IRAs and 401(k)s: How to Pick the Best Plan; Help Your Firm - or Your Clients - Make the Right Choice

EXECUTIVE SUMMARY * RETIREMENT PLANS ARE OFFERED BY a variety of providers, including financial institutions, insurance companies and payroll service providers. But adherence to IRS regulations is the responsibility of the business owner. * ANY BUSINESS WITH ONE EMPLOYEE that does not have any other type of retirement plan can set a simplified employee pension-IRA plan. All contributions to SEPs come from the employer. SEPs are easy to set and maintain, and do not require an annual tax return. * THERE ARE TWO TYPES OF SAVINGS INCENTIVE match plans for employees: the SIMPLE IRA and the SIMPLE 401(k). They require little documentation and no annual tax filing. But employers must make annual contributions to employee accounts. Employer and employee contributions both are vested immediately. * THE TRADITIONAL 401(k) PLAN carries the most reporting requirements and is the most costly to administer. It is better for employees because they can make contributions every year, even if the employer does not. Administration of 401(k) plans is complicated by annual compliance testing and a required annual tax return. * SAFE HARBOR 401(k) PLANS are an attractive alternative for a business that wants a 401(k) plan, but does not want to or is not able to satisfy the annual discrimination testing required by traditional plans. The price to be paid is a safe harbor contribution made to all employee accounts. ********** CPAs with small business clients--or those with decision-making responsibilities for smaller companies--often are called upon to evaluate pension plan options. This article will help by outlining the key features of retirement plans that can be implemented by small businesses: the simplified employee pension-IRA (SEP-IRA); the savings incentive match plan for employees (SIMPLE), IRA and 401(k); the traditional 401(k); and the safe harbor 401(k). THE REGULATIONS The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 offers tax credits to any business with 100 or fewer employees that establishes a pension plan. Such businesses are eligible for credit to 50% of the first $1,000 spent on retirement education and administration, to a maximum of $500 per year for the first three years. Eligible employees must have received $5,000 in compensation, and there must be at least one highly compensated employee who owned more than a 5% interest in the business at any time during the previous year or who receives compensation of more than $95,000 in 2005 (increased from $90,000 for 2004). The law also includes a provision enabling employees age 50 or older to catch up by making incremental contributions to compensate for any years in which they did not participate in a pension plan. Another provision offers a tax credit to low-income participants; they can receive a nonrefundable tax credit of to 50% on to $2000 in contributions to specified plans, for a maximum credit of $1,000. This credit is in addition to the tax deduction already associated with contributions to such plans. In order to ensure that all retirement plans have a representative balance of participants and are not dominated by higher-paid employees, they are subject to annual top-heavy testing (IRC section 416(g)). (See Top-Heavy Testing and Key Employees, above.) If a plan becomes top-heavy, the employer must provide a minimum contribution to all nonkey employees, based on how much they have contributed to the plan--out of their own salaries or in the form of employer contributions--during the year. CPAs therefore should remind their small business clients that it's to the plan administrator to keep a keen eye on account values throughout the plan year and notify the employer if the plan is in danger of becoming top-heavy. To make it less likely that a plan would be deemed top-heavy, the EGTRRA narrowed the definition of key employees by nearly doubling the compensation limit from $67,500 in 2000 to $130,000 in 2001. …