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Retirement plan options.

CPAs often receive inquiries from clients who are considering adopting a retirement plan. The two simplest and most obvious options are the simplified employee pension plan (SEP/IRA) and the qualified profit-sharing plan (PSP). This article compares the SEP/IRA and the PSP plans to help CPAs and their clients quickly review the features of both. However, this article is not a substitute for a complete study of the detailed rules regarding each of these plans or for a consultation with a specialist in the employee benefits field. The notes (beginning on page 53) provide more details about the various options and are followed by a discussion of the most significant advantages of selecting one plan over the other.


Note 1: Generally, an employer that experiences a high turnover in the first two years will consider the two-year waiting period with immediate vesting. This alleviates the need for setting up accounts and handling forfeitures for a number of employees. However, if the turnover occurs in the first five years, for example, the employer may be better off applying the one-year eligibility rule and selecting a vesting schedule.

There are also decisions to make about how to determine what a "year of service" means for eligibility purposes. Generally, an employer with a number of part-time employees working less than 18 hours per week will apply a 1,000-hours-of-service standard to keep part-time employees from becoming eligible for the plan, thus cutting down on the cost of the plan (or, alternatively, allowing full-time employees to receive a higher benefit for the same cost to the employer). Also, under the 1,000-hour standard, someone who is hired midyear in a full-time position may be able to become a plan participant earlier than under the elapsed-time method. Under the elapsed-time method, employees become eligible after the passage of a certain amount of time, regardless of the actual number of hours for which they are paid.

Note 2: Generally, the excluded classification may not make up more than 29% of the non-highly-compensated employees. This statement of the nondiscrimination rule is an oversimplification but can be used as a "rule of thumb." Small employers should remember that one or two employees can represent a large percentage and any unexpected change in the workforce during a plan year can cause a violation of the nondiscrimination rules. Use of any option to exclude a classification of employees will require the employer to check the nondiscrimination rules carefully each year.

Note 3: The vesting option selected must be at least as favorable as one of the following schedules:

Alternatively, if the plan is a "top heavy" plan (more than 60% of the money in the plan is in the accounts of "key employees" (such as an officer earning over $60,000 [1995 threshold]), the vesting schedule must be at least as favorable as one of the following:

Note 4: The following examples illustrate the differences between an allocation formula that is based on a straight percentage of compensation and one that is integrated with Social Security. (Integration with Social Security is technically called "permitted disparity.") Assume the employer has the following payroll:

The employer decides to put 10% of compensation, or $40,000, into the plan. Under a proportionate formula, the allocation would be as follows:

Under an integrated formula, a portion of the contribution is allocated only to compensation in excess of the Social Security wage base (Social Security wage base for 1995: $61,200). Using the same facts as in the above example, the allocation would be as follows:

Higher-paid individuals receive a greater share of the contribution under the integrated formula.

If the SEP/IRA is a "top heavy" plan, a minimum employer contribution must be made in the amount of the lesser of 3% of compensation or the largest percent of compensation contributed on behalf of any key employee. This may dilute the benefit of Social Security integration if low percentages of compensation will be contributed.

Note 5. An employer may design the plan to require that a participant meet certain requirements each year to receive a share of the employer's contribution. An employer may require that the employee have a year of service for the plan year and be employed on the last day of the year. This option will require the employer to carefully check the nondiscrimination rules each year.

A "safe harbor design" will always meet the nondiscrimination rules and may be preferable for a small employer. The design allows an employer to exclude employees who have less than 500 hours of service for the year from receiving an allocation for the year. In other words, if someone quits very early in the year, no allocation will be made to his or her account. An employee who works more than 500 hours in the year will receive an allocation. If this design is used and the employer adopts a "standardized" master or prototype plan, generally no IRS submission is required.

Note 6: Employee contributions are not permitted in a tax-exempt or government entity. However, 401(k) plans that are sponsored by tax-exempt and government entities before May 6 and June 2, 1986, respectively, are grandfathered and may continue to accept employee contributions.


SEP/IRA advantages:

1. Simplified administration and elimination of many fiduciary, reporting and disclosure obligations.

2. Simplified participant-directed investment. Participants may roll over funds deposited into their IRAs into any other IRA of their choosing, allowing flexibility that is available under a PSP only at a higher cost.

3. The only distribution restrictions are those imposed by the application of the premature distribution penalty.

4. Can be established after the close of the employer's tax year, while a PSP must be established before the close. In either case, the employer's contribution for the year is deductible if made by the due date of the tax return.

5. Ideal for a sole proprietor with no employees.

6. More flexible than the unpopular SARSEPs (salary reduction SEPs), which are limited to companies with 24 or fewer employees (see page 5 1) and which require contributions from at least half of the employees. If there is sufficient participation by non-highly-compensated employees, the highly compensated can contribute more to a 401 (k) plan than to a SARSEP.

PSP advantages:

1. Permits an employer to apply a vesting schedule. If the employee leaves before becoming 100% vested, the other plan participants will be entitled to a share of the forfeiture.

2. Generally protected from creditors in bankruptcy, but only if the PSP is covered by the Employee Retirement Income Security Act, which occurs when one or more employees--in addition to a sole owner and spouse--are covered.

3. Permits an employer to exclude certain classifications of employees and to more narrowly define the employees who will receive allocations of contributions. However, after applying the exclusions and allocation rules, the PSP must meet applicable nondiscrimination rules.

4. Permits loans to certain participants within IRS limitations and guidelines.

5. Allows a waiver of the premature distribution penalty for distributions on termination of employment after age 55.

If the employer is part of a commonly owned or controlled group of corporations or businesses, then all employees of the group must be considered in applying the nondiscrimination rules or eligibility criteria to either a SEP/IRA or PSP. Further, if the owner's spouse or minor children work for the employer, then in applying the compensation limit, the earnings of all such family members must be treated as earned by one person. Also, all family members, including adult children, are treated as one highly compensated employee for applying the nondiscrimination rules to a PSP. This concept is called "family aggregation" and prevents the owner from increasing the benefits available to him or her by spreading them among family members.


* SMALL BUSINESS CLIENTS often ask their CPAs which type of retirement plan is best for them. This article suggests that the simplest and most obvious options are the simplified employee pension plan (SEP/IRA) and the qualified profit-sharing plan (PSP).

* THERE ARE ADVANTAGES and disadvantages to each type of plan as well as a host of rules governing specific situations.

* THE SIDE-BY-SIDE comparison of plan features and the notes and discussion that follow will help CPAs and their clients quickly review the features of both types of plan and decide which is best for a particular business.
COPYRIGHT 1995 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1995, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Small, Evelyn E.
Publication:Journal of Accountancy
Date:Jul 1, 1995
Previous Article:Deductible? Maybe not.
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