The Financial Planner

Continuing with more detailed descriptions from my Small Business Retirement Plans Quick List, the next plan I wanted to detail was the Savings Incentive Match Plan for Employees, or as it is more commonly known, the SIMPLE IRA. Just as the name suggests, it is a Simplified plan. Here I will discuss the SIMPLE IRA from the employer and the employee perspectives highlighting the pros and cons of each.

What is a SIMPLE IRA and How Does it Work?

In order to have a SIMPLE IRA plan, you must be a small business - generally, you must have 100 or fewer employees. However, there is a 2-year grace period for growing employers to still be considered a small business even if they go over the 100-employee limit. If you do opt for a SIMPLE IRA plan, your employees can elect to defer part of their salary. Each employee is immediately 100% vested in (or “owns”) all contributions to his or her SIMPLE IRA.

A SIMPLE IRA plan is a Savings Incentive Match Plan for Employees. Because this is a simplified plan, the administrative costs should be lower than for other, more complex plans. Under a SIMPLE IRA plan, employees and employers make contributions to traditional Individual Retirement Arrangements (IRAs) set up for employees (including self-employed individuals), subject to certain limits. It is ideally suited as a start-up retirement savings plan for small employers who do not currently sponsor a retirement plan.

Employers MUST make contributions, however employees can if they would like.

Setting Up a Simple IRA

The process behind establishing a SIMPLE IRA is incredibly easy. It only requires a couple of forms to get it up and running. A SIMPLE IRA can only be established if you have fewer than 100 employees and no other current retirement plan available.

Step 1: Contact a retirement plan professional or a representative of a financial institution that offers retirement plans. Many financial institutions will probably have a pre-approved SIMPLE IRA plan form that you can review.

Step 2: Choosing a financial institution to maintain employees’ SIMPLE IRAs is one of the most important decisions you will make, since that entity becomes a trustee to the plan. (Alternatively, you can decide to let employees choose the financial institution that will receive their contributions.)

Regardless of who makes the choice, only the following institutions can be designated as trustees of SIMPLE IRA plans: banks, mutual funds, insurance companies that issue annuity contracts, and certain other financial institutions that have been approved by the IRS.

Trustees agree to:

a) Receive and invest contributions, and

b) Provide the employer with a summary description of the plan features each year.

Step 3: Choose a model form or other plan document offered by your financial institution. If your financial institution offers a model SIMPLE IRA plan document, you will have a choice of two forms to use:

a) IRS Form 5304-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) - Not for Use With a Designated Financial Institution; or

b) IRS Form 5305-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) - for Use With a Designated Financial Institution.

The model form you use will depend on whether you decide to select the financial institution that will receive contributions or to let your employees select financial institutions.

c) If employees are allowed to select the financial institutions that will receive their SIMPLE IRA plan contributions, you will fill out Form 5304-SIMPLE.

d) If you require that all contributions under the SIMPLE IRA plan be initially deposited with a designated financial institution, you will fill out Form 5305-SIMPLE.

Your choice of the employees covered will be set out in your selected plan document. You can choose to cover all employees without restriction. Alternatively, you can limit the employees covered to those who received at least $5,000 in compensation during any 2 years prior to the current calendar year and who are reasonably expected to receive at least $5,000 during the current calendar year.

Step 4: Complete and sign the selected IRS form (or other plan document, if not using a model form). When it is completed and signed, this document becomes the plan’s basic legal document, describing your employees’ rights and benefits. Do not send it to the IRS; instead keep it handy.

Employee Eligibility for a SIMPLE IRA

Eligibility for a SIMPLE IRA is any employee who has made $5,000 or more in the previous 2 years, and who is expected to earn at least $5,000 this year.

SIMPLE IRA Contribution Limits

Employee - $10,500 in 2007 and 2008. If the employee is age 50 or over, a “catch-up” contribution is also allowed. This additional catch-up contribution amount is: 2007 and 2008 - $2,500.

Employer - Generally, a dollar-for-dollar match up to 3% of pay or a 2% non-elective contribution for each eligible employee.

SIMPLE IRA Filing Requirements

An employer generally has no filing requirements. The annual reporting required for qualified plans (Form 5500 series) is not required for SIMPLE IRA plans. The financial institution that holds the SIMPLE IRAs for the plan handles most of the other paperwork.

SIMPLE IRA Withdrawals:

Permitted, but withdrawals are included in income and are subject to a 10% additional tax if the participant is under age 59-1/2. Also, if withdrawals are made within the first two years of participation, the 10% additional tax is increased to 25%.

SIMPLE IRA Pros and Cons

SIMPLE IRA Pros and Cons

Pros:

1. Easy to set up and run – usually just a phone call to a financial institution gets things started.

2. Administrative costs are low.

3. Employees can contribute, on a tax-deferred basis, through convenient payroll deductions.

4. You can choose either to match the employee contributions of those who decide to participate or to contribute a fixed percentage of all eligible employees’ pay.

Cons:

1. Employers MUST contribute to the plan regardless of whether and employee contributes or not.

2. Contributions are not flexible.

3. Contribution limits are lower than other retirement plans.

Overall this plan is really more of a benefit to the employee than the employer, or small business owner. Though it is a nice incentive to maintain employees, it is fairly skewed into the employee’s favor. This plan is something I would typically use if you have some employees that are with you for many years. People you just want to reward for their service and dedication to your business since you are required to contribute every year regardless.

If you are considering a SIMPLE IRA, the IRS has put together a nice little SIMPLE IRA Checklist that will help you in determining if the play is right for you.

Since I have already written the small business retirement plans quick list it is now time to break down each retirement plan that I listed before in more depth. The first that we will cover is called the Simplified Employee Pension Plan (SEP). Most of the information involves using it as an employer, but I have included the exceptions and differences in rules if you plan to use the SEP IRA as self-employed persons, partnerships, sole proprietors, independent contractors, and owner-employees of an unincorporated trade or business; however, it may be set up by any type of business.

What is a SEP?

The Simplified Employee Pension Plan, or SEP IRA as it is more commonly known, is one of the many options for funding a retirement account for your employees of any business, or just for yourself if you are self-employed. The SEP IRA is very easy to understand and the administration costs are very low, unlike other plans such as the most widely known retirement plan , the 401k. The costs are almost non-existent if you are self-employed and have no employees. Contributions are made directly to an Individual Retirement Account or Annuity (IRA) set up for each employee by the employer. No employee contributions are allowed.

Standard withdrawal rules for qualified retirement plans apply. Withdrawals before the age of 59.5 are subject to penalty, and withdrawals are taxable upon taking the money out. Money in the plan is able to grow tax-deferred while it is in the plan like any other IRA.

Setting Up a SEP IRA

The process of setting up a SEP IRA is a short and painless process. An employer must set up a SEP IRA agreement and have eligible employees. There are three basic steps according to the IRS that must be satisfied in order to create a Simplified Employee Pension Plan:

1. A formal written agreement must be executed. This written agreement may be satisfied by adopting an Internal Revenue Service (IRS) model SEP using Form 5305-SEP, Simplified Employee Pension - Individual Retirement Accounts Contribution Agreement. A prototype SEP that was approved by the IRS may also be used. Approved prototype SEPs are offered by banks, insurance companies, and other qualified financial institutions. Finally, an individually designed SEP may be adopted.

2. Each eligible employee must be given certain information about the SEP. If the SEP was established using the Form 5305-SEP, the information must include a copy of the Form 5305-SEP, its instructions, and the other information listed in the Form 5305-SEP instructions. If a prototype SEP or individually designed SEP was used, similar information must be provided.

3. A SEP-IRA must be set up for each eligible employee. SEP-IRAs can be set up with banks, insurance companies, or other qualified financial institutions. The SEP-IRA is owned and controlled by the employee and the employer sends the SEP contributions to the financial institution where the SEP-IRA is maintained.

Employee Eligibility for a SEP IRA

To be eligible for a SEP IRA as an employee the following conditions must be met:

1. The employee is at least 21 years of age.

2. has worked for the employer in at least 3 of the last 5 years

3. has received at least $450 (subject to annual cost-of-living adjustments) in compensation from the employer for the year ($500 for 2007).

Employees may be excluded from the plan under only 2 conditions: (a) employees covered by a union agreement whose retirement benefits were bargained for in good faith by the employees’ union and the employer; and (b) nonresident alien employees who have no U.S. source compensation from the employer may be excluded.

SEP IRA Contribution Limits

Annual contributions an employer can make for an employee in a given year may not exceed the lesser of the following:

1. 25% of an employee’s income

2. $44,000 for 2006 ($45,000 for 2007 and subject to annual cost-of-living adjustments for later years).

The limits apply in the aggregate to contributions an employer makes for its employees to all defined contribution plans, which includes SEPs. Only up to $220,000 in 2006 ($225,000 in 2007 and subject to annual cost-of-living adjustments for later years) of an employee’s compensation may be considered. Contributions must be made in cash. Property cannot be contributed.

Regardless of the limits, an employer can choose any percentage, or total below the amount stated as the maximum allowable by the IRS. Employers are NOT required to contribute to the employees’ SEP IRAs every year. It is at the full discretion of the employer, but when contributions are made, they must be made into the SEP IRA accounts of every eligible employee.

Deducting SEP IRA contributions

Of course when contributing to an employee retirement plan an employer has the right to deduct some, or all of that contribution from the business’s taxes. Let’s look at exactly how much you can deduct for your SEP IRA contributions.

The most that may be deducted on the business’s tax return for contributions to its employees’ SEP-IRAs is the lesser of its contributions or 25% of compensation. (Compensation considered for each employee is limited to $220,000 in 2006, $225,000 for 2007 and subject to annual cost-of-living adjustments for later years.)

If the employee is self-employed and contributes to his or her own SEP-IRA, a special computation to figure out the maximum deduction for these contributions must be made. When figuring the deduction for contributions made to a self-employed individual’s SEP-IRA, compensation is net earnings from self-employment which takes into account the following deductions:

1. the deduction for one-half of the individual’s self-employment tax, and

2. the deduction for contributions to the individual’s own SEP-IRA.

See Publication 560 for details on determining the deduction.

SEP IRA for Self-Employed Individual

Self-employed individuals are subject to the same contribution limits as they would be for the sontributions they made for employees. 25%, or $45,000, whichever is less. Although the plan is very easy to use, there may be better options than using a SEP IRA if you have a significantly higher income and would like to contribute more to a retirement plan. Especially if you are married. In a leter post I will discuss the option of using the Solo 401K plan, or the Individual 401k plan as an option for sole proprietorships, partnerships, LLCs and corporations (including both subchapter S and C corporations) who have no employees.

SEP IRA Pros and Cons

Pros:

Contributions do not have to be made every year, which is very appealing. Contributions are not set at any level, and do not have to be the same every year. Very easy and cheap to set up and administer. Immediate vesting for the employee (which is an employer con). Employees must have worked for you for 3 out of the last 5 years to be eligible for contributions. If you have a high employee turnover rate, or you have a few employees that are important to your business this can be a plan that sort of disqualifies short-term employees, but at the same time rewards your loyal ones.

Cons:

Must cover all qualifying employees. Employees cannot contribute. Vesting is immediate. This means that once you put the money in it is theirs.

One of the best strategies I would use with clients that had pension plans was to have them supplement it with life insurance. There is a very good reason for this for the people that are looking to retire, and are married. Many times when someone retires and wants to start collecting on their pension plans they worked so hard for all their lives they take a reduced benefit so that if they die they will be able to leave their spouse a benefit as well. This is a nice thought, but isn’t there a better way to utilize a pension plan and have more money while you are alive? Yes. Yes there is.

Let’s consider a typical situation of the day when you start collecting on your pension. You may elect to take the reduced benefit of say 70% so that your spouse can continue to collect 40-50% of your pension if you die before they do. Most people elect to get their distributions in this way. For some it is the correct solution, but for many they could just take a 100% distribution for themselves and supplement it with a life insurance policy.

Let’s use some remedial math to look at a situation which would make the most sense for someone collecting on a pension, and qualifies for life insurance coverage. Hypothetically, if you were to take a 100% distribution on your pension you are going to get $1000 a month. So that means if you took only a 70% distribution you would get only $700 a month, but your spouse would get $500 a month after you died until they dies. What if life insurance only cost you $100 a month to cover the need for your spouse after you died? Wouldn’t it make more sense to collect $1000 a month and pay the $100 for insurance every month than it would be to just collect $700 a month? Of course it would! You would still have $900 a month while you were alive instead of $700. Your spouse would also get a big lump sum payment after you died from the life insurance policy instead of the piddly 50% benefit ever month from your pension.

Any financial advisor worth his salt should think of using this strategy for a client that has a pension plan when they will retire. More importantly, you need to think about this a bit before you retire. There is a big difference in the monthly cost of life insurance as you get older. As some insurance agents like to say: “One year older, and closer to death.”. This just means that the risk of you dying to an insurance company is greater the older you are so the cost of the insurance is more. If you get yourself insured younger the premiums will be much lower and you may avoid the unfortunate possibility that you could become uninsurable as you age due to disease, or any other ailment that disqualifies you from coverage.

As always, planning for your retirement starts as early as possible, but when it comes to life insurance as a retirement supplement this couldn’t be more true. If you have a pension plan for when you retire ask your financial advisor about this strategy. I guarantee they will love it since it not only helps you tremendously if all the numbers fall into place, but they make a good sum of money selling life insurance to you so it is a win-win for everyone.