Commonsense CPA: Understanding Your Business’s Retirement Plan Options

“The question isn't at what age I want to retire, it's at what income.”  - George Foreman

This month's Commonsense CPA offers up another primer on a basic but powerful tool in your business's arsenal for hiring and employee retention, and one that's increasingly legally mandated for businesses of all sizes - your retirement plan. 

Not necessarily the sexiest topic (see last month's CCPA's PSL-themed depreciation missive for the really hot stuff), retirement planning should always be somewhere in the back of everyone's mind, and has leapt to the fore as Schroedinger's Recession continues to loom alongside less than thrilling narratives about Quiet Quitting and inflation. Everyone wants to be confident about those rainy day savings, and a compelling retirement plan presented clearly can be a huge feather in your cap for employee morale.

To that end, we're getting into the nitty gritty with three of the most common options for businesses - SIMPLE and SEP IRAs, and 401(k)s. Understanding the legal nuances of how these plans are set up and distributed is invaluable for your business, your employees, and for your own life, and they can be surprisingly easy to implement if you aren't already making use of a good plan.

Here at Harmony we're always happy to dive deeper - read on for our breakdown and don't hesitate to reach out if you're thinking of making changes to your business or your own finances.

Matt Hetrick, CPA
President and founder of Harmony Group Inc.

Understanding Your Business’s Retirement Plan Options

Having a well-thought retirement plan is something that many employees expect and is a core benefit offered by most companies in competitive talent environments. Business owners can make multiple choices about what plan they want to maintain for themselves and their employees. Furthermore, more and more states are mandating that all employers have a qualifying retirement plan for employees.

We are going to cover three of the most common options for employer retirement plans: SIMPLE IRAs, SEP IRAs, and 401(k)s. All of these plans are “Defined Contribution Plans” where the employer makes a defined monetary contribution whereas a pension plan where an employee receives guaranteed monthly income is known as a “Defined Benefit Plan.”

With most individual retirement plans, or IRAs ((Individual Retirement Accounts), there is a “Traditional” and “Roth” option. The traditional option features pre-tax deductible contributions but withdrawals are taxed. In contrast, Roth contributions are made after-tax but withdrawals are tax-free. All retirement plan accounts discussed here allow for capital gains to be accrued tax free but have required withdrawal rules when participants reach a certain age.

In most defined contribution plans, employees aged fifty or over are able to make an additional $3,000 yearly catch-up contribution. Also in most IRAs the employee can choose to make withdrawals at any time but withdrawals are subject to inclusion in taxable income and subject to a 10% additional tax unless the money is withdrawn in the first two years of service, in which case the additional tax would be 25%.

Savings Incentive Match Plan for Employees (SIMPLE) IRA

A Savings Incentive Match Plan for Employees Individual Retirement Account or SIMPLE IRA is a retirement plan available to small businesses with under 100 employees. A prime benefit of the SIMPLE IRA is the ease of setting up the plan because there is no filing requirement with the IRS. A business just uses a Form 5304-SIMPLE (employee selecting the financial institution), Form 5305-SIMPLE (employer will be designating the institution) or your own documentation to execute a written agreement and keep that information in your records before setting up an IRA account for each employee. Self-employed individuals can set up a SIMPLE IRA along the same guidelines.

A SIMPLE IRA requires annual notice to employees of certain plan aspects before the beginning of the election period but plans can be set up at any time. While creating a SIMPLE IRA is voluntary for the employer if initiated it must be in place for the whole calendar year, although they can be terminated in a subsequent year.

Any employee who earned at least $5,000 in compensation during any of the prior two years and expects to receive at least $5,000 during the current calendar year can elect to participate in a SIMPLE IRA. Plan conforming employer contributions must be made to all participating employees.

Both employers and employees can contribute to a SIMPLE IRA. Participating employees in a SIMPLE IRA can make elective deferral contributions from their salary, reducing their taxable income but not FICA obligations, up to an annual limit of $14,000. Employers can choose annually one of two contribution methods to fund a SIMPLE IRA: (1) 2% of participating employee’s salary (subject to caps) as a nonelective contribution regardless of employee contribution or (2) a dollar-for-dollar match of the employee’s contribution maxing out at 3% of the employee’s compensation. Employers can lower the matching contribution two years in a 5 year period but cannot go below 1%.

Simplified Employee Pension (SEP) - IRA

Despite the pension in the name, a Simplified Employee Pension (SEP) IRA is not a defined benefit plan but is an employer funded IRA plan (or annuity program). Like a SIMPLE IRA, a SEP is designed to be simple to set up and administer. It requires an employer to adopt a formal written agreement that is distributed to each employee. Employers then set up SEP-IRA accounts for each employee with a qualified financial institution to directly fund the SEP IRA Accounts.

The maximum eligibility requirements - IE the most restrictive your business can be - for employee opt-in to an SEP are that an employee is over the age of 21; worked for the business in 3 of the last 5 years and received at least $650 in the last two years and $600 in the prior years. Employers can choose to have a less restrictive plan, such as allowing employees to participate immediately upon hire. Employers must make conforming distributions for every employee participating in the plan during the plan year but SEPs can be terminated at any time.

Employer contributions to a SEP are largely voluntary but cannot exceed the lesser of 25% of compensation or $61,000. Compensation of up to $305,000 can be considered for a SEP compensation limit, including the total compensation for an employee excluding severance, nontaxable fringe benefits and worker’s compensation. Employer contributions to a SEP are not included in an employee’s gross income unless they exceed the statutory limits.

Since the employer is making the contributions, employees are allowed to contribute up to the statutory maximum to separate IRAs (currently $6,000) even if they are participating in their employer’s SEP. Those contributions can be made to an employer's SEP-IRA account if the employer permits it, including catch-up contributions after age 50. However, the amount of your contribution that’s deductible may be impacted by your participation in your employer’s SEP. Withdrawal rules are identical to those discussed in the SIMPLE IRA.

Self-employed individuals can set up a SEP even if they participate in another company’s retirement plan but all self-employed individuals need to be aware there is additional complexity around determining Section 1402(a) net earnings, so consult the compensation contribution guidelines.

401(k)

The earliest defined contribution plans, largely favored by bigger corporations, 401(k) plans are employer administered retirement plans where the company designates a plan administrator and creates investment accounts for employees who can elect to make individual salary contributions with the employer often providing a matching contribution.

The tax rules around contributions/withdrawals mirror those in the other plans with the distinctions around Roth plans. In a traditional 401(k), employers can elect to make non-elective contributions consisting of a portion of an employee’s salary or elect to match a percentage of employee contributions. Employers can add vesting requirements around employee matching in a traditional 401(k) as well as limit what investments are available.

The employee makes elective deferrals from their salary to contribute to the plan, similar to the SIMPLE IRA, up to a maximum contribution of $20,500 (with catch-up payments allowed). Employers have more flexibility around contributions but employee and employer contributions cannot exceed the lesser of the employee’s total compensation or $61,000.

Unlike the other options, 401(k) plans are highly regulated by the federal government with fiduciary requirements outlined in the Employee Requirement Income Security Act (ERISA). The IRS does recognize some simpler to administer options: Safe Harbor 401(k), Automatic Enrollment 401(k) and Simple 401(k) plans to ease administering a 401(k) but each has its own technical requirements. All retirement plans need to be discussed and implemented in consultation with experts, but this applies especially to 401(k) plans given their complexity.

Having a retirement plan is an essential benefit to hire the right employees and choosing the right one requires consulting with your financial advisors. Your Harmony team is a great place to start – we look forward to having these conversations.

Journal Entries

The _____ is too Damn High (Part III)

Inflation is still running rampant, although it’s showing possible signs of cooling as August Consumer Price Index showed a .1% total increase led by rising costs of food, shelter and medical care, but offset by falling gas prices, although OPEC production cuts will likely reverse that trend. Even if government intervention can cool inflation in more volatile goods, there is a category of “Sticky” goods and services that tend to maintain higher prices – items such as furniture, appliances and other personal services. So timing bigger purchases around inflation may require a longer time horizon depending on the category of goods.
 

I Need a Dollar, A Dollar is All I Need

The tightening of the Fed’s monetary policy by rising interest rates and the dollar’s place as a traditional safe haven in times of crisis has created a super-powered dollar that is soaring compared to other currencies – the Euro is trading under a dollar for the first time since 2001.  What a strong dollar means is entirely dependent on your point-of-view. A strong dollar is good for American consumers who enjoy cheaper prices on imported goods and can enjoy overseas vacations at a serious discount. It’s not good for American businesses (or investors) who have to compete with cheaper imports, face headwinds in their export sales, and lose out when repatriating foreign revenue. For foreign nations it’s pretty much all bad as they lose investment capital to dollar investments, pay more in dollar-denominated loans, and have diminished import revenue. 
 

IRS Updates Inherited IRA Guidance

Congress passed the Secure Act of 2019, which requires that non-eligible beneficiaries who inherit an IRA take required minimum distributions and deplete the entire balance within 10 years for accounts inherited after 2019. If the beneficiary is at retirement age they must take distributions immediately. If required minimum distributions aren’t taken a 50% excise tax applies to the distributions not taken in the calendar year. As discussed in the main article, since traditional IRA distributions are taxable these required minimum distributions can create negative tax consequences for adult wage earners who may be in a higher tax bracket. The IRS has waived these penalties for 2021-2022 for people who inherited accounts after 2019 as they issue new guidance. We’ll use this space to remind you that estate planning is an essential part of your retirement plan and Harmony is happy to assist in those conversations.