EA2 Study Unit 19.1-19.4 Retirement Plans for Small Businesses

• This study unit discusses retirement plans that the owner of a small business, including a self- employed person, can set up and maintain for employees
• The IRS tests three types of plans: simplified employee pension (SEP) plans, SIMPLE plans, and qualified plans
• A SEP is a simple plan that allows contributions to retirement plans without involvement with the more complex qualified plan
• Some advantages available to qualified plans do not apply to SEP, for example, special tax treatment that may apply to qualified plan lump-sum distributions

Simplified Employee Pension (SEP)

• A SEP is a written agreement that allows an employer to make contributions toward his or herretirement (if a self-employed individual) and his or her employees' retirement without becoming involved in more complex retirement plans
• Under a SEP, an employer contributes directly to traditional individual retirement accounts(SEP-IRAs) for each qualifying employee and/or self-employed individual
• The employer can set up a SEP plan for a year as late as the due date (including extensions) for the business income tax return for the year
• The employer must make contributions to the SEP plan by the due date of the employer's return, including extensions. Contributions are reported on Form 5498
• A SEP-IRA is owned and controlled by the employee
• The employer can have another retirement plan
• A self-employed individual is an employee for SEP purposes even if they are the only qualifying employee
• Self-employment services must represent a material income-producing factor
• Any salaries and wages received in addition to self-employment income should be included in compensation
• In the occasion of a net loss from self-employment, it should not be subtracted from any salaries and wages received when determining compensation
• The deduction is taken on Form 1040, Schedule 1
• A qualifying (eligible) employee meets all of the following conditions:
• At least 21 years old
• Has worked for the employer during at least 3 of the 5 years immediately preceding the tax year
• Has received from the employer at least $750 in compensation during the tax year
• The following groups of employees can be excluded from coverage under a SEP:
• Employees who are covered by a collective bargaining agreement and whose retirement benefits were bargained for in good faith
• Nonresident alien employees who have no U.S. source earned income from their employer
• A leased employee may have to be included in the SEP of the organization receiving the services if certain conditions are met
• A SEP does not require contributions every year, but it must not discriminate in favor of highly compensated employees
• A highly compensated employee is any employee who meets either of the following two conditions:
• The employee owns (or owned last year) more than 5% of the capital or profits interest in the employer, the outstanding stock, or the total voting power of all stock of the employer corporation
• The employee's compensation from the employer for the preceding year is more than $135,000 if the preceding year is 2023, and (if the employer elects to apply this clause for last year) the employee was in the top 20% when ranked on the basis of last year's compensation
• An employer is permitted to make contributions to each participating employee's SEP each year and may deduct the amount of the contributions from the business's gross income
• The contributions are limited to the lesser of 25% of the employee's compensation or $66,000
• These limits apply to contributions the employer makes for employees to all defined contribution plans, which includes SEPs
• Compensation up to $330,000 in 2024 may be considered
• A 10% excise tax is generally imposed on the employer on contributions in excess of the deductible amount
• Unlike contributions to IRAs, contributions to SEP-IRAs are excluded from an employee's income rather than deducted from it
• Any excess employer contributions must be included in income without any offsetting deduction
• An employee's deduction for contributions to a qualified plan, including a SEP, is generally allowed for the tax year in which contributions are paid
• Contributions paid on or before the due date of returns, including extensions, for a particular tax year are deemed paid on the last day of that tax year
• Special rules apply for self-employed individuals who contribute to their own SEPs
• Compensation for the self-employed is equal to net earnings from self-employment
• For SEP purposes, the individual's net earnings must take into account the deduction for contributions to a SEP because the deduction amount and net earnings are dependent on each other
• The maximum rate becomes 20% after the computation
• A new rate must be determined to take into account the contribution deduction, see "Self-Employed Person's Rate Worksheet" for details and calculation
• Income passed through to shareholders of S corporations is not considered to be earnings from self-employment
• When an employer starts up a SEP, SIMPLE, or qualified retirement plan, the firm may be eligible for a credit of ordinary and necessary costs of starting up the plan for the first 3 years of the plan, with a maximum credit limit ranges from $500 to $5,000
• Eligible small businesses are those that have 100 or fewer employees who receive at least $5,000 in compensation from the employer in the year preceding the start-up of the retirement plan
• The credit amount equals 100% of the start-up costs for employers with 50 or fewer employees and 50% for employers with more than 50 employees

Savings Incentive Match Plans for Employees (SIMPLE)

• Employers with 100 or fewer employees who received at least $5,000 in compensation from the employer in the preceding year may adopt a SIMPLE individual retirement account plan (SIMPLE IRA) if they do not maintain another qualified plan
• Self-employed individuals may participate in a SIMPLE plan.
• If a SIMPLE plan has been adopted, it must be available to every employee who received at least $5,000 in compensation from the employer during any 2 preceding years and is reasonably expected to receive at least $5,000 in compensation during the current year
• Generally, compensation means the sum of wages, tips, and other compensation subject to federal income tax withholding, including elective salary deferral contributions the participant made to the SIMPLE IRA plan
• An employer may establish a SIMPLE plan even if none of its employees wish to participate
• The plan allows employees to make elective contributions of up to $15,500 for 2024 ($19,000 if 50 or older) and requires employers to make matching contributions. Employee contributions are salary reductions
• A SIMPLE plan is not subject to nondiscrimination rules or other complex requirements applicable to qualified plans
• An employer can choose to cover all employees without restriction or limit the employees covered to those who received at least $5,000 in compensation during any 2 preceding years and who are reasonably expected to receive at least $5,000 in the current year
• SIMPLE plans may be structured as an IRA or as a 401(k) qualified cash or deferred compensation
• Contributions to a SIMPLE IRA account are limited to employee elective contributions andrequire employer matching contributions or nonelective contributions
• There are two formulas for employer matching
• Matching contribution formula: Employers are generally required to match employee contributions on a dollar-for-dollar basis up to 3% of an employee's compensation for the year, not limited by the annual compensation limit
• Alternative formula: An employer may elect to make a nonelective contribution of 2% of compensation for each eligible employee who has earned at least $5,000 in compensation from the employer during the year, though only the first $330,000 of compensation is considered
• Employer contributions are expressed as a percentage of compensation, not as a flat dollar amount
• Employers must continue to make contributions even in lean years of at least 1% of employee compensation
• Employers must contribute an employee's elective deferral to the employee's SIMPLE account no later than 30 days after the last day of the month for which the contributions are made
• An employer must make matching contributions by the due date of the tax return, including extensions
• Contributions by the employer must be 100% vested
• Employers may deduct contributions for the year in which they are made -Matching contributions are deductible for the year only if made by the due date of the tax return, including extensions
• Distributions from a SIMPLE IRA plan are generally taxed like distributions from an IRA and are generally includible in income for the year received
• Penalties may be applied upon Withdrawals
• Withdrawals before age 59 1/2 are subject to a 10% tax
• Withdrawals within the first 2 years are subject to a 25% tax
• An employee's elective contributions will be treated as wages for purposes of employment tax but the employer's matching or nonelective contributions are not wages
• Participants may roll over distributions tax-free from one SIMPLE account to another or from a SIMPLE account to an IRA or a qualified plan without penalty if the individual has participated in the SIMPLE plan for at least 2 years
• Tax-free rollovers to tax sheltered annuities are not allowed

Qualified Plans

• Qualified employer plans set up by a self-employed person are sometimes called a Keogh or HR10 plan
• The plans described here can be set up and maintained by corporations, sole proprietors, or partnerships but a common-law employee or a partner cannot set up one of these plans
• Qualified plans must be set up by year end
• A self-employed person is both an employer and an employee for qualified plan purposes
• To set up a qualified plan, an employer must either:
• Adopt an IRS-approved prototype or master plan offered by a sponsoring organization and communicate it to the employees or
• Prepare and adopt a written plan that satisfies the qualification requirements of the Internal Revenue Code and communicate it to the employees
• Although advance IRS approval is not required, approval may be applied for

Minimum Participation Requirements

• An employee must be allowed to participate in the plan if he/she has reached age 21 and has at least 1 year of service (2 years if the plan is not a 401(k) plan)
• A plan cannot exclude an employee because (s)he has reached a specified age
• A defined contribution plan provides an individual account for each participant where benefits are largely based on amount contributed, affected by income, expenses, gains and losses, and forfeitures
• Two Types Are Profit-Sharing and Money Purchase Pension Plans
• Profit-sharing: plan for sharing employer profits with the firm's employees; employer does not have to make contributions out of net profits to have a profit-sharing plan
• Money purchase pension plan: contributions are fixed and are not based on the employer's profits, this applies even if the compensation of a self-employed individual as a participant is based on earned income derived from business profits
• A defined benefit plan is any plan that is not a defined contribution plan where contributions are based on a computation of the contributions needed to fulfill the requirements established by an employer
• To be a qualified plan, a defined benefit plan must benefit at least 50 employees or 40% of all employees, whichever is greater
• Generally, contributions made to a qualified plan, including those made for a self-employed individual's own benefit, are deductible and subject to limits
• Self-employed individuals may make contributions if they have net earnings
• Common-law employees cannot set up retirement plans for income from their work, even if that it is self-employment income for Social Security tax purposes
• A person who is a common-law employee also can be considered self-employed in other circumstances
• For a defined contribution plan in 2024 - annual contributions and other additions cannot exceed the lesser of:
• 100% of the employee's compensation or $66,000
• Employer contributions to a SEP must be added to other contributions to defined contribution plans
• For Defined benefit plan in 2024, the annual benefit for a participant under a defined benefit plan cannot be more than the lesser of:
• 100% of the participant's average compensation for his or her highest 3 consecutive calendar years or $265,000
• Compensation is the pay a participant receives from an employer for personal services for a year; including wages and salaries, fees, commissions, tips, fringe benefits, and bonuses, and excluding reimbursement for other expenses
• Each year, the annual limit on deductions to a qualified plan starts again whether or not contributions made in a prior year were less than the deductible limit
• If the total of an employee's elective deferrals (salary reduction) under a qualified 401(k) plan exceeds the limit for the year, the employee can elect to withdraw the excess or leave the excess in the plan
• If the employee takes out the excess deferral by April 15 of the year following the contribution year, it will be reported in the employee's gross income for the year of contribution and taxable in the tax year that the income was taken out and not subject to the additional 10% tax on premature distributions
• If the employee takes out the excess deferral after April 15 of the year following the contribution year, the amount will be included in income but not included in the employee's cost basis in figuring the taxable amount of any eventual benefits or distributions under the plan
• The employer deduction is limited based on the type of plan
• Profit-sharing plan deduction cannot be more than 25% of the compensation from the business paid to all participating common-law employees
• Money purchase pension plan deduction is generally limited to 25% of the compensation paid to participating common-law employees
• Defined benefit plan deductions are based on actuarial assumptions that must be computed by an actuary
  • If an employer contributes more than can be deducted in the current year, the excess can be carried over and deducted in later years
• Elective Deferrals [401(k) Plans]
• A qualified plan can include a cash or deferred arrangement, called an elective deferral, under which eligible employees can elect to have part of their before-tax pay contributed to the plan rather than receive the pay in cash. The contribution remains tax-free until it is distributed
• An employer may, under a qualified 401(k) plan, also make contributions (other than matching contributions) for participating employees without giving them a choice to take cash instead
• For 2024, the basic limit on elective deferrals is $22,500 ($30,000 if 50 or older)
• If an excess deferral exists and is not withdrawn by April 15 of the following year, the amount will be included in income and not included in cost basis when determining a future gain
• If it is withdrawn by April 15, it will be included in gross income but no penalty will apply
• The recipient of an eligible rollover distribution from a qualified plan can defer the tax on it by rolling it over into an IRA or another eligible retirement plan, this may be subject to withholding tax
• If it is expected that a recipient receives more than $200, the payor must withhold 20% of distribution for federal income tax
• Tax will not be withheld if the taxpayer has the eligible rollover distribution paid directly to another qualified plan or an IRA in a direct rollover
• An eligible rollover distribution is any distribution that is not:
• A required minimum distribution
• An annual or more frequent distribution under a long-term annuity contract or as part of a similar long-term series of periodic distributions
• The portion of an employees nondeductible contributions
• A hardship distribution
• Loans treated as distributions
• Dividends on employer securities

Retirement Distributions and Loans

• Annuity Distributions are annuity distributions taxed using an exclusion ratio
• Joint and survivorship annuity stops being when both spouses are deceased and single life annuity stops being when the employee dies
• A nonannuity distribution made on or after an annuity starting date is generally included in full in gross income
• If distributions are less than the RMD for the year, a 25% (10% if corrected within 2 years) excise tax will be imposed on the amount not distributed
• Taxpayers must begin receiving distributions by April 1 of the calendar year following the later of the employee attaining age 73 or retiring from the employer offering the plan
• For a traditional IRA, the beginning distribution date is April 1 of the calendar year following the taxpayer attaining age 73
• For each year following the initial distribution, the required distribution date is December 31
• The terms of a qualified plan may state that the plan can lend money to participants
• Loans are basically treated as distributions
• A loan will not be treated as a distribution to the extent that loans to the employee do not exceed the lesser of $50,000, or one-half of the present value of the employee's vested accrued benefit under such plans, or $10,000
• Plan loans generally have to be repaid within 5 years, unless the funds are to acquire a principal residence for the participant
• Plan loans must be amortized in level payments, made not less frequently than quarterly over the term of the loan A pledge of the participant's interest under the plan with a third party, as well as a direct or indirect loan from the plan itself, is treated as a loan
• Any outstanding loan balance when a plan terminates must be contributed to a qualified plan before the tax return due date in order to avoid taxation as a distribution
• If a distribution is made to the taxpayer under the plan before he/she reaches age 59 1/2, the taxpayer may have to pay a 10% additional tax on the premature distribution that applies to the amount received that the taxpayer must include in income
• Exceptions:
• Are made to a beneficiary after the death of the taxpayer
• Result from the taxpayer having a qualifying disability
• Are part of a series of substantially equal periodic payments beginning after separation from service
• Are made to the taxpayer after (s)he separated from service if the separation occurred during or after the calendar year in which the taxpayer reached the earlier 55 years of age or 25 years of service under the plan
• If a participant receives a distribution that is not eligible for rollover treatment, such as a long-term periodic distribution or a required distribution, the 20% withholding requirement does not apply, but a taxpayer may still choose not to have tax withheld from these distributions
• Certain transactions between a plan and a disqualified person are prohibited and are subject to a 15% excise tax on the amount involved. If the transaction is not corrected in time, an additional tax of 100% of the amount involved is imposed. Both taxes are payable by any disqualified person who participated in the transaction
• Includes for a transfer of plan income/assets to or use of them by for benefit of a disqualified person, dealing with plan income or assets by a fiduciary in his/her own interest, the receiving of consideration by a fiduciary for his/her own account from a party that is dealing with the plan, or any of the acts between the plan and disqualified person: Selling, exchanging, or leasing property, Lending money or extending credit, and furnishing goods, services, or facilities
• The following are disqualified persons:
• A fiduciary of the plan, a person providing services to the plan, an employer/employee organization if any employees/members are covered by the plan, any direct/indirect owner of 50%+, a member of the family of the aforementioned parties, a corporation, partnership, trust, or estate with direct/indirect owner
• Prohibited transactions do not take place if a disqualified person receives benefits to which s/he is entitled as a plan participant and beneficiary, however, the same terms apply as for other qualified persons. To qualify for the tax benefits available a qualified plan must meet requirements of the tax law, which include but are not limited to:
  • Plan assets must not be diverted, minimum coverage, the plan must benefit at least 50 employees or 40% of all employees/2 employees, contributions/benefits must not discriminate, contribution/benefit limits must not exceed, minimum nonforfeitable vesting standards, required benefit payments, no assigned/alienated benefits, benefits must not be reduced for Social Security increases, and elective deferrals must be limited
• Generally, an annual return/report form is required to be filed by the last day of the 7th month after the plan year ends, usually the Form 5500, Annual Return/Report of Employee Benefit Plan
• The Form 5500-SF, Short Form Annual Return/Report of Small Employee Benefit Plan is a simplified annual reporting form that can be used only if all conditions are met which include the plan being for small plans (fewer than 100 at the beginning of the year), meet condition for being exempt from books/records from independent auditor, has all assets invested in readily determinable fair value investments, and holds no employer securities
• The Form 5500-EZ, Annual Return of One-Participant is used if the plan covers only a participant/spouse and a sole owner, or partners/spouses in a business partnership
• Beginning January 1, 2021, every qualifying one-participant plan must file Form 5500-EZ.
• Plans must file a Form 5500-EZ for the final plan year to report that assets have been distributed
• The Form 1099-R, Distributions From Pensions, etc., is used generally on which distributions from pensions, annuities, profit-sharing and retirement plans are reported
• Period statements must be to participants account benefits provided if there is IRS approved master or prototype plans: banks, trade/professional organizations, and insurance companies. All Forms 5500, SF, EZ are required to be filed electroncially with the Department of Labor through EFAST2.

Explore key aspects of retirement plan reporting, compliance, and plan types. Understand the forms, filings, and factors influencing plan benefits. Learn about defined benefit and defined contribution plans.