Tax Deferred Retirement Plans

By Kenneth H. Bridges, CPA, PFS     July 2001

Tax deferred retirement plans represent a win-win situation whereby the employer gets a current tax deduction and the employee is able to defer taxation until withdrawals are made at retirement.  Also, amounts build up inside the plan on a tax-deferred basis, permitting much more rapid accumulation of wealth.  For these reasons, companies frequently find a tax deferred retirement plan to be essential for attracting and retaining skilled workers, and employees find them to be a great way to accumulate savings for retirement.  This article describes some of the more popular types of tax deferred retirement plans.

IRA

Probably the simplest of all tax-favored retirement plans is the Individual Retirement Account (IRA).  An IRA does not require any action at all on the part of the employer company.  The account is opened, maintained and contributed to by the employee.  An IRA can be opened with any bank, mutual fund company, brokerage firm or other qualified IRA custodian, and the employee has up until April 15th of each year to make a tax-deductible contribution for the preceding year.

While IRAs are quite simple, their usefulness is frequently very limited.  Annual contributions to an IRA cannot exceed $2,000, and if you or your spouse were covered by an employer-sponsored plan at any time during the year, then your deduction may be limited.  Married individuals who were covered by an employer-sponsored plan can take a full deduction to the extent their income (combined with that of their spouse) for the year is less than $53,000, a partial deduction if their income is between $53,000 and $63,000, and no deduction if their income is greater than $63,000.  For single individuals who were covered by an employer-sponsored plan, the phase-out of the deduction occurs between $33,000 and $43,000 of income.   For married individuals whose spouse (but not themselves) are covered by an employer-sponsored plan, the phase-out of the deduction occurs at income between $150,000 and $160,000 of combined income.

The above dollar amounts are for calendar year 2001.  Tax legislation enacted in June 2001 increases the maximum contribution to $3,000 beginning in 2002.  Also beginning in 2002, for persons who have reached age 50, the contribution limit will be increased by $500.

Those who cannot make a deductible IRA because they (or their spouse) are covered by an employer-sponsored plan and their income exceeds the phase-out range, may consider making a nondeductible IRA contribution.  They do not get a deduction for the contribution, but the inside build-up in value occurs on a tax-deferred basis.  Also, those who are eligible to make a deductible IRA contribution may instead choose to make a nondeductible Roth IRA contribution. With a Roth IRA, there is no deduction on the front end, but the investment earnings in the account can forever escape taxation.   The Roth IRA is subject to the same maximum dollar limitations described above, and the ability to make a Roth contribution is phased our for single filers at $95,000 to $110,000 of income, and for married filers at $150,000 to $160,000 of income.

In general, an IRA works well for employees who do not wish to contribute more than $2,000 ($3,000 beginning in 2002) per year to their retirement plan. Otherwise,  the IRA is generally just too restrictive.

SEP

A Simplified Employee Pension (SEP), as the name implies, is a simplified plan designed for smaller employers or self-employed individuals.  It can be established by completing a simple one-page form provided by the IRS.  You have until the extended due date of your tax return for a particular year to establish the SEP and make a deductible contribution for that year.  Contributions are discretionary, but in setting up the SEP you as employer agree that you will contribute the same percentage of each qualified employee’s compensation, not in excess of 15%[1] of compensation (currently up to $170,000[2]).

The primary advantages of the SEP are:  (1) its simplicity and low cost of implementation and maintenance; (2) it allows higher amounts to be contributed than a regular IRA; and (3) contributions are not subject to FICA tax.

The primary disadvantages of the SEP are:  (1) the employer has to contribute the same percentage of compensation for all qualified employees; and (2) the employees are immediately 100% vested in such contributions.

A SEP generally works best for a self-employed person with no employees, or a small company with a few employees where the employer desires to contribute the same percentage of salary for everyone (perhaps in lieu of cash bonuses).

SARSEP

A Salary Reduction Simplified Employee Pension (SARSEP) is a SEP which permits employees to elect to contribute a portion of their own money to the plan (like a 401(k)).  A SARSEP can only be used by companies with fewer than 25 employees, and at least 50% of eligible employees must choose to participate in the salary reduction arrangement.

Each employee can elect to defer up to the lesser of 15% of annual compensation or 10,500.  The amount deferred by each “highly-compensated employee” cannot exceed 125% of the average amount deferred by non-highly-compensated employees.  Elective contributions, unlike employer contributions, are subject to FICA tax.

A SARSEP generally works best for a small company where most of the employees wish to contribute a portion of their salary to the plan.   Legislation enacted in 1996 replaced the SARSEP with SIMPLE plans (discussed below).  Accordingly, SARSEPs may not be set up after 1996, but SARSEPs that were in place prior to 1997 may continue.

SIMPLE Retirement Plans

As discussed above, for tax years beginning after 1996, the SARSEP was essentially replaced by so-called SIMPLE plans.  SIMPLE plans are available to employers with fewer than 100 employees.  A SIMPLE plan can take the form of an IRA established for each participant or the form of a SIMPLE 401(k).  Employer contributions to a SIMPLE plan cannot exceed $6,500[3] per year.  If the SIMPLE plan has a 401(k) feature, then the employee can elect to defer up to this same amount of his or her compensation.

An employer sponsoring a SIMPLE plan generally must match employee deferrals up to 3% of compensation or, alternatively, make a nonelective contribution of 2% of compensation of all eligible employees.

A SIMPLE plan generally works best for a small company that wishes to provide a plan whereby its employees can make elective deferrals, but is willing to forego the flexibility and higher contribution limits provided by a traditional profit sharing/401(k) plan in order to avoid the greater administrative burden that comes with such a plan.

Profit Sharing Plan / 401(k)

With a 401(k) profit sharing plan (PSP), the employer may make discretionary contributions on behalf of the employees and the employees may elect to contribute a portion of their own salary.  With a PSP, there is greater flexibility than with a SEP, SARSEP, or SIMPLE plan in determining eligibility, and employer contributions can be made subject to a vesting schedule.  With a vesting schedule, if the employee does not stay with the company for a prescribed period of time, then some or all of the contributed amounts are forfeited and may be reallocated amongst the employees who do remain with the company or used to reduce future employer contributions.  The PSP, unlike the SARSEP or SIMPLE plan, can be used by a company of any size, and it is not required that a certain percentage of the employees choose to participate in the salary reduction arrangement.

The employer can contribute up to the lesser of 25% of compensation (up to $170,000) or $35,000 for each employee.  However, the employer’s deduction cannot exceed 15% of total eligible compensation.[4]

Each employee can elect to defer up to the lesser of 25%[5] of annual compensation or $10,500.[6]  The amount deferred by each “highly-compensated employee” cannot exceed 125% of the average amount deferred by non-highly-compensated employees or the lesser of 200% or 2 percentage points over the average amount deferred by non-highly-compensated employees.  Elective contributions, unlike employer contributions, are subject to FICA tax.

The PSP can permit participant loans to employees, and the amounts in the plan are protected from the participant’s creditors in the event of the participant’s bankruptcy.

The 401(k) profit sharing plan is currently the most popular type of plan.  It is much more flexible than a SEP, SARSEP, or SIMPLE plan.  However, the disadvantage to a smaller company is the higher cost of implementation and administration of the plan.

Money Purchase Pension Plan

With a money purchase pension plan, unlike the profit sharing plan under which contributions are discretionary, the employer is required to contribute a certain percentage of each employee’s compensation to the plan.  For this reason, the money purchase pension plan is less popular than the profit sharing plan.  However, by combining the two types of plans it is possible to put a higher percentage (25%) of compensation into the plan.

Defined Benefit Plan

With a defined benefit plan, the employer promises a specified amount of benefits at retirement, typically in the form of a monthly retirement pension based on a level of compensation and years of service.  Contributions to the plan are actuarially calculated to provide the promised benefits and are not allocated to individual accounts of participants.  Such plans are not as popular as the profit sharing plan.

Small Business Tax Credit for Plan Expenses

For plans set up after 2001, legislation enacted in June 2001 provides that a small business (generally defined as those with less than 100 employees and at least one non-highly compensated employee), may, for the first three years of the plan’s existence, claim a tax credit for 50% of the first $1,000 of administrative and retirement-education expenses associated with the plan.

Employee Tax Credit for Contributions

Recent legislation provides for a tax credit to eligible employees for up to $1,000 (based on credit of up to 50% of contributions of up to $2,000) for contributions to a retirement plan.  The credit will be available for years 2002 through 2006, and is available to single individuals with income of up to $25,000, heads of household with income of up to $37,500, and married couples with income of up to $50,000.

Summary

There are advantages and disadvantages to each type of tax deferred retirement plan, and which is best for you will depend upon the specifics of your situation.  What is clear, however, is that tax deferred retirement plans represent a win-win situation whereby the employer gets a current  tax deduction and the employee is able to defer taxation until withdrawals are made at retirement.

This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice.  The article provides only a very general summary of complex rules.  For advice on how these rules may apply to your specific situation, contact a professional tax advisor.

Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.

This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice.  The article provides only a very general summary of complex rules.  For advice on how these rules may apply to your specific situation, contact a professional tax advisor.