Plans for Small Businesses and Nonprofit Organizations
Introduction
Retirement planning is anything but a one-size-fits-all process. There are so many different types of plans available. There are even plan types that are best suited for small businesses. These plans offer reduced flexibility, in terms of plan design, but they are much easier and more cost-effective to administer. Nonprofit organizations have their own category. Some nonprofits choose to offer a 401(k) or some other plan type that we have already discussed, but they are the only business type that can use a 403(b). Exhibit A, at the end of the textbook, summarizes all of the various contribution limits for the plan types discussed throughout this book.
Learning Goals
Understand what makes a simplified employee pension (SEP) plan unique and when it might be useful.
Describe the savings incentive match plan for employees (SIMPLE) plan and discuss when it should be used.
Determine when a plan is top-heavy and what this indicates for the plan in question.
Describe the features and restrictions of a 403(b) plan.
SEP Plans
An SEP plan is offered through an employer, but is not a qualified plan. It is funded using an Individual Retirement Account (IRA), and it is a part of the “other” category, mentioned in Chapter 1. From one point of view, it is like a person dressed up at Halloween. IRA on the inside ... SEP on the outside.
An SEP is very easy to establish and maintain because of lower regulatory hurdles. This ease makes an SEP a favorite among small businesses. It is very similar to a profit-sharing plan, in that an SEP offers the employers the flexibility of discretionary contributions. Because an SEP only involves employer contributions, there are no catch up contributions available.
When it comes to the contribution allocation formula, an SEP will differ from a profit-sharing plan. Recall that a profit-sharing plan is permitted to contribute based upon a level percentage of compensation or integrating with the social security (which we will thoroughly describe in a later chapter). SEPs also can use both of these methods. Profit-sharing plans, however, can also use age-weighting schemes or cross-testing (again, both will be thoroughly described in a later chapter), while the SEP cannot use these last two contribution allocation methods. This makes it difficult for the plans to be tilted in the favor of older, higher-salary employees (owners).
Because an SEP is funded with an IRA, the SEP participants are granted the ability to withdraw money whenever they need. This does not mean that the distributions will be tax-free or penalty-free. There may be penalties and tax consequences for the preretirement age withdrawals. The point is that the SEP participants will have much easier access than in most other retirement account types, and they will not need to be reliant on plan loans and hardship withdrawals to access savings before retirement, like they do with a 401(k) plan. In fact, an SEP participant is not permitted to take a plan loan because it is funded with an IRA.
One distinguishing feature that the employers really need to be aware of is the vesting requirement. Within an SEP, the employees must be immediately 100 percent vested. If that is a problem for a given employer, then they need to consider alternative plan types.
An SEP has some applicable rules that mimic the qualified plans, while others are very similar to the IRAs. Like a qualified plan, SEPs can contribute up to 25 percent of the gross compensation, subject to a maximum contribution of $53,000 (2016 limit). While 401(k)s are subject to ADP compliance testing, SEPs adhere to top-heavy rules, which will be thoroughly described in a later chapter.
To summarize our discussion on SEPs, these plan types are most often chosen by small businesses because they are easy to establish and low cost to operate. The simple allocation formula is also attractive to small business owners. One caveat is that they must make participation available to any employee who is at least 21-year old and has worked for the company for three out of the last five years with at least $600 (2016 threshold) per year in earnings in each tax year. This means that the part-time employees will potentially be covered by an SEP while they would not be eligible for many other plan types. If a 25-year old employee has earned only $1,500 in each of the last three years, then they must be included in the plan.
SIMPLE Plans
A SIMPLE plan is available to any employer with fewer than 100 employees. They must cover any employee who has earned at least $5,000 in any previous two years, and they are reasonably expected to earn at least $5,000 again this year. If an employee earns $4,000 in year 1, $5,000 in year 2, $3,000 in year 3, $5,000 in year 4, and is reasonably expected to earn at least $5,000 during the current year, then they are eligible for coverage by a SIMPLE plan. The years of $5,000 earnings need not be consecutive for eligibility to apply. Like an SEP, a SIMPLE plan will also be available to many part-time employees.
Employees covered by a SIMPLE plan can defer up to $12,500 (2016 limit) of their salary, which is subsequently matched by the employer. Notice that this deferral amount is less than an SEP and also less than a 401(k). The employer match must be either (1) a dollar-for-dollar match up to 3 percent of the total compensation or (2) the employer contribution of 2 percent of an employee’s total compensation, regardless of whether or not the employee contributes out of their gross pay. One neat feature is that if the employer picks option #1, then they could drop their match from 3 to 2 percent for any two years during a five-year period. This gives the small business a little flexibility. Because a SIMPLE plan involves employee contributions, they also offer a catch up provision of $3,000 (2016 limit).
Because SIMPLEs are funded with an IRA, they have IRA-inspired limitations. SIMPLEs cannot offer loans or insurance products. They have certain asset class restrictions that follow the IRA asset class restrictions, and they share tax rules with IRAs. Again, we will explore each of these traits in detail when we will discuss IRAs in another chapter.
While SEPs are often compared with the profit-sharing plans due to their discretionary contribution feature, SIMPLEs are sometimes compared with 401(k)s because they offer employee salary deferrals and employer matching.
Both SEPs and SIMPLEs must cover the part-time employees, assuming that they meet a very low threshold of hours worked ($600 for SEPs and $5,000 for SIMPLEs). Traditionally, we think of SEPs and SIMPLEs as plan types for small employers. However, some large employers, such as Starbucks, do offer retirement plan access for their part-time employees. They obviously have more than 100 workers so, they are offering a 401(k) and not a SIMPLE plan. A SIMPLE plan mandates that the part-time employees must be covered. A 401(k) plan could cover the part-time employees, but there is no mandate to do so ... this provides a larger employer the flexibility to cover the part-time employees now, but they could eliminate this option if business conditions necessitate.
A SIMPLE plan is easier to administer than a 401(k) plan, albeit with more rigid contribution rules and lower employee deferral limits. Unlike 401(k)s, SIMPLEs also eliminate the possibility for loans. SIMPLEs offer reduced flexibility for the employees, but the lack of a loan provision is actually healthier for their long-term retirement potential. One important distinction is that an employer who offers a SIMPLE plan cannot offer any other form of retirement savings account. For example, an employer cannot offer both a SIMPLE and a profit-sharing plan.
SIMPLE 401(k) Plans
A SIMPLE 401(k) plan is a hybrid investment option that falls somewhere between a SIMPLE itself and a 401(k) plan. The primary advantage of this plan type is that it does not require nondiscrimination or top-heavy testing like the 401(k). This can be very appealing for a small business owner because this represents a direct time and cost savings. Because of the 401(k) pedigree, plan loans are also back on the table.
However, a SIMPLE 401(k) plan does have some drawbacks. While the traditional 401(k) deploys vesting schedules for the employer contributions, SIMPLE 401(k) requires 100 percent immediate vesting. This might not be a problem for an employer, but they should at least know about the policy. SIMPLE 401(k)s also share the lower contribution rate of $12,500 (2016 limit) with the SIMPLE plan. This is a disadvantage because the 401(k) plan boasts the elevated rate of $18,000 (2016 limit).
The eligibility for an employee to participate in a SIMPLE 401(k) plan is a combination of the eligibility requirements from its parent plans. The SIMPLE 401(k) retains the 100 employee limit and the $5,000 (2016 limit) threshold of the SIMPLE plan, but unlike the traditional SIMPLE plan, it adds a 401(k)-induced requirement of being 21-years old with one year of service. This is different from a traditional SIMPLE plan where there is no age requirement.
Top-Heavy Rules
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) added another layer of compliance testing for coverage of the rank-and-file employees. This testing is called the top-heavy rules, and it is very simple to apply. We defined “highly compensated employees” in Chapter 5. This category of employees was used for the ADP and ACP testing applicable to 401(k) accounts. Now, we have a new category of elite employees. For top-heavy testing, the upper echelon of employees is called key employees. Key employees meet one of three criteria. The first criterion is that they are a 5 percent owner. This threshold is the same as for a highly compensated employee. The second criterion is that a key employee may only own 1 percent of the business, but earn at least $150,000 in salary. The third criterion of a key employee is reserved for the officers of the company who earn a salary of at least $170,000 (2016 limit), irrespective of ownership interest. These last two criteria are different from an HCE. Someone earning $121,000 per year could be considered an HCE, but not a key employee!
A defined-benefit (DB) plan is deemed to be top-heavy if 60 percent of the present value of the expected future benefits is allocated to key employees. A defined-contribution (DC) plan is deemed to be top-heavy if 60 percent of the current account balances is allocated to the key employees. At least the percentages are the same as a memory cue!
What happens if a plan is deemed to be top-heavy? In this instance, the plan must do two things: have a special vesting schedule and implement a special contribution system.
A top-heavy DB plan must have a vesting schedule that is at least as generous as a three-year cliff vesting schedule or a six-year graded vesting schedule. That should sound familiar because those are already the mandated vesting schedules for a DC plan. They do not have any extra vesting requirement if they are deemed to be top-heavy. The DB plans, on the other hand, must adopt a vesting schedule at least as generous as a DC plan.
A top-heavy DB plan must offer a contribution scheme that is at least as generous as 2 percent for each year of service with a service cap of 10 years. This means that the minimum benefit in a top-heavy DB plan is 20 percent of the final average compensation (FAC). In a top-heavy DC plan, the contribution scheme must be at least as generous as 3 percent of the compensation, unless the percentage for the key employees is less. There is a special contribution scheme if the employer offers both a DB and a DC plan for their employees. If the employer chooses to satisfy the top-heavy rules with the DB plan then all is the same, but if they choose to satisfy the rules with the DC plan, then the minimum contribution is now increased to 5 percent of the compensation.
Typically, it is small companies that have top-heavy issues. It would be very difficult for a large company, like General Electric, to have 60 percent of the benefits reserved for the key employees when the number of nonkey employees greatly outnumbers the volume of the key ones. You will notice that much of the compliance testing is aimed at preventing small employer abuses. Specifically, top-heavy rules apply to SEPs and SIMPLEs.
403(b) Plans
The universe of nonprofit companies has a unique plan available for only them ... the 403(b) plan. Examples of nonprofit companies are hospitals, schools, and charities. Sometimes, you will hear nonprofits referred to as 501(c)(3)s. This is simply the location in the Internal Revenue Code that awards them a special status. A 403(b) plan is available to any full-time employee of a nonprofit organization. However, it is not available to any contractors who work for the nonprofits. They must technically be an employee, and they must be willing to defer at least $200 from their gross pay. If they meet these two simple requirements, then they are eligible.
A 403(b) plan can offer either employer matching or nonelective contributions. Recall that nonelective contributions mean that the employer contributes regardless of whether the employee does or not. Much like 401(k)s, loans are allowed and so are in-service hardship withdrawals.
Employees can defer as much as $18,000 (2016 limit) from their gross pay, while the maximum total contribution (including the employers contribution) is limited to the lesser of (1) 100 percent of the total compensation or (2) $53,000 (2016 limit). A unique feature of a 403(b) plan is that employees who have at least 15 years of service with an employer are also eligible for an additional catch-up contribution of $3,000 annually.
It is important to understand that salary deferral limits are aggregated between SEPs, 401(k)s, and 403(b)s on the chance that an employee would have more than one plan type available to them.
Some 403(b) plans are exempt from Employee Retirement Income Security Act (ERISA) of 1974, which means that they are exempt from the nondiscrimination testing and therefore, are require lower cost to administer. Plans offered by governments, churches, and plans without a provision for the employer contributions do not need to comply with ERISA. Noncompliance does not mean that they can do whatever they wish. They still must provide their eligible employees with the documentation that contains the material terms of the plan being offered and clarifies who is responsible for administering the plan. If a nonprofit is not expressly exempt from ERISA, then it will still apply. If ERISA does apply, then the 403(b) plan will need to pass a coverage test called a 410(b) test. The 410(b) test is slightly complex, but basically it conveys that you must cover a certain percentage of nonhighly compensated employees (NHCEs) (somewhere between 60 and 70 percent) to avoid compliance issues. The actual calculation of the 410(b) test is beyond the scope of this textbook. If matching contributions from the employer are involved, then the ACP test will apply, and if the employer offers nonelective contributions, then they must satisfy a 401(a)(4) test.1 The actual calculation of the 401(a)(4) test is also beyond the scope of this textbook. Just be aware that these tests are special for 403(b) plans.
A 403(b) plan can include either mutual funds or annuity products as investment vehicles. If they chose mutual funds, then ERISA is back on the table, even if they are an exempt entity. This is a very important rule.
Retirement Plans Startup Costs Tax Credit
In late 2014, the IRS announced a new tax credit aimed at helping defray the costs for a small employer to establish a retirement plan for its employees. This credit is available if a company installs an SEP, SIMPLE, or any qualified plan. It is important to note that this is a credit and not a deduction. With a tax deduction, a business will subtract the amount of the deduction from its taxable income before it calculates its taxes. For example, if a business had taxable income of $150,000, an effective tax rate of 32 percent and a $1,000 deduction, then they would end up with $149,000 ($150,000 - $1,000) of taxable income and $47,680 ($149,000 × 32%) of taxes owed. If this were instead a $1,000 tax credit, then they would pay taxes on the entire $150,000 for a tax liability of $48,000. However, the $1,000 tax credit would actually lower their taxes owed dollar-for-dollar. They would now owe $47,000 ($48,000 - $1,000). In this simple example, the business would save $680 by utilizing a tax credit not a tax deduction. This is a huge difference!
To be eligible for this tax credit, employers must meet three criteria. The first criterion is that they must have 100 or fewer employees who received at least $5,000 (2016 limit) in annual compensation. This is the same requirement as that used for SIMPLE plans. The second criterion is that at least one plan participant must be an NHCE. The third criterion is that in the previous three tax years, the employer must not have offered another retirement plan to its employees. This is just for truly new plans.
The credit can be used to pay for an eligible startup and operating costs. The actual startup costs, administrative costs, and costs to educate employees are all considered eligible for this credit. The amount of the credit is limited to 50 percent of your startup costs up to a maximum of $500 per tax year. That may not sound like much, but the idea is to provide an additional incentive beyond the natural incentives that the employer will enjoy. One catch is that the employer cannot claim the credit and deduct the actual startup costs. They will need to determine which option provides a better tax liability. This catch will make this tax credit less appealing to companies, but it is still a new option to be aware of.
Discussion Questions
A company wants to establish a tax-advantaged plan for its employees. The company is relatively new, and profits are unpredictable with a meaningful amount of variability. The employer would like to reward its employees when the company does well, and is somewhat concerned that the company has no retirement plan at all, which might make it difficult to attract experienced people to work there. Due to the inherent uncertainty of their profits, the company is extremely concerned about minimizing the costs of maintaining the plan. Which type of plan should this employer consider?
A small employer wants to offer a tax-advantaged retirement plan to only their full-time employees. Is an SEP plan a good idea to recommend?
A small employer with 75 employees already has a profit-sharing plan in place for their employees. They are trying to be a good corporate citizen, and they are considering also adding a SIMPLE plan following the 3 percent dollar-for-dollar matching formula. What advice do you have for this company?
A company with very stable earnings and cash flow has had a modest money-purchase pension plan for a long time. The participation in the plan precludes employees (87 employees) from participating in other plan types. The company wants to encourage its employees to save for retirement themselves. They also want the employees to have access to plan loans. What steps should this employer consider?
A very small S-Corporation has four employees. The owner realizes that the competing employers are sponsoring 401(k) plans. To compete with the other employers, the owner would like a similar plan but is not willing to pay significant administrative expenses. Which plan would you suggest?
A church-based nonprofit organization wants to install a retirement plan that could cover everyone who works at the organization. They have three full-time employees and 10 self-employed subcontractors. They are planning on allowing their workers to choose from a list of 15 mutual funds. They are trying to keep administrative costs as low as possible. What advice would you give them?