3. Retirement Plans

Important Change for 2002

Many changes to the tax laws for retirement plans were made by the Economic Growth and Tax Relief Reconciliation Act of 2001 that was enacted on June 7, 2001. Most of those changes take effect in 2002. For information about those changes not covered in this chapter, see Publication 560, Retirement Plans for Small Business, or Publication 553, Highlights of 2002 Tax Changes.

Introduction

This chapter discusses retirement plans you can set up and maintain for yourself and your employees. Retirement plans are savings plans that offer you tax advantages to set aside money for your own and your employees' retirement.

In general, a sole proprietor or a partner is treated as an employee for retirement plan purposes.

SEP, SIMPLE, and qualified plans offer you and your employees a tax favored way to save for retirement. You can deduct contributions you make to the plan for your employees. If you are a sole proprietor, you can deduct contributions you make to the plan for yourself. You can also deduct trustees' fees if contributions to the plan do not cover them. Earnings on the contributions are generally tax free until you or your employees receive distributions from the plan in later years.

Under certain plans, employees can have you contribute limited amounts of their before-tax pay to a plan. These amounts (and the earnings on them) are generally tax free until your employees receive distributions from the plan in later years.

In general, individuals who are employed or self-employed can also set up and contribute to individual retirement arrangements (IRAs).

Topics

This chapter discusses:

• Simplified employee pension (SEP) plans
• SIMPLE (Savings incentive match plan for employees) retirement plans
• Qualified plans (also called H.R. 10 plans or Keogh plans when covering self-employed individuals)
• Individual retirement arrangements (IRAs)

Useful Items You may want to see:

Publication

• 560   Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans)
• 590   Individual Retirement Arrangements (IRAs)

Form (and Instructions)

• W-2   Wage and Tax Statement
• 5304-SIMPLE   Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) - Not for Use With a Designated Financial Institution
• 5305-SIMPLE   Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) - for Use With a Designated Financial Institution

See chapter 14 for information about getting publications and forms.

Simplified Employee Pension (SEP)

A simplified employee pension (SEP) is a written plan that allows you to make deductible contributions toward your own and your employees' retirement without getting involved in more complex retirement plans. A corporation also can have a SEP and make deductible contributions toward its employees' retirement. However, certain advantages available to qualified plans, such as the special tax treatment that may apply to lump-sum distributions, do not apply to SEPs.

Under a SEP, you make the contributions to a traditional individual retirement arrangement (called a SEP-IRA) set up for each eligible employee.

SEP-IRAs are set up for, at a minimum, each eligible employee. A SEP-IRA may have to be set up for a leased employee, but need not be set up for an excludable employee. For more information, see Publication 560.

Form 5305-SEP.   You may be able to use Form 5305-SEP, Simplified Employee Pension - Individual Retirement Accounts Contribution Agreement, in setting up your SEP.

Contribution Limits

Contributions you make for 2002 to a common-law employee's SEP-IRA are limited to the lesser of $40,000 or 25% of the employee's compensation. Compensation generally does not include your contributions to the SEP, but does include certain elective deferrals unless you choose not to include them.

Annual compensation limit.   You generally cannot consider the part of an employee's compensation over $200,000 when you figure your contribution limit for that employee.

More than one plan.   If you also contribute to a defined contribution retirement plan (defined later), annual additions to all a participant's accounts are limited to the lesser of $40,000 or 100% of the participant's compensation. When you figure this limit, you must add your contributions to all defined contribution plans. A SEP is considered a defined contribution plan for this limit.

Contributions for yourself.   The annual limits on your contributions to a common-law employee's SEP-IRA also apply to contributions you make to your own SEP-IRA.

Deduction Limit

The most you can deduct for employer contributions (other than elective deferrals) for a common-law employee is 25% of the compensation (limited to $200,000 per participant) paid to him or her during the year from the business that has the plan, not to exceed $40,000 per participant.

Deduction of contributions for yourself.   When figuring the deduction for employer contributions made to your own SEP-IRA, compensation is your net earnings from self-employment minus the following amounts.

1. The deduction for one-half your self-employment tax.
2. The deduction for contributions to your own SEP-IRA.

The deduction for contributions to your own SEP-IRA and your net earnings depend on each other. For this reason, you determine the deduction for contributions to your own SEP-IRA indirectly by reducing the contribution rate called for in your plan. Use Worksheet 3-A, shown under Qualified Plan, later, to figure the rate.

SEP and defined contribution plan.   If you also contributed to a qualified defined contribution plan, you must reduce the 25% deduction limit for that plan by the allowable deduction for contributions to the SEP-IRAs of those participating in both the SEP plan and the defined contribution plan.

SEP and another qualified plan.   If you also contributed to any other type of qualified plan, treat the SEP as a separate profit-sharing (defined contribution) plan when applying the overall 25% deduction limit described in section 404(h)(3) of the Internal Revenue Code.

If your SEP contribution is more than the deduction limit (nondeductible contribution), you can carry over and deduct the difference in later years. However, the contribution carryover, when combined with the contribution for the later year, is subject to the deduction limit for that year.

Employee contributions.   Employees can also make contributions of up to $3,000 (or $3,500 if they are 50 or older) for 2002 to their SEP-IRAs independent of the employer's SEP contributions. However, the employee's deduction for IRA contributions may be reduced or eliminated because the employee is covered by an employer retirement plan (the SEP plan). See Publication 590 for details.

Salary Reduction Simplified Employee Pension (SARSEP)

An employer is no longer allowed to set up a SARSEP. However, participants in a SARSEP set up before 1997 (including employees hired after 1996) can continue to have their employer contribute part of their pay to the plan.

A SARSEP is a SEP set up before 1997 that included a salary reduction arrangement. Under the arrangement, employees can choose to have you contribute part of their pay to their SEP-IRAs rather than receive it in cash. This contribution is called an elective deferral because employees choose (elect) to set aside the money and the tax on the money is deferred until it is distributed.

This choice is available only if all the following requirements are met.

• The SARSEP was set up before 1997.
• At least 50% of the eligible employees choose the salary reduction arrangement.
• You had 25 or fewer eligible employees (or employees who would have been eligible if you had maintained a SEP) at any time during the preceding year.
• Each eligible highly compensated employee's deferral percentage each year is no more than 125% of the average deferral percentage (ADP) of all nonhighly compensated employees eligible to participate (the ADP test). See Publication 560 for the definition of a highly compensated employee and information on how to figure the deferral percentage.

Limit on elective deferrals.   In general, the total income an employee can defer under a SARSEP and certain other elective deferral arrangements for 2002 is limited to the lesser of $11,000 or 25% of the employee's compensation (as defined in Publication 560). This limit applies only to amounts that reduce the employee's pay, not to any contributions from employer funds.

Catch-up contributions.   Beginning in 2002, a SEP can permit participants who are age 50 or older at the end of the calendar year to make catch-up contributions. (If the participant's 50th birthday is on January 1, 2003, the participant is considered age 50 at the end of 2002.) The catch-up contribution limit for 2002 is $1,000 ($2,000 for 2003). Elective deferrals are not treated as catch-up contributions for 2002 until they exceed the limit discussed earlier under Limit on elective deferrals, the SARSEP ADP test (see Publication 560), or the plan limit (if any). However, the catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts.

• The catch-up contribution limit.
• The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.

Catch-up contributions are not subject to the limit discussed under Limit on elective deferrals, earlier.

Deduction limit and elective deferrals.   Compensation, as discussed earlier, under Deduction Limit, includes elective deferrals. Beginning in 2002, elective deferrals are no longer subject to this deduction limit. However, the combined deduction for a participant's elective deferrals, and other SEP contributions, cannot exceed $40,000.

Employment taxes.   Elective deferrals that meet the ADP test are not subject to income tax in the year of deferral, but they are included in wages for social security, Medicare, and federal unemployment (FUTA) tax.

Reporting SEP Contributions on Form W-2

Your contributions to an employee's SEP-IRA are excluded from the employee's income. Do not include these contributions in your employee's wages on Form W-2 for income, social security, or Medicare tax purposes. Your SEP contributions under a salary reduction arrangement are included in your employee's wages for social security and Medicare tax purposes only.

Example.   Jim's salary reduction arrangement calls for 10% of his salary to be contributed by his employer as an elective deferral to Jim's SEP-IRA. Jim's salary for the year is $30,000 (before reduction for the deferral). The employer did not choose to treat deferrals as compensation under the arrangement. To figure the deferral, the employer multiplies Jim's salary of $30,000 by 9.0909%, the reduced rate equivalent of 10%, to get the deferral of $2,727.27. (This method is the same one you, as a self-employed person, use to figure the contributions you make on your own behalf. See Worksheet 3-A, under Qualified Plan, later.)

On Jim's Form W-2, his employer shows total wages of $27,272.73 ($30,000 - $2,727.27), social security wages of $30,000, and Medicare wages of $30,000. Jim reports $27,272.73 as wages on his individual income tax return.

If his employer does not make the choice explained above, Jim's deferral would be $3,000 ($30,000 x 10%). In this case, the employer uses the rate called for under the arrangement (not the reduced rate) to figure the deferral and the ADP test. On Jim's Form W-2, the employer shows total wages of $27,000 ($30,000 - $3,000), social security wages of $30,000, and Medicare wages of $30,000. Jim reports $27,000 as wages on his return.

In either case, the maximum deductible contribution would be $6,000 ($30,000 x 20%).

More information.   For more information on employer withholding requirements, see Publication 15.

For more information on SEPs, see Publication 560.

SIMPLE Retirement Plans

A Savings Incentive Match Plan for Employees (SIMPLE plan) is a written arrangement that provides you and your employees with a simplified way to make contributions to provide retirement income. Under a SIMPLE plan, employees can choose to make salary reduction contributions to the plan rather than receiving these amounts as part of their regular pay. In addition, you will contribute matching or nonelective contributions.

SIMPLE plans can only be maintained on a calendar-year basis.

A SIMPLE plan can be set up in either of the following ways.

• Using SIMPLE IRAs (SIMPLE IRA plan).
• As part of a 401(k) plan (SIMPLE 401(k) plan).

See Publication 560 for information on SIMPLE 401(k) plans.

Many financial institutions will help you set up a SIMPLE plan.

SIMPLE IRA Plan

A SIMPLE IRA plan is a retirement plan that uses SIMPLE IRAs for each eligible employee. Under a SIMPLE IRA plan, a SIMPLE IRA must be set up for each eligible employee. For the definition of an eligible employee, see Who Can Participate in a SIMPLE IRA Plan?, next.

Who Can Set Up a SIMPLE IRA Plan?

You can set up a SIMPLE IRA plan if you meet both the following requirements.

• You meet the employee limit.
• You do not maintain another qualified plan unless the other plan is for collective bargaining employees.

Employee limit.   You can set up a SIMPLE IRA plan only if you had 100 or fewer employees who received $5,000 or more in compensation from you for the preceding year. Under this rule, you must take into account all employees employed at any time during the calendar year regardless of whether they are eligible to participate. Employees include self-employed individuals who received earned income and leased employees.

Once you set up a SIMPLE IRA plan, you must continue to meet the 100-employee limit each year you maintain the plan.

Grace period for employers who cease to meet the 100-employee limit.   If you maintain the SIMPLE IRA plan for at least 1 year and you cease to meet the 100-employee limit in a later year, you will be treated as meeting it for the 2 calendar years immediately following the calendar year for which you last met it.

A different rule applies if you do not meet the 100-employee limit because of an acquisition, disposition, or similar transaction. Under this rule, the SIMPLE IRA plan will be treated as meeting the 100-employee limit for the year of the transaction and the 2 following years if both the following conditions are satisfied.

• Coverage under the plan has not significantly changed during the grace period.
• The SIMPLE IRA plan would have continued to qualify after the transaction if you had remained a separate employer.

The grace period for acquisitions, dispositions, and similar transactions also applies if, because of these types of transactions, you do not meet the rules explained under Other qualified plan, next, or Who Can Participate in a SIMPLE IRA Plan?, later.

Other qualified plan.   The SIMPLE IRA plan generally must be the only retirement plan to which you make contributions, or benefits accrue, for service in any year beginning with the year the SIMPLE IRA plan becomes effective.

Exception.   If you maintain a qualified plan for collective bargaining employees, you are permitted to maintain a SIMPLE IRA plan for other employees.

Who Can Participate in a SIMPLE IRA Plan?

Eligible employee.   Any employee who received at least $5,000 in compensation during any 2 years preceding the current calendar year and is reasonably expected to receive at least $5,000 during the current calendar year is eligible to participate. The term employee includes a self-employed individual who received earned income.

You can use less restrictive eligibility requirements (but not more restrictive ones) by eliminating or reducing the prior year compensation requirements, the current year compensation requirements, or both. For example, you can allow participation for employees who received at least $3,000 in compensation during any preceding calendar year. However, you cannot impose any other conditions on participating in a SIMPLE IRA plan.

Excludable employees.   The following employees do not need to be covered under a SIMPLE IRA plan.

• Employees who are covered by a union agreement and whose retirement benefits were bargained for in good faith by the employees' union and you.
• Nonresident alien employees who have received no U.S. source wages, salaries, or other personal services compensation from you.

Compensation.   Compensation for employees is the total wages required to be reported on Form W-2. Compensation also includes the salary reduction contributions made under this plan, compensation deferred under a section 457 plan, and the employees' elective deferrals under a section 401(k) plan, a SARSEP, or a section 403(b) annuity contract. If you are self-employed, compensation is your net earnings from self-employment (line 4 of Short Schedule SE (Form 1040)) before subtracting any contributions made to the SIMPLE IRA plan for yourself.

How To Set Up a SIMPLE IRA Plan

You can use Form 5304-SIMPLE or Form 5305-SIMPLE to set up a SIMPLE IRA plan. Each form is a model savings incentive match plan for employees (SIMPLE) plan document. Which form you use depends on whether you select a financial institution or your employees select the institution that will receive the contributions.

Use Form 5304-SIMPLE if you allow each plan participant to select the financial institution for receiving his or her SIMPLE IRA plan contributions. Use Form 5305-SIMPLE if you require that all contributions under the SIMPLE IRA plan be deposited initially at a designated financial institution.

The SIMPLE IRA plan is adopted when you (and the designated financial institution, if any) have completed all appropriate boxes and blanks on the form and you have signed it. Keep the original form. Do not file it with the IRS.

Other uses of the forms.   If you set up a SIMPLE IRA plan using Form 5304-SIMPLE or Form 5305-SIMPLE, you can use the form to satisfy other requirements, including the following.

• Meeting employer notification requirements for the SIMPLE IRA plan. Page 3 of Form 5304-SIMPLE and Page 3 of Form 5305-SIMPLE contain a Model Notification to Eligible Employees that provides the necessary information to the employee.
• Maintaining the SIMPLE IRA plan records and proving you set up a SIMPLE IRA plan for employees.

Deadline for setting up a SIMPLE IRA plan.   You can set up a SIMPLE IRA plan effective on any date between January 1 and October 1 of a year, provided you did not previously maintain a SIMPLE IRA plan. This requirement does not apply if you are a new employer that comes into existence after October 1 of the year the SIMPLE IRA plan is set up and you set up a SIMPLE IRA plan as soon as administratively feasible after you come into existence. If you previously maintained a SIMPLE IRA plan, you can set up a SIMPLE IRA plan effective only on January 1 of a year. A SIMPLE IRA plan cannot have an effective date that is before the date you actually adopt the plan.

Setting up a SIMPLE IRA.   SIMPLE IRAs are the individual retirement accounts or annuities into which the contributions are deposited. A SIMPLE IRA must be set up for each eligible employee. Forms 5305-S, SIMPLE Individual Retirement Trust Account, and 5305-SA, SIMPLE Individual Retirement Custodial Account, are model trust and custodial account documents the participant and the trustee (or custodian) can use for this purpose.

A SIMPLE IRA cannot be designated as a Roth IRA. Contributions to a SIMPLE IRA will not affect the amount an individual can contribute to a Roth IRA.

Deadline for setting up a SIMPLE IRA.   A SIMPLE IRA must be set up for an employee before the first date by which a contribution is required to be deposited into the employee's IRA. See Time limits for contributing funds, later, under Contribution Limits.

Notification Requirement

If you adopt a SIMPLE IRA plan, you must notify each employee of the following information before the beginning of the election period.

• The employee's opportunity to make or change a salary reduction choice under a SIMPLE IRA plan.
• Your choice to make either reduced matching contributions or nonelective contributions (discussed later).
• A summary description and the location of the plan. The financial institution should provide you with this information.
• Written notice that his or her balance can be transferred without cost or penalty if you use a designated financial institution.

Election period.   The election period is generally the 60-day period immediately preceding January 1 of a calendar year (November 2 to December 31 of the preceding calendar year). However, the dates of this period are modified if you set up a SIMPLE IRA plan in mid-year (for example, on July 1) or if the 60-day period falls before the first day an employee becomes eligible to participate in the SIMPLE IRA plan.

A SIMPLE IRA plan can provide longer periods for permitting employees to enter into salary reduction agreements or to modify prior agreements. For example, a SIMPLE IRA plan can provide a 90-day election period instead of the 60-day period. Similarly, in addition to the 60-day period, a SIMPLE IRA plan can provide quarterly election periods during the 30 days before each calendar quarter, other than the first quarter of each year.

Contribution Limits

Contributions are made up of salary reduction contributions and employer contributions. You, as the employer, must make either matching contributions or nonelective contributions, discussed later. No other contributions can be made to the SIMPLE IRA plan. These contributions, which you can deduct, must be made timely. See Time limits for contributing funds, later.

Salary reduction contributions.   The amount the employee chooses to have you contribute to a SIMPLE IRA on his or her behalf cannot be more than $7,000 for 2002 ($8,000 for 2003). These contributions must be expressed as a percentage of the employee's compensation unless you permit the employee to express them as a specific dollar amount. You cannot place restrictions on the contribution amount (such as limiting the contribution percentage), except to comply with the $7,000 limit.

If an employee is a participant in any other employer plan during the year and has elective salary reductions or deferred compensation under those plans, the salary reduction contributions under a SIMPLE IRA plan also are elective deferrals that count toward the overall $11,000 annual limit on exclusion of salary reductions and other elective deferrals.

Catch-up contributions.   For tax years beginning after 2001, a SIMPLE plan can permit participants who are age 50 or older at the end of the calendar year to make catch-up contributions. (If the participant's 50th birthday is on January 1, 2003, the participant is considered age 50 at the end of 2002.) The catch-up contribution limit for 2002 is $500. This limit increases by $500 each year thereafter until it reaches $2,500 in 2006. The limit is subject to cost-of-living increases after 2006. The catch-up contributions a participant can make for a year cannot exceed the lesser of the following amounts.

• The catch-up contribution limit.
• The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.

Employer matching contributions.   You generally are required to match each employee's salary reduction contributions (other than catch-up contributions) on a dollar-for-dollar basis up to 3% of the employee's compensation. This requirement does not apply if you make nonelective contributions as discussed later.

Example.   In 2002, your employee, John Rose, earned $25,000 and chose to defer 5% of his salary. You make a 3% matching contribution. The total contribution you can make for John is $2,000, figured as follows.

Salary reduction contributions ($25,000 × .05)	$1,250
Employer matching contribution ($25,000 × .03)	750
Total contributions	$2,000

Lower percentage.   If you choose a matching contribution less than 3%, the percentage must be at least 1%. You must notify the employees of the lower match within a reasonable period of time before the 60-day election period (discussed earlier) for the calendar year. You cannot choose a percentage less than 3% for more than 2 years during the 5-year period that ends with (and includes) the year for which the choice is effective.

Nonelective contributions.   Instead of matching contributions, you can choose to make nonelective contributions of 2% of compensation on behalf of each eligible employee who has at least $5,000 of compensation (or some lower amount of compensation that you select) from you for the year. If you make this choice, you must make nonelective contributions whether or not the employee chooses to make salary reduction contributions. Only $200,000 of the employee's compensation can be taken into account to figure the contribution limit.

If you choose this 2% contribution formula, you must notify the employees within a reasonable period of time before the 60-day election period (discussed earlier) for the calendar year.

Example 1.   In 2002, your employee, Jane Wood, earned $36,000 and chose to have you contribute 10% of her salary. You make a 2% nonelective contribution. Both of you are under age 50. The total contributions you can make for her are $4,320, figured as follows.

Salary reduction contributions ($36,000 × .10)	$3,600
2% nonelective contributions ($36,000 × .02)	720
Total contributions	$4,320

Example 2.   Using the same facts as in Example 1, above, the maximum contribution you can make for Jane if she earned $75,000 is $8,500, figured as follows.

Salary reduction contributions (maximum amount)	$7,000
2% nonelective contributions ($75,000 × .02)	1,500
Total contributions	$8,500

Time limits for contributing funds.   You must make the salary reduction contributions to the SIMPLE IRA within 30 days after the end of the month in which the amounts would otherwise have been payable to the employee in cash. You must make matching contributions or nonelective contributions by the due date (including extensions) for filing your federal income tax return for the year.

When To Deduct Contributions

You can deduct SIMPLE IRA contributions in the tax year with or within which the calendar year for which contributions were made ends. You can deduct contributions for a particular tax year if they are made for that tax year and are made by the due date (including extensions) of your federal income tax return for that year.

Example 1.   Your tax year is the fiscal year ending June 30. Contributions under a SIMPLE IRA plan for the calendar year 2002 (including contributions made in 2002 before July 1, 2002) are deductible in the tax year ending June 30, 2003.

Example 2.   You are a sole proprietor whose tax year is the calendar year. Contributions under a SIMPLE IRA plan for the calendar year 2002 (including contributions made in 2003 by April 15, 2003) are deductible in the 2002 tax year.

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