When an employer considers establishing a retirement plan for their organization, there are numerous factors to consider. How much will the Company contribute and what will the employee cost be? What is involved in plan administration? Can the employer assume the responsibility for plan administration or should a professional service provider be hired and at what cost?
Simplified retirement plans were created by the IRS as a means to encourage small businesses to provide retirement plans for their employees, with limited administration and no annual filing of Form 5500. This selling point has led to the misconception that there is no administration required for these plans, when, in fact, they are self-administered by the employer, who has the sole responsibility for making sure the plans comply with IRS and Department of Labor (“DOL”) regulations. If an employer is interested in establishing a simplified retirement plan they have two options- a Simplified Employee Pension (SEP) or a Savings Incentive Match Plan (Simple Plan).
The SEP plan allows plan sponsors to contribute directly to traditional IRAs that are set up for their employees. These plans are funded solely by the employer. Employees are not permitted to make salary deferral contributions to these plans, with the exception for grandfathered SAR-SEP plans.
A SEP-IRA must be established on behalf of all employees who, at the very minimum, are at least 21 years old, have been employed by the employer for three of the last five years and had annual compensation of at least $600. The employer has the option to select more liberal eligibility requirements, such as no service requirement at all.
Other significant drawbacks for this “simplified” Plan include no vesting of contributions, ease of plan entry, essentially the same contributions for every participant (including owners), and potential taxation by certain States.
The typical Simple Plan is a Simple IRA. The Simple Plan permits both employer and employee contributions. Under this plan, it is mandatory that employers contribute on behalf of all participating employees, in one of two ways, either with a 2% of pay contribution or matching 100% of an employee’s salary deferral contributions limited to the first 3% an employee contributes. The Simple Plan can only be offered by employers with 100 or fewer employees.
A Simple-IRA must be established on behalf of all employees who have compensation of at least $5,000 in any prior 2 years, and are reasonably expected to earn at least $5,000 in the current year.
Other drawbacks include a mandatory employer contribution every year, no vesting of this contribution, and potential taxation by States of both employee and employer contributions. A traditional 401(k) plan mitigates these drawbacks and the SEP drawbacks outlined above.
These plans are easy enough to set up. However, after being set up, what often happens is that there is no annual monitoring of these plans by the employer or the financial institution that established the employees’ IRA accounts. In that respect, these plans differ from traditional retirement plans, such as 401(k), profit sharing, or defined benefit, where an employer must engage a third party administrator, such as Benefits 21 LLC, to address the annual compliance requirements.
IRS auditors have published the following most common compliance failures associated with SEP and Simple plans:
- Plan documents have not been updated for current law
- Employees of related businesses were excluded from participating
- Eligible employees were excluded from participating
- Contributions to participants’ IRAs were miscalculated because the wrong definition of compensation was used
- Contributions to each participant’s SEP-IRA weren’t a uniform percentage of the participant’s compensation
- Contributions to participants’ IRAs exceeded the maximum legal limits
- Simple plans had more than 100 employees who earned $5000 or more
- A business incorrectly maintains another retirement plan
- Employer contributions were not given to terminated eligible employees
- Simple plan annual employee notification requirements were not followed
Traditional plans (i.e. 401(k), Profit Sharing, Defined Benefit) typically do not suffer these failures because those Plans are actively administered by firms such as ours because these services are provided as part of our engagement. Even if Employers are reticent to change plan types, they should consider engagement of a professional administrator to ensure compliance.
The consequences of a compliance failure can be costly for an employer, especially if the failure involves excluding eligible employees or contributions. The IRS and DOL correction methods for such failures require depositing missed contributions along with lost earnings to each affected employees’ accounts. To receive formal approval for any correction, an employer is required to file an application with the IRS or DOL for a fee, as well as, engaging an outside party to prepare the submission.
In the worst-case scenario where the plan is disqualified, the employer’s deductions would be disallowed and the employees’ IRAs would become taxable, including rollover IRAs.
Time to make a change
Even if the burden of ensuring that its SEP or Simple Plan remain compliant isn’t enough, an employer may want to switch to a traditional retirement plan for purely economic reasons.
Business owners who are looking to maximize their annual pension contributions may find a SEP plan too costly if they have to include all eligible employees. For example, a business owner who earns $265,000 a year(the maximum IRS compensation limit) and wants to make the maximum $53,000 SEP contribution on his/her behalf would be required to make a comparable 20% of pay contribution on behalf of all eligible employees. Compare this with a 401(k) plan that has a new comparability profit sharing design, where an employer may only have to contribute 5% of pay for all eligible employees.
Obviously, SEP plans are most beneficial to business owners that have no employees. However, a business owner who is age 50 or older can benefit more from a Solo 401(k) plan which would allow an additional $6,000 catch-up contribution for a total annual contribution of $59,000. The Form 5500 annual filing requirement becomes effective once the plan assets in a Solo 401(k) plan exceed $250,000.And from an employee’s tax perspective, both employee and employer contributions to SEP and Simple IRAs are included in New Jersey taxable wages (neither receive the tax-deferred treatment that is afforded 401(k) plans).
Once an employer decides that its SEP or Simple plan is no longer suitable and that a traditional plan would be more beneficial, the employer would then proceed to terminate the plan. These two types of plans s have different plan termination methods, and neither method requires that notification be given to the IRS or DOL.
To terminate an SEP, the employer notifies the financial institution that there will be no further contributions to the plan and that they want to terminate their contract or agreement. Employees are also notified of the plan termination.
To terminate a Simple plan, notification must be provided to the employees within a reasonable amount of time before November 2nd that the employer will discontinue the Simple IRA plan effective the following January 1st. So, for example, if an employer decides to terminate their plan on November 23, 2016, the earliest effective termination date would be January 1, 2018. An employer cannot terminate their Simple IRA plan in the middle of a plan year.
Once notification is provided to the employees, the employer than notifies the financial institution and payroll provider of the plan termination.
Below is a comparison chart summarizing the basic characteristics of the SEP, Simple IRA and traditional 401(k) plans.
|Employee Eligibility Requirements||Must be offered to all employees who are at least 21 years old, employed by the employer for 3 of the last 5 years and had compensation of $600 for 2016||Must be offered to all employees who have compensation of at least $5,000 in any prior 2 years, and are reasonably expected to earn at least $5,000 in the current year.||Generally, must be offered to all employees at least 21 years old who worked at least 1,000 hours in a previous year.|
|Contributors to the Plan||Employer can decide whether to make contributions year to-year.||Employee can decide how much to contribute. Employer must make matching contributions or contribute 2% of each employee’s compensation.||Employee salary reduction contributions and employer contributions.|
|Maximum Annual Contributions||Up to 25% of compensation but no more than $53,000 for 2016.||
Employee: $12,500 in 2016. Participants age 50 or over can make additional contributions up to $3,000 for 2016.
Employer: Either match employee contributions 100% of first 3% of compensation (can be reduced to as low as 1% in any 2 out of 5 yrs.); or contribute 2% of each eligible employee’s compensation.
Employee: $18,000 in 2016. Participants age 50 or over can make additional contributions up to $6,000 for 2016.
|Employer Eligibility||Any employer with one or more employees.||Any employer with 100 or fewer employees that does not currently maintain another retirement plan.||
Any employer with one or more employees.
The Simplified Plans are good examples of “no-frills” retirement planning, which is exactly the IRS’ intention when these plans were created. Because of the limited options offered by these plans, they can be well-suited for employers looking for a low cost retirement plan. However, the employer must be well-educated in the limited plan administration required by these plans and also be diligent in keeping these plans compliant. Otherwise, the ultimate cost for correcting a noncompliant SEP or Simple plan could be significant.
The areas that cause the most problems for employers in maintaining a SEP or a Simple plan are:
- Having a properly executed plan document which is timely updated for changes in IRS code and regulations
- Including all eligible employees
- Properly calculating employer contributions
A traditional retirement plan requires paying an annual administration fee to a service provider, but the economic benefits an employer can reap with a well-designed plan could very well more than cover these costs.