term profit-sharing can be misleading. The company sponsoring the plan does not need to have profits in order to make a contribution to the plan. Further, if the company does have profits, it is not required to make a contribution.

If contributions are made, the employer must have a non-discriminatory formula for determining how the contributions are divided. Contributions are divided into a separate account for each employee, as with other types of defined contribution plans.

Here’s one way profit sharing plan contributions may be allocated between employees.  The employer adds up all of its employees’ eligible compensation.  To determine each employee’s share of the profit sharing contribution, the employee’s eligible compensation is divided by the total compensation to get a fraction.  Then the total contribution is multiplied by the fraction.

Eligibility, setup, administration, ERISA rules and contribution limits are generally the same as those for other defined benefit pension plans. The profit sharing plan may permit a participating employee to access his account values indirectly, through plan loans.

Best Fits

1. An employer who wants control over whether or not to make a contribution

2. An employer with an older, more highly compensated key employee group

MONEY PURCHASE PLAN

Overview

An employer is required to make a contribution to a money purchase plan on behalf of each plan participant each year. The money purchase plan document sets forth the percentage of annual eligible compensation on which the contribution is based. 

The participant’s benefit is based on the amount of contributions to their account and the gains or losses associated with the account at the time of retirement.

Eligibility, setup, administration, ERISA rules and contribution limits are generally the same as those for other defined benefit pension plans. The profit sharing plan may permit a participating employee to access his account values indirectly, through plan loans.

Best Fits

1. The employer believes that employees can generate a higher retirement benefit for each dollar contributed than under other plans.

2. Companies that are generating reliable annual profits that can be used to meet required contributions to the plan.

EMPLOYEE STOCK OWNERSHIP PLAN (ESOP)

Overview

In an ESOP, a company sets up a pension trust fund, into which it contributes shares of its own stock or cash to buy existing shares.

As with other defined contribution plans, shares and cash in the pension trust are allocated to individual employee accounts. Allocations are made either on the basis of relative pay or another non-discriminatory formula.

When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value. Closely held companies must have an annual outside valuation to determine the price of their shares.

Eligibility, setup, administration, ERISA rules and contribution limits are generally the same as those for other defined benefit pension plans.

Best Fits

1. ESOPs are commonly used to provide a ready market for the shares of departing owners of successful closely held companies, where non-employee ownership succession is undesirable.

2. ESOPs can be used to motivate and reward employees, as their indirect stock ownership can align employees with the financial success of the company.

Simplified Administration Pension Plans

Simplified Employee Pension (SEP)

Under a Simplified Employee Pension (SEP), the employer makes regular contributions to each employee’s IRA. Contributions under a SEP are deductible by the employer, and not included in the employee’s income. The amount that can be contributed to a highly compensated employee’s SEP is much greater than the individual might contribute on a deductible basis to his or her own IRA.

Implementation

For most employers, implementing a SEP is a three-step process:

1. Fill out and sign IRS Form 5305-SEP.

2. Give each employee a copy of the completed Form 5305-SEP, along with other required information.

3. Make sure each eligible employee has an IRA set up to accept SEP contributions.

It is possible for employers to choose to implement SEP IRAs without using Form 5305-SEP. If an employer chooses to by-pass the IRS form, the employer must create a plan document and comply with more complex administrative details.

A SEP may be created for a particular tax year as late as that year’s tax filing deadline, including extensions.

Eligibility

All eligible employees must be included under a SEP plan. An eligible employee is someone who meets all three of the following tests:

1. The employee is at least 21 years old.

2. The employee has been employed by the SEP sponsor for 3 of the last 5 years.

3. The employee earned at least a minimum amount of compensation for the tax year ($550 in 2009 or 2010).

Contributions

Under a SEP plan, the employee contributes the same flat percentage of an employee’s wages for each eligible employee. The maximum that may be contributed is 25%.

Some employees, including employee-owners, may be limited in the amount of wages that count for SEP contribution purposes. For tax years 2009 and 2010, the SEP contribution is based on maximum employee compensation of $245,000.

For an employee-owner, the percentage that may be contributed to a SEP is the same as that for employees. However, the actual percentage for a self-employed individual may need to be adjusted slightly to account for the effect of the employer portion of social security taxes.

Employee Access

SEP contributions are made into IRA accounts. These accounts have no special restrictions, and participants are 100% vested in the contributions and earnings at all times. All regular IRA rules with regard to distributions, taxes and penalties apply to SEP-IRAs.

Administration

Employers who have properly established a SEP using Form 5305-SEP are not required to annually file Forms 5500 or 5500-EZ for the SEP, except under limited circumstances. The only other requirement is that annual contributions to the plan—if the employer chooses to make SEP contributions for the year—must be made by the deadline for the tax return for the relevant year.

Best FitS

The SEP is the best pension choice in those situations:

1. The employer wants the easiest possible pension plan to set up and administer.

2. The only employee of the business is the owner, or only the owner and spouse.

3. There are few employees of the business, and the owner earns substantially more than the other employees combined.

SIMPLE Plan

A savings incentive match plan for employees (SIMPLE) is a kind of qualified plan usually designed to have an employer and employee both contribute to the employee’s retirement. Under the most basic SIMPLE arrangement, an employer creates special SIMPLE IRAs for eligible employees, and both make the kinds of contributions described below.

A SIMPLE plan is similar to a Section 401(K) plan in the way that it works. In fact, a SIMPLE plan can be a part of a 401(K) plan; a variant known as a SIMPLE 401(K) plan.

SIMPLE IRA Plan

Implementation

Only those employers with 100 or fewer eligible employees may set up and maintain a SIMPLE IRA plan.

For most employers, implementing a SIMPLE IRA plan is a three-step process:

1. Fill out and sign either IRS Form 5304-SIMPLE (if the participants have control over where their SIMPLE IRAs are established) or Form 5305-SIMPLE (if the employer controls where the SIMPLE IRAs are established).

2. Give each employee a copy of the completed page 3 of Form 5304 or 5305.

3. Make sure each eligible employee has a SIMPLE IRA set up to accept SIMPLE contributions

As with a SEP IRA plan, it is possible for an employer to create a customized SIMPLE IRA document. However, most use the standard IRS forms.

A SIMPLE IRA may usually only be created for a particular tax year between January 1 and October 1 for the given year.

Eligibility

An eligible employee for SIMPLE IRA purposes must include an employee who

• Earned $5,000 or more in compensation during any two years prior to the current year, and

• Is reasonably expected to earn $5,000 or more in the current year.

Contributions

SIMPLE IRA contributions are made up of employee salary reduction contributions and employer contributions.

Employee salary reduction contributions are made pre-tax with the employee’s money. The maximum amount that an employee can choose to contribute to a SIMPLE IRA in 2009 or 2010 is $11,500. Those older than 50 by the end of the calendar year may elect to make special catch-up salary reduction contributions of an additional $2,500.

The employer must commit to one of the following contribution methods prior to the tax year for which the SIMPLE IRA plan is in effect:

1. The employer matches the employee’s actual salary reduction contribution, up to a maximum of 3% of the employee’s salary

2. The employer matches less than 3% of the employee’s actual salary reduction contribution, but not less than 1%. However, an employer may not elect this option for more than two years out of five.

3. The employer contributes 2% of the employee’s salary to the SIMPLE IRA, regardless of whether the employee made a salary reduction contribution.

Salary reduction contributions must be deposited into the participant’s SIMPLE IRA within 30 days of the end of the month in which the salary would have been paid. The employer contributions must be made by the due date—including extensions--of the employer’s tax return for the year.

Employee Access

As with SEP IRAs, participating employees are 100% vested in their SIMPLE IRAs from the plan’s inception. However, for the first two years of an employee’s participation in a SIMPLE, the early distribution penalty tax is increased from 10% to 25%.

Administration

Under a SIMPLE IRA plan, the employer is generally not required to annually file Form 5500 or Form 5500-EZ.

However, an employer must notify each employee more than 60 days prior to the start of a new SIMPLE plan year of the employee’s opportunity to enter either into a salary reduction agreement or to modify the employee’s prior agreement.

Best Fits

1. The employer wants employees to share responsibility for their retirement savings.

2. The employer of a small company wants much simpler administration than a Section 401(k) plan

SIMPLE 401K Plan

A SIMPLE 401K plan has some characteristics of a Section 401K plan and the SIMPLE IRA. The SIMPLE 401K plan is only available for those employers who have 100 or fewer employees.

Implementation

There is no standardized IRS form for the implementation of a SIMPLE 401K plan. As with more complex pension plans described below, a SIMPLE 401K requires the adoption of an IRS-approved written pension plan. In general, a third party such as a bank or insurance company will provide a pension prototype and administrative services for an employer’s SIMPLE 401K plan.

A SIMPLE 401K plan does not use IRA accounts for participating employees. The same implementation deadlines apply to both SIMPLE IRA and SIMPLE 401K plans.

Eligibility

Employees who are at least 21 years old and have completed at least one year of service must be allowed to participate in the SIMPLE 401(k) plan.

Contributions

The same employer and employee contribution rules and limits apply to both SIMPLE 401K plans and SIMPLE IRA plans.

Employee Access

Even though IRA accounts are not used for eligible employees, participants are 100% vested in their SIMPLE 401K account balances from the plan’s inception. The plan document may permit the participants to access their account balances through plan loans, following the normal Section 401K plan rules.

Administration

Unlike a SIMPLE IRA plan, an employer sponsoring a SIMPLE 401K plan must file Form 5500 every year. The employer is also required to give eligible employees the same kind of annual notice as for SIMPLE IRA plans regarding eligibility and contributions.

Special Considerations

While the administrative burden for a SIMPLE 401K plan is greater than that for a SIMPLE IRA, the SIMPLE 401K plan offers advantages over a regular Section 401K plan. For example, the plan is not subject to the discrimination rules that everyday 401(k) plans are, and the simple contribution formulas allow for easier administration.

Best Fits

1. The employer wants to implement a 401(k) style plan, but also wants easier administration.

2. An employer is a candidate to implement a SEP or a SIMPLE IRA, but wants to add loans and hardship withdrawals flexibility for employees.

Conclusion

The holy grail of employee benefit planning continues to be a benefit plan that generates a tax deduction for the employer, and no income tax result for the employee. While pension plans have their drawbacks, their tax benefits for employers and overall benefits for employees can make them attractive.

There are situations in which a closely held business owner will opt for a full administration pension plan. However, the setup and administrative costs for such plans can be prohibitive.

Closely held business owners are more likely to embrace the simplicity of SEP or SIMPLE pension plans. For those who have only owner-employees, SEPs may allow for easy administration and maximum contributions. For those with a more diverse workforce, a SIMPLE plan may be the more economical choice.

The business owner’s biggest challenge in deciding on a pension plan is this: How can the needs of the business, the business owner and the business’s employees be best balanced? As financial professionals, it’s up to us to help them decide.

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