Simplified Employee Pension (SEP) Plans
SEP plans are employer-funded retirement accounts that allow small businesses to direct at least 3 percent and up to 15 percent of each employee's annual salary, to a maximum of $30,000, into tax-deferred individual retirement accounts (IRAs) on a discretionary basis. SEP plans are easy to set up and inexpensive to administer, as the employer simply makes contributions to IRAs that are established by employees. The employees then take responsibility for making investment decisions regarding their own IRAs. Employers thus avoid the risk and cost involved in accounting for employee retirement funds. In addition, employers have the flexibility to make large percentage contributions during good financial years, and to reduce contributions during hard times. SEP plans are available to all types of business entities, including proprietorships, partnerships, and corporations. In general, eligibility is limited to employees 21 or older with at least three years of service to the company and a minimum level of compensation. The maximum level of compensation for SEP eligibility is $170,000.
Savings Incentive Match Plan for Employees (SIMPLE)
SIMPLE plans take two forms: a SIMPLE IRA and a SIMPLE 401(k). Both plans became available in January 1997 to businesses with less than 100 employees, replacing the discontinued Salary Reduction Simplified Employee Pension (SARSEP) plans. They were intended to provide an easy, low-cost way for small businesses and their employees to contribute jointly to tax-deferred retirement accounts. An IRA or 401(k) set up as a SIMPLE account requires the employer to match up to 3 percent of an employee's annual salary, up to $6,000 per year. Employees are also allowed to contribute up to $6,000 annually to their own accounts. Companies that establish SIMPLEs are not allowed to offer any other type of retirement plan. As of early 1997, most small businesses chose the SIMPLE IRA option, as the SIMPLE 401(k) proved more expensive than a regular 401(k) due to the company matching requirements. The main problem with the plans, according to many financial planners, was that legislation is already being drafting that would make SIMPLE less simple and more expensive for the businesses that the plans were created to serve.
Profit Sharing Plans
Profit sharing plans enable employers to make a discretionary, tax-deductible contribution on behalf of employees each year, based on the level of profits achieved by the business. The total annual contribution is generally allocated among employees as a percentage of their compensation. Plan costs are tax deductible for the employer, and plan earnings are tax deferred for employees. Profit sharing plans are easy to implement, offer design flexibility, and provide a wide range of investment choices. Eligibility is typically limited to employees who are at least 21 years of age and who have at least one year of service. The employer's maximum deduction is 15 percent of the total annual salaries paid to nonowner employees (adjusted to 13.04 percent for the small business owner).
A common variation is the age-based profit sharing plan, in which contributions are based on an allocation formula that factors in the age or number of years to retirement of participants. Age-based profit sharing allows employers to reward valued older employees for their length of service. Another variation is the new comparability profit sharing plan, which allows employers to define classes of employees and set up the retirement plan so that certain classes benefit the most in terms of allocation. These types of profit sharing plans are similar to defined-benefit plans, but the employer contributions are discretionary.
Money Purchase Pension Plans
Money purchase pension plans are similar to regular profit sharing plans, but the employer contributions are mandatory rather than discretionary. The main advantage of money purchase plans is that they allow larger employer contributions than regular profit sharing plans. The employer determines a fixed percentage of profits that will be allocated to employee retirement accounts according to a formula. The maximum employer contribution jumps to 25 percent of payroll for nonowner employees (adjusted to 20 percent for the small business owner) or a total of $30,000 per employee. There are also combination money purchase-profit sharing plans that allow employers to select a fixed percentage for mandatory contribution and also retain the option of contributing additional funds on a discretionary basis when cash flow permits.
401(k) Profit Sharing Plans
The popular 401(k) plans are profit sharing plans that include a provision for employees to defer part of their salaries for retirement. The employer can make annual profit sharing contributions on behalf of employees, the employees can contribute up to $10,000 of pre-tax income themselves, and the employer can choose to match some portion of employee contributions. 401(k) plans offer a number of advantages. First, they allow both employer and employee to make contributions and gain tax advantages. Second, they can be set up in such a way that employees can borrow money from the plan. Third, 401(k) plans enable employees to become active participants in saving and investing for their retirement, which raises the level of perceived benefits provided by the employer. The main disadvantages are relatively high set-up and administrative costs. Eligibility for 401(k) plans is typically limited to employees at least 21 years of age who have at least one year of service with the company.
