Small business owners who want to provide their employees with a way to save for retirement in a tax-efficient manner have several different options and plans to choose from -- from very simple and low-cost plans to very complex and expensive ones. Today, I will discuss traditional 401(k) and SIMPLE-IRA plans, which are both very common in the marketplace.
Section 401(k) of the Internal Revenue Code was enacted in 1978 after years of confusion among taxpayers and the IRS about restrictions and unclear guidance applicable to pre-1978 "cash or deferred" arrangements. A properly established 401(k) plan allows a covered employee to elect to have a portion of his or her compensation (otherwise payable in cash) contributed into a qualified plan as a pre-tax reduction in salary (up to a limit of $18,000 for 2015 and 2016 and extra $6,000 catch-up contribution for employees 50+ years old). In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employee's elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested.
Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform two annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.
A "safe harbor" 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans.
SIMPLE IRA Plan
This plan provides small employers with a simplified method to contribute towards their employees' retirement savings. There are two basic requirements for an employer to establish a SIMPLE IRA plan: (1) the business must have 100 or fewer employees who earned $5,000 or more during the preceding calendar year; and (2) the business may not have another retirement plan in place.
Under the SIMPLE IRA plan, employees may choose to make pre-tax salary reduction contributions and the employer is required to make either matching contributions or so-called "nonelective" contributions into the plan. SIMPLE IRA plans have lower start-up and annual costs because they are easier to operate. No annual financial reports are required to be filed with the IRS and no annual testing has to be performed.
SIMPLE IRA plans operate on a calendar-year basis. You may initially set up a SIMPLE IRA plan for a calendar year as late as October 1 of that year. A SIMPLE IRA must be set up for each employee with contributions under the plan. Employees must receive notice of their right to participate, to make salary reduction contributions, and to receive employer contributions. In addition, employees must receive information about the plan, including a copy of the summary description. The required notice also informs employees of the plan's election periods during which eligible employees can decide to contribute to the plan.
Employees can make salary reduction contributions in any amount to a SIMPLE IRA plan up to the legal annual limits. The maximum annual amount that an employee can contribute is $12,500 for 2015 and 2016. Additional employee contributions (known as "catch-up" contributions) are allowed for employees age 50 or over. The additional contribution limit is 3,000 for 2015 and 2016.
Each year, employees can change their contribution levels during the plan's election period. This election period must be at least 60 days long, and employees must receive prior notice about an upcoming election opportunity. SIMPLE IRA plans that have already been established must have an annual election period that extends from November 2 to December 31. A plan can have more election periods each year in addition to this 60-day election period.
Participants cannot take loans from their SIMPLE IRAs. SIMPLE IRA contributions and earnings can be withdrawn at any time. When participants take a distribution, they typically can elect to take a lump-sum distribution of their account, or roll over their account to an IRA or another employer's retirement plan. Distributions from a SIMPLE IRA are generally subject to income tax for the year in which they are received. If a participant takes a withdrawal from a SIMPLE IRA before age 59½, generally a 10 percent additional penalty tax applies. If the withdrawal occurs within two years of beginning participation, the 10 percent penalty tax is increased to 25 percent. SIMPLE IRA contributions and earnings may be rolled over tax-free from one SIMPLE IRA to another. A tax-free rollover may also be made from a SIMPLE IRA to another type of IRA, or to another employer's qualified plan, after two years of beginning participation in the original plan.
Comparing 401(k) and SIMPLE IRA and Additional Features:
Feature 401(k) SIMPLE IRA
Eligible employer Any business Fewer than 100 $5k empl. +no
Eligible employees Cannot exclude EEs EEs who earned older than 21, with 1 yr $5k in the past 2
of service, or 1000 hrs yrs and expect
of service per year to earn $5k now
Maximum employee contribution $18,000 $12,500
Roth option permitted Yes No
Catch-up contributions (50+ age) $6,000 $3,000
Employer contributions Optional up dollar-for-dollar
to 25% of comp. up to 3% match
or 2% nonelect.
Vesting Options available Immediate
Loans permitted Yes No
ADP/ACP testing Yes No
"Top-heavy" testing Yes No
Annual tax filing Yes No
Deadline to establish Last day of tax year October 1st
Contributions permitted past 70.5 of age Yes No
Distributions required at 70.5 of age No, if still employed Yes
unless 5%+ owner
Penalty for early distributions 10% penalty 10% penalty,
first 2 years
For a small employer who is establishing a retirement plan for the first time, the SIMPLE IRA plan may be the better option because it is easier to establish and operate and does not cost as much. There are investment providers who will establish and maintain SIMPLE IRA accounts for employers and employees with no start-up costs and no annual fee. Employers are free to discontinue the SIMPLE IRA plan at any time, so "upgrading" to 401(k) can be accomplished very easily should the employer decide they have outgrown the SIMPLE IRA plan and 401(k) started to make more sense.
Disclaimer: Information included in this article is not meant to be exhaustive and there may be additional requirements and/or features not discussed here. Consult your tax advisor for details.