March 18, 1997

FINALLY, A RETIREMENT PLAN SMALL BIZ CAN AFFORD

In the midst of tax season it's good to know there's something in the IRS code that's cause for celebration. It's the new, congressionally mandated SIMPLE-IRA plans. This fresh twist on the individual retirement account lets more small-business owners save for their own -- and their employees' -- retirement while greatly easing regulatory burdens that may have discouraged them in the past (for a quick overview, See BW Enterprise, 10/21/96, "How Do You Offer a Pension Plan? Simple").

Congress, of course, is gaga over acronyms, and it dubbed the Savings Incentive Matching Plan for Employees SIMPLE to signify the streamlined paperwork requirements for small businesses setting up these plans.

While the SIMPLE regulations are easier and cheaper to digest than the previous rules, they are, alas, a product of Congress and the IRS, which means they're not *that* simple. To make best use of them, it's helpful to trace their family tree.

By now, you've probably discovered the first rule of small-business retirement planning: It's hard to do. That's mainly because of expense but also because of the IRS rules that govern so-called qualified plans like 401(k)s. (The term "qualified" simply means a plan conforms to specified limits on the amount the owner of a business can contribute in comparison to his lowest-paid employee.)

Qualified plans, however, are by far the most lucrative way to save funds for retirement. The employer gets a tax deduction for money going into the plan, and both employees and employer-owners get to watch their contributions grow tax-free.

Aside from finding money to fund a qualified plan, small businesses have had to cope with:

--The cost of starting a plan, normally $1,000 to $2,000. Ongoing administrative charges can easily run more than $75 per employee, per year, since small employers typically hire an outside service to keep track of the plan.

--The additional cost and complexity of meeting the IRS' discrimination rules that determine if top management's saving options are unfairly generous compared to other employees'. IRS-required start-up documentation often totals 50 to 75 pages.

---The cost of educating employees about the savings plans as well as the cost of completing annual IRS and Labor Dept. reports. Penalties are levied on companies that file improperly.

Of course, larger employers can more easily absorb the costs and risks of these qualified plans. For them, annual administrative expenses can run as low as $25 per participant, which is three to four times less than the typical cost to small companies.

The bottom line: For small-business owners to run a qualified plan they not only have to spend thousands of start-up dollars but they also must invest substantial time and money in record-keeping, employee education, and government compliance. And this doesn't yet include the actual cash contributions to employees' plans. In all, qualified plans demand a level of commitment few small businesses are capable of meeting.

In the past, an alternative to qualified plans was the Simplified Employee Pension (SEP) and a more recent variation -- the SEP coupled with a Salary Reduction feature (SAR-SEP). With the SEP, an employer contributed up to 15% of a participant's total annual compensation to an individual retirement account. Using the SAR-SEP, the employees made contributions of their own pre-tax dollars.

Although both of these plans were typically an improvement over the qualified plans, they both had significant drawbacks for many small employers. The SEP was entirely employer funded, and since the rules liberally defined who was an eligible employee (generally, those who made over $400 per year), the expense to small businesses was traditionally too high to maintain.

The SAR-SEP was often referred to as a Poor Man's 401(k) for business owners, because using it, the owners could avoid the IRS "qualifying" costs. They did, however, have to met some strict criteria before the SAR-SEP could start. Half the eligible employees had to participate for the plan to take effect. And the government allowed only 25 eligible participants for each company.

Also, owners and highly compensated employees were allowed to set aside only 125% of the average salary deferral of their employees. Thus, if the employees saved an average of 4%, the owner could put only 5% into a personal plan. If the employees didn't contribute anything, the owner couldn't either.

Despite its complexities, the SAR-SEP was still much less complex than a 401(k). But as part of new tax laws, SAR-SEPs were discontinued as of December 31, 1996. Congress intends for the SIMPLE to replace the SAR-SEP, although existing SAR-SEPs can continue under the prior rules.

Given this background -- the complicated compliance rules and the fact that SEP and SAR-SEP plans were not attracting the participation Congress had hoped for -- the lawmakers authorized the SIMPLE-IRA, a new form of the Individual Retirement Account.

Do not confuse the SIMPLE-IRA with the SIMPLE 401(k). Although they are similar in many respects, the SIMPLE 401(k) is not nearly as advantageous to the employer as the SIMPLE-IRA. Since the SIMPLE 401(k) must meet many of the same requirements as a traditional "qualified" 401(k), the cost is substantially higher to business owners.

The first rule of the SIMPLE-IRA is to forget all of the rules for qualified and SEP plans. Qualified plans and SEPs are designed for the primary benefit and protection of employees. SIMPLE-IRA plans are still designed for their benefit, too, but offer employers much more discretion. Congress shifted the emphasis because it found small businesses were wary of the other plans' red tape. That virtually paralyzed their retirement offerings. Now, the qualified plans' discrimination tests are gone.

The SIMPLE-IRA allows for employees (as well as the business owner) to place up to $6,000 of salary into an IRA account. Employees contribute pretax dollars, which lowers their taxable income, and thus their income tax, just as would happen with a 401(k). Of course, once the funds are deposited into the IRA account, they are governed by most standing IRA rules. However, the early withdrawal penalty under SIMPLE-IRA is 25% instead of the normal 10%. The 25% penalty does not apply in the case of death, disability, or withdrawals made after the age of 59 1/2.

An employer can save money for his own retirement plan regardless of whether employees do or not. The maximum total amount per year is $12,000 -- $6,000 of salary deferral plus a 3% match on a salary of $200,000 or more.

TECHNICAL REQUIREMENTS FOR THE SIMPLE-IRA:

--Employees must be given 60 days each year to decide whether or not to participate in the plan. And to be an eligible sponsor of a SIMPLE-IRA, the employer must have had 100 or fewer employees receiving compensation of $5,000 or more each the preceding tax year. Once the employer has established a valid SIMPLE plan, he may generally be able to continue on the program for two more years even if the number of employees exceeds 100.

--There is no long-term fixed commitment on behalf of the employer. Once started, the law only requires that the plan run for the entire calendar year, although it can be terminated the year after.

--A plan document is required: Either the six-page IRS Form 5305 SIMPLE or a commercial provider's prototype document. This once-a-year filing is the only necessary IRS form.

--The SIMPLE-IRA must be offered to all employees who have received at least $5,000 of compensation in at least two prior years and those who expect to receive at least $5,000 of compensation in the current year. Note, these are minimum requirements. An employer can choose lower cutoffs as well.

--The employer can choose to exclude union employees, certain airline pilots, and nonresident aliens who receive non-U.S.-source income from the plan.

--The employer cannot maintain any other active qualified plan or SEP plan while the SIMPLE-IRA is in existence.

--Employee salary deferrals are subject to social security and federal unemployment taxes.

Once an employee has decided to participate in the SIMPLE-IRA, he can end his participation at any time; though once he's dropped out of the plan, he cannot reenter until the start of the next year. Also, the employer has the option of allowing participants to modify their salary deferrals during the course of the year. Thus, the employer could present the employee participants with the option of either terminating all participation in the plan or requiring employees to maintain a designated level of contributions.

This flexibility only increases the plan's attractiveness to a small-business owner. Its main attraction, of course, is savings in administrative costs. Since startup fees are minimal and employees own contributions fund most of the savings, an employer can offer a means of retirement savings without going broke. Part of the plan, however, does require employers to contribute a small percentage to the employees' savings.

This contribution can be either in the form of an employer match or an across- the-board contribution. Here's how both work:

EMPLOYER MATCH

The employer can elect to contribute a dollar-for-dollar match of the employees' contributions into the plan, up to 3% of the employees' salary.

Example 1: Douglas has a compensation level of $100,000 and elects to contribute $1,000 into the SIMPLE-IRA. The required employer contribution, if the matching election is made, will be $1,000. Even though 3% of Douglas's salary is $3,000, the employer can never contribute more than the employee.

Example 2: Jane has a compensation level of $200,000 and elects to contribute $6,000 into the SIMPLE-IRA. The required employer contribution, if the matching election is made, will be $6,000. This is computed by comparing 3% of Jane's $200,000 salary to her salary reduction.

Example 3: Sue has a compensation level of $25,000 and elects not to contribute any of her salary into the SIMPLE-IRA. In this case, there would not be any employer contribution into the plan.

Exception: The employer, at his own discretion, can choose to reduce the 3% match to a 1% match for two out of five years. If this is done, the effective average required match over the five year period will be 2.2%.

ACROSS-THE-BOARD CONTRIBUTION

Another way for employers to meet their obligation to contribute is to make an across-tbe-board contribution of 2% of each employees' compensation. Employers must contribute even if employees choose not to.

In either case, the employer must notify employees 60 days in advance which of the two available methods will be used for the current year. The employer can switch required contribution methods on a year-to-year basis.

On a monthly basis, the employer must deposit the employee contributions, but the employer matching isn't due until the filing date of the company's federal tax return -- typically Mar. 15.

PLANNING IDEAS

Now that we have reviewed the technical rules, let's look at how the SIMPLE-IRA can work for the small business.

In most cases, from the standpoint strictly of cost, the employer should elect to fulfill its required contribution by matching the employees' contributions and not by contributing across the board. By making the match, the employer only needs to make contributions for those employees who are willing to voluntarily reduce their pretax salary. Those who are not willing to take a salary reduction will receive nothing from the employer. Based on experience with 401(k) plans, a solid employee participation rate is about 40% to 50%.

Ethical questions aside, the employer could offer retirement benefits but in fact do nothing to encourage employee participation. For example, though the employer is required to inform employees about the plan, he may choose not to actively promote it. Also, the employer can be strict about the plan's terms. He can mandate that employees cannot increase their salary reduction and that their only option for reducing the salary reduction would be to terminate their contributions entirely. The key point is that the less employees contribute, the less costly the plan will be to the employer.

But cut corners too much, and you'll likely alienate employees. Remember, a retirement plan is supposed to attract good workers and inspire their loyalty.

Some other planning tips: Why not put your spouse on the payroll? If your spouse meets the plan requirements, he or she can participate in the SIMPLE-IRA just the same as other qualifying employees. For instance, if the spouse is eligible and is paid a $6,000 salary, that spouse could elect to put the whole $6,000 into the SIMPLE-IRA. You need to be sure that the salary paid to the spouse is reasonable for services actually rendered, but there are no family attribution or aggregation rules to be concerned about.

The SIMPLE-IRA can be a very effective retirement vehicle for small businesses. The pervasive marketing of plans by financial services companies -- which will set up plans for you -- makes them sound like the solution for every small business. That may not always be the case, but they do provide significant benefits to employers who want to reduce the cost of retirement programs while at the same time funding their own retirement.

By Jim Vonachen in Denver. Vonachen is a Certified Public Accountant and partner in charge of the tax practice at Clifton, Gunderson LLC in Denver. He's also a frequent guest of Business Week Online conferences concerned with tax-planning and -filing tips.

Edited by Dennis Berman