CHAPTER 11 SIMPLE PLANS AND SIMPLIFIED EMPLOYEE PENSIONS

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1 CHAPTER 11 SIMPLE PLANS AND SIMPLIFIED EMPLOYEE PENSIONS SIMPLE Plans The Small Business Job Protection Act of 1996 created a simplified retirement plan for small business called the savings incentive match plan for employees (SIMPLE) retirement plan. SIMPLE plans can be adopted by employers that employ 100 or fewer employees on any day during the year and that do not maintain another employment-based retirement plan. A SIMPLE plan can be either an individual retirement account (IRA) for each employee or part of a 401(k) plan. If established in IRA form, a SIMPLE plan is not subject to the nondiscrimination rules generally applicable to qualified plans (including the top-heavy rules), and simplified reporting requirements apply. Within limits, contributions to a SIMPLE plan are not taxable until withdrawn. A SIMPLE plan can also be adopted as part of a 401(k) plan. In that case, the plan does not have to satisfy the special nondiscrimination tests applicable to 401(k) plans and is not subject to the top-heavy rules. The other qualified plan rules continue to apply. In practice, most employers that have implemented a SIMPLE plans have chosen the SIMPLE IRA, rather than the SIMPLE 401(k). SIMPLE Retirement Plans in IRA Form A SIMPLE retirement plan allows employees to make elective contributions to an IRA. Employee contributions have to be expressed as a percentage of the employee s compensation and cannot exceed $11,500 per year in (The dollar limit is indexed for inflation in $500 increments.) If the employee is age 50 or over, a catch-up contribution is also allowed. The limit for this additional catch-up contribution is $2,500 in 2009 and will be adjusted for inflation in $500 increments thereafter. The employer is required to satisfy one of two contribution formulas. Under the matching contribution formula, the employer generally is required to match employee elective contributions on a dollar-for-dollar basis up to 3 percent of the employee s compensation. Under a special rule, the employer can elect a lower percentage matching contribution for all employees (but 113

2 not less than 1 percent of each employee s compensation). A lower percentage cannot be elected for more than two out of any five years. Alternatively, for any year, in lieu of making matching contributions, an employer may elect to make a 2 percent of compensation nonelective contribution on behalf of each eligible employee with at least $5,000 in compensation for such year. No contributions other than employee elective contributions and required employer matching contributions (or, alternatively, required employer nonelective contributions) can be made to a SIMPLE account. Each employee of the employer who received at least $5,000 in compensation from the employer during any two prior years and who is reasonably expected to receive at least $5,000 in compensation during the year generally must be eligible to participate in the SIMPLE plan. 1 Self-employed individuals can participate in a SIMPLE plan. All contributions to an employee s SIMPLE account have to be fully vested. Contributions to a SIMPLE account generally are deductible by the employer. In the case of matching contributions, the employer is allowed a deduction for a year only if the contributions are made by the due date (including extensions) for the employer s tax return. Contributions to a SIMPLE account are excludable from the employee s income. SIMPLE accounts, like IRAs, are not subject to tax. Distributions from a SIMPLE retirement account generally are taxed under the rules applicable to IRAs. Thus, they are includable in income when withdrawn. Tax-free rollovers can be made from one SIMPLE account to another. Early withdrawals from a SIMPLE account generally are subject to the 10 percent early withdrawal tax applicable to IRAs. However, withdrawals of contributions during the two-year period beginning on the date the employee first participated in the SIMPLE plan are subject to a 25 percent early withdrawal tax (rather than 10 percent). Each eligible employee can elect, during the 60-day period before the beginning of any year (or the 60-day period before first becoming eligible to participate), to participate in the SIMPLE plan (i.e., to make elective deferrals), and to modify any previous elections regarding the amount of contributions. An employer is required to contribute employees elective deferrals to the employee s SIMPLE account within 30 days after the end of the month to which the contributions relate. 1 The following employees do not need to be covered under a SIMPLE IRA plan: Employees who are covered by a union agreement and whose retirement benefits were bargained for in good faith by the employees union and the employer. Nonresident alien employees who have received no U.S. source wages, salaries, or other personal services compensation from the employer. 114 Fundamentals of Employee Benefit Programs

3 After the employer sends the SIMPLE IRA plan contributions to the financial institution, that institution will manage the funds. Employees are permitted to move their SIMPLE IRA assets from one SIMPLE IRA to another. Each participating employee must receive an annual statement indicating the amount contributed to his or her SIMPLE IRA for the year. For purposes of the rules relating to SIMPLE plans, compensation means compensation required to be reported by the employer on Form W-2, plus any elective deferrals of the employee. In the case of a self-employed individual, compensation means net earnings from self-employment. SIMPLE 401(k) Plans In general, a cash or deferred arrangement (i.e., 401(k) plan), is deemed to satisfy the special nondiscrimination tests applicable to employee elective deferrals and employer matching contributions if the plan satisfies the contribution requirements applicable to SIMPLE plans. In addition, the plan is not subject to the top-heavy rules for any year for which this safe harbor is satisfied. The safe harbor is satisfied if, for the year, the employer does not maintain another qualified plan and (1) employees elective deferrals are limited to no more than $11,500 (adjusted for inflation after 2009) plus, if the employee is age 50 or over, an additional catch-up contribution is allowed of $2,500 (adjusted for inflation after 2009), (2) the employer matches employees elective deferrals up to 3 percent of compensation (or, alternatively, makes a 2 percent of compensation nonelective contribution on behalf of all eligible employees), and (3) no other contributions are made to the arrangement. Contributions under the safe harbor have to be 100 percent vested. The employer cannot reduce the matching percentage below 3 percent of compensation. There are additional factors that should be considered in the selection of this form of a SIMPLE plan. For example, annual filing of Form 5500 is required; however, participant loans may be permitted (a feature that is not available with a SIMPLE IRA) and in-service withdrawals may be made available by the plan sponsor (but they will be subject to a possible 10 percent penalty if the employee is under age 59½.) Simplified Employee Pensions (SEPs) Introduction Many small businesses have been reluctant to establish a qualified retirement plan for their employees. Some fear the potential burdens associated with administering a plan and complying with complex federal regulations. The U.S. Congress sought to remove some of these obstacles for small businesses in the Revenue Act of 1978, which established 115

4 a new tax-favored retirement plan aimed primarily at small employers the simplified employee pension (SEP). SEPs are arrangements under which an individual retirement account (IRA) is established for each eligible employee. The employee is immediately vested in employer contributions and generally directs the investment of the money. These arrangements are sometimes called SEP-IRAs. A principal difference for individuals between a SEP and an employersponsored IRA is the larger annual contribution available for a SEP (discussed below). SEPs must also meet some qualified retirement plan rules for eligibility, coverage, vesting, and contributions that do not exist for employment-based IRAs. (For further discussion of IRAs, see chapter on individual retirement accounts). SEPs offer employers an alternative to more complex and costly qualified pension plans. Paperwork, recordkeeping, and reporting requirements are kept to a minimum. SEPs may be set up by corporations, unincorporated businesses and partnerships, and self-employed persons. Although companies of any size may create SEPs, the simplicity of the arrangement is designed to interest small businesses. Eligibility Employer contributions must be made for each employee who has reached age 21, has worked for the employer during at least three of the preceding five years, and has received at least $300 in compensation from the employer during the year. The $300 figure is indexed to increases in the cost of living (the figure for 2009 is $550). Contributions Employers Under the Revenue Act of 1978, the maximum an employer could contribute for each employee was the lesser of $7,500 or 15 percent of compensation. The limit on compensation that could be considered for calculating the annual contribution was $100,000. The dollar limit on contributions to SEPs was raised to $15,000 and the compensation limit to $200,000 by the Economic Recovery Tax Act of The Tax Equity and Fiscal Responsibility Act of 1982 raised the dollar limit on contributions to $30,000 and subsequent increases have placed it at $49,000 in 2009 (this figure will be adjusted for inflation in the future). The Omnibus Budget Reconciliation Act of 1993 decreased the compensation limit to $150,000. This figure is $245,000 in 2009, but this limit will be indexed to the cost of living in the future. Employer contributions are considered discriminatory unless the same percentage of compensation is allocated to all eligible employees. In plans integrated with Social Security, a limited disparity is permitted (see later discussion in this chapter). An employer may contribute to a SEP in addition 116 Fundamentals of Employee Benefit Programs

5 to contributing to other qualified pension plans. However, SEP contributions are included in the total contribution and deduction limits on all qualified plans. One of the most flexible features of a SEP from an employer s standpoint is that there is no required annual contribution. For example, if a company has a poor year and profits are low, the employer can decrease the contribution or simply not make one. Employees are fully and immediately vested in the employer s contributions and investment earnings on the contributions. Therefore, the employee has nonforfeitable rights to the funds and will not lose any on separation from service. Employees When SEPs were first created, if the employer contribution was less than the maximum contribution permitted for IRAs that year, the employee was permitted to make up the difference with a tax-deductible contribution to the SEP. In addition, an employee could also contribute up to the maximum tax-deductible level to his or her own IRA. Under rules established by the Tax Reform Act of 1986 (TRA 86), an employee covered under a SEP may not be able to make the full deductible contribution to his or her own IRA if certain conditions are not satisfied. (For further discussion of IRAs, see chapter on individual retirement accounts.) TRA 86 considerably broadened the incentives for employee participation in a SEP by providing a salary reduction option. The provision authorizing salary reduction for SEPs was repealed by the Small Business Job Protection Act of However, an employer may continue to make contributions to a salary reduction SEP that was established in a year beginning before Distributions From their inception, SEPs have been subject to the same penalties on early withdrawals (those made prior to age 59½) that have applied to IRAs. In 1986, this tax was expanded to apply not only to SEPs and IRAs but to all qualified employment-based retirement plans. A 10 percent excise tax is imposed on amounts withdrawn before age 59½, unless one of the specific exceptions enumerated in the chapter on planning for retirement applies. Loans cannot be made from SEPs. Integration Until 1989, employers were permitted to take a portion of the Social Security taxes paid by the employer for each employee into account in calculating the SEP contribution for the employee. That is, the employer could subtract a portion of the Social Security tax paid in a given year from the SEP contribution. This enabled employers to make SEP contributions that were a higher percentage of compensation for higherpaid employees (assuming that their compensation exceeded the maximum taxable wage base) because the Social Security tax is a smaller percentage of their total compensation than it is for lower-paid workers. Effective in 1989, TRA 86 prescribed new integration rules for defined contribution plans that also apply to the nonelective portion of SEP contributions. These rules 117

6 permit a limited disparity between the percentage contribution above and below the Social Security wage base. (For a discussion of integration requirements, see chapter on integrating pension plans with Social Security.) Bibliography Allen, Everett T., Jr. et al. Pension Planning: Pension, Profit-Sharing, and Other Deferred Compensation Plans. Ninth edition. Boston, MA: McGraw-Hill/Irwin, Bickley, Mary C., and William H. Rabel. Individual Retirement Arrangements (IRAs), Simplified Employee Pensions (SEPs), Savings Incentive Match Plans for Employees (SIMPLE Plans), and HR-10 (Keogh) Plans. In Jerry S. Rosenbloom, ed., The Handbook of Employee Benefits: Design, Funding and Administration. Sixth edition. New York: McGraw-Hill, Employee Benefit Research Institute. EBRI Databook on Employee Benefits. Online at Lesser, Gary S., and Susan D. Diehl. SIMPLE, SEP and SARSEP Answer Book. Fourteenth edition. New York: Aspen Publishers, U.S. Department of Labor. SEP Retirement Plans for Small Businesses. Washington, DC: U.S. Department of Labor, revised Fundamentals of Employee Benefit Programs

7 Additional Information American Benefits Council 1501 M Street, NW, Suite 600 Washington, DC (202) U.S. Department of Labor Employee Benefits Security Administration Frances Perkins Building 200 Constitution Avenue, NW Washington, DC (866) U.S. Department of the Treasury Internal Revenue Service 1111 Constitution Avenue, NW Washington, DC (800) (Tax Forms and Publications) (800) (Taxpayer Assistance and Information) 119