Retirement Plans for Small Businesses
If you are the owner of a small business (including a self-employed person), you can set up certain qualified retirement plans. See Qualified Plans, earlier. These plans generally are called Keogh or HR-10 plans. You also can set up a less complicated tax-advantaged retirement plan. See Simplified Employee Pension (SEP), later.
A small employer can also set up a SIMPLE retirement plan. See SIMPLE Retirement Plans after the Simplified Employee Pension (SEP) discussion.
Only a sole proprietor or a partnership (but not a partner) can set up a Keogh plan. For plan purposes, a self-employed person is both an employer and an employee. It is not necessary to have employees besides yourself to set up a Keogh plan. The plan must be for the exclusive benefit of employees or their beneficiaries. You generally can deduct contributions to the plan. Contributions are not taxed to your employees until plan benefits are distributed to them.
See Publication 560 for the definition of employer, employee, and common-law employee.
The limit on your deduction for your contributions to a Keogh plan depends on the kind of plan you have.
Defined contribution plans. The deduction limit for a defined contribution plan depends on whether it is a profit-sharing plan or a money purchase pension plan.
Profit-sharing plan. Your deduction for contributions to a profit-sharing plan cannot be more than 15% of the compensation from the business paid (or accrued) during the year to the common-law employees participating in the plan. You must reduce this 15% limit in figuring the deduction for contributions you make for your own account. See Deduction of contributions for yourself, later.
Money purchase pension plan. Your deduction for contributions to a money purchase pension plan is generally limited to 25% of the compensation from the business paid during the year to a participating common-law employee. You must reduce this 25% limit in figuring the deduction for contributions you make for yourself, as discussed later.
Defined benefit plans. The deduction for contributions to a defined benefit plan is based on actuarial assumptions and computations. Consequently, an actuary must figure your deduction limit.
Employee benefits play an increasingly important role in the lives of employees and their families and have a significant financial and administrative impact on a business. Most companies operate in an environment in which an educated work force has come to expect a comprehensive benefits program. Indeed, the absence of a program or an inadequate program can seriously hinder a company's ability to attract and keep good personnel. Employers must be aware of these issues and be ready to make informed decisions when they select employee benefits. One typical company in California, Target Laboratories (www.targetlab.com) confirms the importance of the company-wide 401k. Designing the right benefit plan for your employees is a complex task. There are many issues to consider, including tax and legal aspects, funding, and finding the right vendors or administrators.
In figuring the deduction for contributions, you cannot take into account any contributions or benefits that exceed the limits discussed under Limits on Contributions and Benefits in Publication 560.
The deduction limit for contributions to a defined benefit plan may be greater than the defined contribution plan limits just described, but actuarial calculations are needed to determine the amount. For more information about these plans, see Kinds of Plans in Publication 560.
Deduction of contributions for yourself. To take a deduction for contributions you make for yourself to a plan, you must have net earnings from the trade or business for which the plan was established.
Limit on deduction. If the Keogh plan is a profit-sharing plan, your deduction for yourself is limited to the smaller of $30,000 or 13.0435% (15% reduced as discussed below) of your net earnings from the trade or business that has the plan. If the plan is a money purchase pension plan, the deduction is limited to the smaller of $30,000 or 20% (25% reduced as discussed below) of your net earnings.
Net earnings. Your net earnings must be from self-employment in a trade or business in which your personal services are a material income-producing factor. If you are a partner who only contributed capital, and who did not perform personal services, you cannot participate in the partnership's plan. Your net earnings do not take into account tax-exempt income (or deductions related to that income) other than foreign earned income and foreign housing cost amounts.
Your net earnings are your business gross income minus allowable deductions from that business. Allowable deductions include contributions to the plan for your common-law employees along with your other business expenses.
If you are a partner other than a limited partner, your net earnings include your distributive share of the partnership income or loss (other than separately computed items such as capital gains and losses) and any guaranteed payments you receive from the partnership. If you are a limited partner, your net earnings include only guaranteed payments you receive for services rendered to or for the partnership.
Net earnings do not include income passed through to shareholders of S corporations.
Adjustments. You must reduce your net earnings by the income tax deduction for one-half of your self-employment tax. Also, net earnings must be reduced by the deduction for contributions you make for yourself. This reduction is made indirectly, as explained next.
Net earnings reduced by adjusting contribution rate. You must reduce net earnings by your deduction for contributions for yourself. The deduction and the net earnings depend on each other. You can make the adjustment to your net earnings indirectly by reducing the contribution rate called for in the plan and using the reduced rate to figure your maximum deduction for contributions for yourself.
Annual compensation limit. You generally cannot take into account more than $160,000 of your compensation in figuring your contribution to a defined contribution plan.
For employees in a collective bargaining unit covered by a plan for which the $160,000 limit does not apply, the compensation limit is $250,000.
Figuring your deduction. Use the Rate Worksheet for Self-Employed illustrated in the following example to find the reduced contribution rate for yourself. Make no reduction to the contribution rate for any common-law employees.
After you have your self-employed rate, you can figure your maximum deduction for contributions for yourself by using the Deduction Worksheet for Self-Employed also illustrated in the example:
Example. You are a sole proprietor and have employees. The terms of your plan provide that you contribute 10 1/2% (.105) of your compensation, and 10 1/2% of your common-law employees' compensation. Your net earnings from line 31, Schedule C (Form 1040) are $200,000. In figuring this amount, you deducted your common-law employees' pay of $100,000 and contributions for them of $10,500 (10 1/2% x $100,000). You figure your self-employed rate and maximum deduction for employer contributions for your benefit as follows: Rate Worksheet for Self-Employed
Plan contribution rate as a decimal (for example, 10 1/2% would be 0.105)
Rate in line 1 plus one, (for example, 0.105 plus one would be 1.105)
Self-employed rate as a decimal (divide line 1 by line 2)
0.0950 Deduction Worksheet for Self-Employed
Step 1 Enter the contribution rate shown in line 3 above
Step 2 Enter the amount from: line 31, Schedule C (Form 1040); line 3, Schedule C-EZ (Form 1040); line 36, Schedule F (Form 1040); or line 15a, Schedule K-1 (Form 1065)
Step 3 Enter your deduction for self-employment tax from line 27, Form 1040
Step 4 Subtract step 3 from step 2 and enter the result
Step 5 Multiply step 4 by step 1 and enter the result
Step 6 Multiply $160,000 by your plan contribution rate. Enter the result, but not more than $30,000
Step 7 Enter the smaller of step 5 or step 6. This is your maximum deductible contribution Enter your deduction on line 29, Form 1040
When to make contributions. To take a deduction for contributions for a particular year, you must make the contributions not later than the due date (plus extensions) of your tax return for that year.
More information. See Publication 560 for more information about retirement plans for small business owners, including the self-employed. It also discusses the reporting forms that must be filed for these plans.
Simplified Employee Pension (SEP)
A simplified employee pension (SEP) is a written plan that allows you to make deductible contributions toward your own and your employees' retirement without getting involved in more complex retirement plans. A corporation also can have a SEP and make deductible contributions toward its employees' retirement. But some advantages available to Keogh and other qualified plans, such as the special tax treatment that may apply to lump-sum distributions, do not apply to SEPs.
Under a SEP, you make the contributions to an individual retirement arrangement (called a SEP-IRA in this chapter), which is owned by you or your common-law employee.
SEP-IRAs are set up for, at a minimum, each qualifying employee. A SEP-IRA may have to be set up for a leased employee, but need not be set up for an excludable employee. You may be able to use Form 5305-SEP in setting up your SEP. For more information, get Publication 560.
Contribution limits. Contributions you make for a year to a common-law employee's SEP-IRA cannot exceed the smaller of 15% of the employee's compensation or $30,000. Compensation, for this purpose, generally does not include employer contributions to the SEP.
Annual compensation limit. You generally cannot consider the part of compensation of an employee that is over $160,000 when you figure your contributions limit for that employee.
For employees in a collective bargaining unit for which the $160,000 limit does not apply, the compensation limit is $250,000
More than one plan. If you also contribute to a defined contribution retirement plan, annual additions to an account are limited to the lesser of (1) $30,000 or (2) 25% of the participant's compensation. When you figure these limits, your contributions to all of the plans must be added. Since a SEP is considered a defined contribution plan for purposes of these limits, your contributions to a SEP must be added to your contributions to defined contribution plans.
Reporting on Form W-2. Do not include SEP contributions on Form W-2, Wage and Tax Statement, unless there are contributions under a salary reduction arrangement.
Contributions for yourself. The annual limits on your contributions to a common-law employee's SEP-IRA also apply to contributions you make to your own SEP-IRA. However, special rules apply when you figure your maximum deductible contribution. See Deduction of contributions for yourself, later.
Deduction limits. The most you can deduct for employer contributions for common-law employees is 15% of the compensation paid to them during the year from the business that has the plan.
Deduction of contributions for yourself. When figuring the deduction for employer contributions made to your own SEP-IRA, compensation is your net earnings from self-employment, which takes into account:
- The deduction allowed to you for one-half of the self-employment tax, and
- The deduction for contributions on behalf of yourself to the plan.
The deduction amount for (2), above, and your compensation (net earnings) are each dependent on the other. For this reason, the deduction amount for (2) is figured indirectly by reducing the contribution rate called for in your plan. This is done by using the Rate Worksheet for Self-Employed, shown earlier in the chapter.
SEP and profit-sharing plans. If you also contributed to a qualified profit-sharing plan, you must reduce the 15% deduction limit for that plan by the allowable deduction for contributions to the SEP-IRAs of those participating in both the SEP and the profit-sharing plan.
SEP and other qualified plans. If you also contributed to any other type of qualified plan, treat the SEP as a separate profit-sharing plan for purposes of applying the overall 25% deduction limit described in section 404(h)(3) of the Internal Revenue Code.
Employee contributions. Participants can also make contributions of up to $2,000 to their SEP-IRAs independent of the employer's SEP contributions. The portion of the IRA contributions that is deductible may be reduced or eliminated because the participant is covered by an employer retirement plan (the SEP plan).
Salary Reduction Arrangement
An employer is no longer allowed to establish a SARSEP. However, participants in a SARSEP established before 1997 (including employees hired after 1996) can continue to elect to have their employer contribute part of their pay to the plan.
A SEP can include a salary reduction (elective deferral) arrangement. Under the arrangement, employees can elect to have you contribute part of their pay to their SEP-IRAs. The income tax on the part contributed is deferred. This choice is called an elective deferral, which remains tax free until distributed (withdrawn).
This election is available only if:
- At least 50% of your employees eligible to participate choose the salary reduction arrangement,
- You had 25 or fewer employees who were eligible to participate in the SEP (or would have been eligible to participate if you had maintained a SEP) at any time during the preceding year, and
- The deferral each year by each eligible highly compensated employee (as defined in Publication 560) as a percentage of pay (deferral percentage) is no more than 125% of the average deferral percentage (ADP) of all nonhighly compensated employees eligible to participate (the ADP test). You generally cannot consider compensation of an employee in excess of $160,000 in figuring an employee's deferral percentage.
Limits on elective deferrals. In general, the total income an employee can defer under a salary reduction arrangement included in a SEP and certain other elective deferral arrangements for 1998 is limited to the lesser of 15% of the participant's compensation (as defined in Publication 560) or $10,000. This limit applies only to the amounts that represent a reduction from the employee's pay, not to any contributions from employer funds.
Employment taxes. Elective deferrals, not exceeding the ADP test, are not subject to income tax in the year of deferral, but are included in wages for social security, Medicare, and unemployment (FUTA) tax purposes.
Reporting SEP Contributions on Form W-2
Your SEP contributions are excluded from your employees' income. Unless there are contributions under a salary reduction arrangement, do not include these contributions in your employees' wages on Form W-2, for income, social security, or Medicare tax purposes. Your SEP contributions under a salary reduction arrangement are included in your employees' Form W-2 wages for social security and Medicare tax purposes only.
Example. Jim's salary reduction arrangement calls for a deferral contribution rate of 10% of his salary to be contributed by his employer as an elective deferral to Jim's SEP-IRA. Jim's salary for the year is $30,000 (before reduction for the deferral). The employer did not elect to treat deferrals as compensation under the arrangement. To figure the deferral amount, the employer multiplies Jim's salary of $30,000 by 9.0909%, the reduced rate equivalent of 10%, to get the deferral amount of $2,727.27. (This method is the same one that you, as a self-employed person, use to figure the contributions you make on your own behalf.) See Rate Worksheet for Self-Employed, earlier in the chapter.
On Jim's Form W-2, the employer shows total wages of $27,272.73 ($30,000 minus $2,727.27), social security wages of $30,000, and Medicare wages of $30,000. Jim reports $27,272.73 as wages on his individual income tax return.
If the employer elects to treat deferrals as compensation under the salary reduction arrangement, Jim's deferral amount would be $3,000 ($30,000 x 10%) because, in this case, the employer uses the rate called for under the arrangement (not the reduced rate) to figure the deferral and the ADP test. On Jim's Form W-2, the employer shows total wages of $27,000 ($30,000 minus $3,000), social security wages of $30,000, and Medicare wages of $30,000. Jim reports $27,000 as wages on his return.
In either case, the maximum deductible contribution would be $3,913.05 ($30,000 x 13.0435%).