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Investing in a 401(k) or 403(b) may sound like a great idea, and if you have access to one at work, it is a tremendous way to increase your retirement nest egg. However, 401(k)s also pose a large cost to the employers who offer them. Because of that, many smaller businesses can’t afford to establish 401(k)s at work for their employees. But that doesn’t mean that the employees don’t have any kind of retirement account to use. There are a few different types of plans that smaller businesses and self-employed workers can use that will offer them the same type of preferred tax treatment, as well as the encouragement to save money for retirement. We’re talking about the SEP, SIMPLE, and Keogh plans. These plans are self-directed because they allow the employee, or self-employed worker, to choose exactly what the contributions are being invested in. While the employer who established the SEP and SIMPLE will choose the institution at which the plan is started, the employee will have the final say over which available investments will be used for all contributions. Depending upon where the plans are established, the employees could have quite a range of available choices.
SEP Plans
Employers may establish SEP (simplified employee pension) plans for their employees using either individual retirement arrangements (IRAs) or annuities that are individually owned by each employee.
These plans require less paperwork than the more recognizable types of retirement accounts, thus making them easier for small business owners and self-employed workers to establish and fund. The SEP is more attractive to smaller business owners, but, there is no current regulation stating how big or small a business must be in order to adopt an SEP. Any business could offer its employees the opportunity to contribute to a SEP if so desired.
SEP plans offer the same type of tax treatment for all contributions and distributions as other types of retirement accounts. Any contribution made by an employer on an employee’s behalf won’t be counted as part of that employee’s current gross income, and the employer may write off the contribution as a company expense. The interest and gains of the account accrue tax-deferred, and the SEP owner won’t have to pay any type of income tax on the account until distributions begin. Self-employed people who contribute to their own SEP may deduct their contributions on their tax returns. Technically speaking, SEP plans aren’t considered qualified retirement plans, as 401(k)s are. Instead, they are classified as traditional IRAs that meet the tax law requirements to become SEPs.
Business owners who use the SEP for their employees may contribute up to the lesser of (a) 25 percent of the employee’s compensation or (b) $40,000 (indexed in 2002). Other rules include immediate and 100-percent vesting for eligible employees of employer contributions, and contributions may be made any time before taxes are due. For example, you could make your SEP contribution for the year 2002 anytime before April 15, 2003. Employees may also withdraw any amount from their SEPs at any time. Because these are IRA accounts, they are owned and controlled by the individual employees, not the employer. However, SEP IRAs are also under the same rules as traditional IRAs. That means all distributions will be 100percent taxable to the IRA owner, plus a 10-percent early-withdrawal penalty if the owner is younger than 591/2 years old.
SIMPLE Plans
The SIMPLE plan is relatively new, having been introduced in 1997. It comes in two forms: the SIMPLE IRA
to elect to receive their compensation or earned income as cash or to contribute them to their SIMPLE IRAs through a qualified salary reduction arrangement. The employer must then make a contribution to the employees’ SIMPLE plans on either a matching (up to three percent of compensation) or nonelective (two percent of compensation) arrangement, no matter what elective the employee has chosen. If the employee has chosen to go with the salary reduction agreement, the employer will make the matching contribution, generally dollar for dollar up to three percent of compensation or $7000 (for the year 2002;). With the current limitations on deferral amounts, an employee whose employer sponsors a SIMPLE program could have as much as $14,000 deferred during the year 2002, as long as the employee earns $233,000 of compensation or more (3 percent of 233,000 is approximately $7000). Employer contributions are done on a tax-deferred basis to the employee. There is no tax due on the account until distributions have begun. Employees contributing to their SIMPLE IRAs on the salary reduction plan will do so on a pretax basis. As with traditional IRAs, the gains and interest will accrue tax- deferred. The same distribution rules apply. For those people taking money out of their SIMPLE prior to age 591/2, there will be a 10-percent early-withdrawal penalty. But SIMPLE owners face an additional early-withdrawal penalty in certain cases. If you were to open up and contribute to a SIMPLE plan, and within two years of doing this took distribution from the account, you would face a 25-percent early-withdrawal penalty, rather than the 10-percent penalty. After the first two years, the penalty will drop back down to 10 percent. You may roll over a SIMPLE IRA from one to another with no penalty. You may also roll over the SIMPLE into a traditional IRA, provided the 25-percent penalty has disappeared.
Similar to SEP plans, SIMPLE IRAs are traditional IRAs that meet the stringent requirements for being a SIMPLE. Plan contributions must be made to the SIMPLE IRA, not to a traditional or a Roth IRA. Eligible employees and self-employed workers may make contributions that are either a percentage of expected compensation or a fixed dollar amount.
As with SEP plans, employees are immediately 100 percent vested i- their employer’s contributions to their SIMPLE accounts. They may take withdrawals at any time from the plan, bearing in mind the tax laws. If we compare SIMPLE and 401(k) feature by feature, the advantage almost always goes to the
Special note: With the recent tax law changes by Congress, new rules regarding employer-sponsored retirement plans have been instituted. They are:
- Annual additions to a participant’s profit sharing or 401(k) account, including employee and employer contributions and allocated forfeitures, may be as high as $40,000 (or 100 percent of compensation, whichever is less)—this is up from $35,000 or 25 percent of compensation. The amount for 403(b) accounts is $35,000.
- A benefit of as much as $160,000 (or 100 percent of average compensation, whichever is less) may be provided for a defined pension plan benefit for years beginning after January 1, 2002—this is up from $140,000 and 100 percent of compensation.
- Plans may consider up to $200,000 of the participant’s compensation when applying contribution limits—this is up from $170,000.
- Participants who are age 50 and older who have contributed the maximum amount are allowed to “catch up” and contribute more the their retirement plans. 401 (k). 401(k) plans are better for two very important goals of small pla- sponsors: maximizing contributions and skewing employer contributions. However, the SIMPLE IRA is still very attractive to employers who look for low-cost plan with few administrative burdens.
SIMPLE 401(k) plans are different from the SIMPLE IRAs because the employees don’t own their individual accounts. The other requirements for a SIMPLE 401(k) are the same as for the SIMPLE IRA, however, the 401(k) must meet some additional requirements that are set forth for traditional 401(k)s.
Keogh Plans
Keogh plans have been around much longer than SIMPLEs, as they were established in 1962 as part of the Self-Employed Individuals Retirement Act. Historically, Keogh plan followed statutory provisions that governed partnerships and people who are selfemployed. However, the only distinction that still exists is the manner in which self-employed individuals determine their income for the purpose of applying the above limitations.
Keogh defined contribution plans allow up to 20 percent of earned income or $40,000, whichever is less. So if you were to earn $20,000 per year doing some extra work that was considered selfemployment work, you could start a Keogh with a $4000 contribution for that calendar year. Those who contribute to a Keogh will still be able to make their annual contributions to their traditional and Roth IRAs.
Keoghs are subject to the same tax treatment as other types of retirement accounts. Interest and gains are accrued o- a tax deferred basis. Any withdrawal made before age 591/2 will be subject to a 10- percent early-withdrawal penalty, and all withdrawals will be subject to ordinary income tax. Contributions made on an employee’s behalf for an employee won’t be counted as part of the employee’s current taxable income, and any contributions made by an employee as part of a salary reduction agreement will be done on a before-tax basis. |
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