FOR SMALL BUSINESSES, WHETHER INCORPORATED OR NOT, TAX TIME APPROACHETH. For the new business or
one that does not have a retirement plan, this might be a good time to consider establishing one.
Although other types of plans exist, namely 401k or Keogh plans, many companies elect to go with
either a Simplified Employee Pension (SEP) [IRC Sec 408(k)] or a Savings Incentive Match Plan
(SIMPLE) [IRC Sec 408(p)]. The advantage that these plans have over the others are: a) they can
be established at a lower cost, b) their nondiscrimination provisions, if any, are simpler, and
c) they are easier to administer.
Establishing a Plan (SEPs) have no restrictions on the number of employees that a
business has to be eligible to establish a plan. Businesses with 100 or fewer employees who received
at least $5,000 of compensation for the prior year and which do not have any other employer-sponsored
retirement plan may set up a SIMPLE. Both types of plans may be set up as a calendar year plan by
completing FORM 5305 (either 5305 SEP or 5305 SIMPLE) which has been pre-approved by the IRS and are
available from most banks or mutual fund companies. SIMPLEs must be set up as a calendar year
Employee Eligibility Nondiscriminatory employer contributions under a SEP must
be made for each employee who has reached age 21, has performed services for the employer during
at least three of the immediately preceding five years, and has received at least $400 for the current
year (indexed for inflation). For a company with a SIMPLE, contributions must be made for each
employee who received at least $5,000 in compensation during any two preceding years and who can
reasonably be expected to receive that much during the current year. Either type of plan may establish
less restrictive requirements.
Employer Contributions Employer contributions under a SEP must follow a written
allocation formula that sets forth the employee eligibility requirements and how the employee’s
share is computed. The maximum deductible employer contribution is the lesser of a) 15% of the
employee’s compensation subject to FICA taxes without regard to the employer’s contribution or
b) $30,000. For 2000, the maximum compensation allowed is $170,000 which effectively reduces the
maximum amount to $25,500. Employer contributions may be changed from year to year; they are not
mandatory for any year.
Employer contributions under a SIMPLE are mandatory. The employer may choose the contribution level for
the following year by providing notice to eligible employees by November 1st of the current
year. Employers may choose to match their employees’ contribution up to a maximum of 3% of
compensation or to contribute a fixed 2% of employee compensation without regard to the employee’s
contribution. Under the 3% choice, the employer has the option to reduce their matching portion
to as low as 1% for any two years in a five year consecutive period. The maximum employer contribution
for any year is $6,000.
Contributions for self-employed individuals are calculated by multiplying the application contribution
rate and self-employment income after deducting one-half the self-employment tax and the retirement
plan contribution. For individuals wishing to make the maximum contribution, this results in an
effective contribution rate of 13.043% of SE income after deducting one-half of the self-employment
tax. In figuring the effective rate for other contribution percents, divide the rate by 1 plus the
rate, i.e. for a 10% contribution, divide .10 by 1.10 to get an effective rate of 9.091%.
Employee Contributions Employees participating in a SEP may also contribute to their own IRA subject
to the rules that apply to contributions by an individual. Employees may contribute a maximum of
$6,000 per year to a SIMPLE. This contribution, known as an elective deferral, is subject to FICA
taxes but not included in taxable income reported on the employee’s W-2. Employees’ contributions
must be remitted to the plan custodian within 30 days from the end of the month in which they were
Employer’s Deductions for Contributions The maximum annual amount that an employer can deduct is 15%
under a SEP. Excess contributions are carried over to future years subject to the same 15% limitation.
An employer’s deduction for a SIMPLE cannot exceed $6,000. Under either type of plan, the deduction
Is taken for the applicable year as long as it is made by the due date (including extensions) for the
business’s tax return.
Small companies wishing to retain skilled employees or closely-held businesses wishing to provide for
the owner's retirement may find a SEP or SIMPLE retirement plan attractive alternatives to the more
complex and costly Keogh or 401k plans. As always, each plan has specific requirements and circumstances
vary from employer to employer, so consult your tax advisor before setting up your plan.
Tom Van Hazebroeck is a CPA who provides tax planning, computer consulting and accounting services
to small businesses and individuals. Mr. Van Hazebroeck can be reached by email at
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