Small Businesses Offering Retirement Plans

Only 34.4% of firms with fewer than 25 employees offered retirement plans to their employees. Source: Congressional Research Service, 2004

Retirement plans that can be implemented by small businesses includes, the simplified employee pension-IRA (SEP-IRA), the traditional 401(K), the safe harbor 401 (K), and the savings incentive match plan for employees (SIMPLE)…SIMPLE IRA and SIMPLE 401(K).

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 up 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 up to 50% on up 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)). If a plan becomes top-heavy, the employer must provide a minimum contribution to all non-key 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.

What is Top-Heavy Testing and Key Employees?

A “key employee” is one who at any time during the preceding plan year was:

* A 5% owner
* A 1% owner whose annual compensation exceeded $150,000
* An officer receiving more than $130,000 in compensation.

The IRS considers a plan “top-heavy” if the account values for key employees exceed 60% of the account values for all employees. For example: A small business employs a total of 11 people, three of whom meet the criteria for “key employees.” If the account values for the three key employees total $15,000, while the account values for all 11 employees total $24,000, the plan would be considered top-heavy because the account values for the key employees equals 63% of the account values for all employees.

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. It also allowed companies to count matching contributions toward satisfying the minimum contribution requirements.

The top-heavy rules are particularly harsh on small businesses that employ family members; they discriminate by treating all family members as key employees, regardless of salary level and percentage of ownership (IRC section 318). This makes it difficult for family-based small businesses to pass top-heavy testing and continues to be a major deterrent to their implementing pension plans.

Source: aicpa.org