* Defined Benefit – These plans provide either a pension or an annuity payout to the employee upon retirement. The employer makes payments to the plan using actuarial formulas based on the employee’s wages, time of service and projected retirement date. These particular plans fall under Code §414 of Chapter 26 of the Federal Code.
* Defined Contribution – A separate account is set-up in a trust for each employee. Both the employer and employee make contributions to this account over many years. The contributions made by the employer are tax deductible and the amounts contributed by the employee are tax deferred.
Most small if not all small businesses utilize defined contribution plans due to simplicity and the shifting of legal compliance to a third-party that manages the trust. The employee is merely a beneficiary of that trust. This lesson touches base on the various options for small businesses related to retirement (defined contribution types) and their respective characteristics. The next section explains the tax consequences to the employee. The final section covers the accounting issues and how the values are reconciled at year-end. As the accountant, your job is to ensure legal compliance and proper payroll documentation for the employer and reporting to the employee.
- 1 Small Business Employee Retirement Plans
- 2 Tax Consequences of Retirement Plans
- 3 Accounting for Retirement Plan Contributions
- 4 Summary – Employer Provided Retirement Plans
Small Business Employee Retirement Plans
There are generally three types of defined contribution plans. The following are each type and the respective legal and compliance issues involved.
Profit – Sharing
Profit-sharing plans allow the employer to make discretionary contributions to the plan contingent on a predefined formula approved by the IRS. The company selects a dollar value to contribute for the upcoming year and the plan’s formula allocates this amount to each participant in the plan. To become a participant, an employee must reach a minimum age (usually 21) and time period of work. The employer is not required to make a contribution every year; but over time most make substantial and recurring amounts.
For example, an employer may pay in 5% of profits every year.
For those employers desiring to pay in a flat dollar amount every year, the plan is referred to as a money purchase plan and not a profit-sharing plan.
The most popular profit-sharing plan is called the 401(k) plan which adheres to §401(k) the Internal Revenue Code. This type of plan allows the employer to contribute a matching percentage of an employees contributions to their account. The employee’s contribution is called the ‘deferred arrangement’ via a ‘elective contribution’ whereby their contribution is not taxed for income tax purposes. Please note, this deferred amount is still taxed for FICA purposes. The plan’s compliance is very complicated and it requires a separate tax entity to maintain the plan. Typical costs to an employer range from $200 per employee to $400 per employee per year. Therefore this plan is not cost-effective for employers with less than 100 employees.
Stock Bonus Plans
Unlike profit-sharing plans which require cash, stock bonus plans are usually in the form of stock (an equity position). A common stock bonus plan is an employee stock ownership plan (ESOP) which follows special rules and receives unique tax advantages.
For any employer with less than 500 employees, a stock bonus plan or an ESOP is simply too complicated and expensive to maintain. Suffice it to say these are not legitimate options for small business. The overall best option for small business is the IRA based retirement plan.
IRA Based Retirement Plans
IRA based retirement plans are absolutely the best option for small business (less than 100 employees). They are simple to set-up, very cost-effective and require little to no maintenance to keep going from one year to the next. They are related to profit sharing in that the employer contributes a percentage of each employee’s compensation to the account and the employer may elect to defer some of his own earnings.
The process is simple, the employer uses a third-party administrator (TPA) that already has an approved model for the plan. Individual retirement accounts (IRA) are set up for each employee. The model, called the master or prototype plan, sets the contribution limits. The employer usually selects a matching contribution amount up to a certain percentage of an employee’s compensation, typically in the one to three percent range.
The employee elects a certain percentage of their compensation as a deduction and the employer simply matches up to a certain amount. As an example, if the employer elects a 3% match and the employee wants a deferral of 4%, the total contribution to the account is 7%. If the employee elects a 2% deferral then the total contribution is 4% (2% from the employer matching the employee’s elective contribution). The key is that employer will match UP to a set amount.
There are three IRA based plans used by small businesses. The following are the three plans and the basic rules for them.
Simplified Employee Pension (SEP)
SEP’s are Code §408(k) plans and allow the employer to contribute money to an employee’s IRA up to 25% of wages. The employer’s contribution must be equal across the entire staff. The rules are:
(1) Employees must be at least 21;
(2) Employee must receive at least $600 in annual wages; AND
(3) The employer must decide how much to contribute each year.
Employees may elect to contribute to this plan by electing a percentage called a ‘salary reduction agreement’ or SARSEP.
Savings Incentive Match Plan for Employees (SIMPLE)
A SIMPLE Plan falls under Code §408(p) of the Internal Revenue Code. Unlike the SEP, the employer matches up to 3% of an employee’s wages. In this plan the employer may elect to simply contribute a flat percentage up to 3% of wages. The restrictions are:
(1) Employees may contribute up to $12,500 per year;
(2) Employees age 50 or more are allowed an additional $3,000 as catch-up contributions;
(3) The employer may contribute up to 3% of an employee’s earnings; AND
(4) Employees are not eligible if earnings are less than $5,000 per year.
Payroll Deduction IRA
Employers are allowed to establish traditional IRA or a Roth IRA for each employee. The employer may simply elect to have deferred amounts contributed to the traditional IRA or post contributions to a Roth. The payroll contribution is strictly one-sided as the employer does not contribute monies in these types of IRA based plans.
The overall goal of all retirement plans is to provide a long-term benefit to employees. It is almost a requirement to provide this benefit to recruit and retain staff. There are tax benefits to both the employer and employee.
Tax Consequences of Retirement Plans
Both the employer and the employee receive tax benefits associated with a contribution to the retirement plan. The employer’s contribution is 100% deductible. In addition, if properly used, an employer can use this as additional compensation and save money on the FICA component of this contribution. As an example, suppose an employer contributes $50,000 per year to a plan. This $50,000 contribution in lieu of additional compensation saves the employer $3,825 per year in FICA taxes (the matching component).
For the employee, the employer’s contribution saves them 7.65% in FICA taxes too. As for the employee’s contribution, the only savings is with income taxes. For those employees in states with income taxes the amount contributed saves both federal and state income taxes. However, the employee’s contribution is still taxed for FICA purposes. Unlike other benefits, a retirement contribution by the employee is not 100% deducted from gross wages before calculating taxes. The contribution amount is only excluded in calculating federal and state income taxes as illustrated here:
Thomas earns $1,625 per week as a mechanic. His employer requires Thomas to pay $30 per paycheck (weekly) for a fully pre-tax health insurance plan. Other pre-tax benefits cost Thomas $12,75 per week. Thomas contributes $78 per week to the company’s SARSEP. This is Thomas’ paycheck analysis.
. Basis Deductions
Gross Wages $1,625.00
. – Health Insurance (30.00) 30.00
. – Other (12.75) 12.75
Fully Taxable Wages 1,582.25
FICA Taxes 121.04
Elective Deferral – SARSEP (78.00) 78.00
Income Taxable Wages 1,504.25
– Income Taxes (Fed) 168.47
– Income Taxes (State) 86.49
Total Taxes (376.00)
Net Check $1,128.25
Total Deductions 496.75 496.75
Gross Wages $1,625.00
In Thomas’ case, FICA taxes are calculated on the $1,582.25 basis after deducting the pre-tax items. The retirement plan contribution of $78 is subtracted to determine income taxable wages for both federal and state purposes. Now that the taxes have been determined, it is time to do the accounting.
Accounting for Retirement Plan Contributions
The amount contributed by the employer is recorded to the labor benefits account. In QuickBooks, the cost of sales and/or expense benefits account is set up as a control account with ID’s for the various benefits provided as follows:
Control ID Nomenclature
HI Health Insurance
RET-E Retirement Contributions (Employer Only)
RET-M Retirement Matching Contributions by the Employer
HRA Health Reimbursement Arrangement
CC Child Care
LI Life Insurance
DEN Dental Plan
VIS Vision Care
FLEX Flexible Spending Accounts
Both the employer’s contribution and matching payments are debited to this account. The credit is posted to either cash or to the accrued benefits account under accrued payroll in the current liabilities section of the balance sheet.
The goal is to get the values of both the employer flat contributions and matching contributions to reconcile to the benefits spreadsheet and of course the actual amounts paid to the plan provider. So it is essential that the benefits spreadsheet is updated each payroll for each employee along with the summary sheet for the respective benefits. Actual amounts paid are not only recorded in the accounting software, but are recorded to the summary report too. Include a link of the check number to a copy of the check dispersed. Therefore, any outstanding balance will match the dollar amount as reported in the accrued payroll – benefits ledger for that respective benefit.
Not only must the accountant reconcile for purposes, you must reconcile to the quarterly payroll reports. I’m referring to Form 941 and state reports (typically unemployment). In addition, at year-end the accountant must reconcile to both W-2’s and the W-3. The following sections explain this reconciliation to tax reports in more detail. In preparation for these sections, please refresh your memory of what is involved by reading the following two lessons:
Reconciliation to Form W-2
The W-2 form is an employee’s annual report identifying:
1) Taxable Wages
2) Federal Income Taxes Withheld
3) Social Security Wages
4) Social Security Amount Withheld (6.2% of First $128,400)
5) Medicare Wages
6) Medicare Amount Withheld (1.45% of all Medicare Wages)
7) State Income Wages
8) State Income Taxes Withheld
9) Contributions to a Retirement Plan
10) Contribution Amounts for Other Tax Deferred Benefits
11) Payments Made for Non Tax Deferred Benefits
Notice the W-2 form does NOT identify gross wages. Gross wages are the starting point for the reconciliation process. Gross wages are reconciled to the cost of labor. In most cases, gross wages will equal social security wages as many small business employers do not offer pre-tax benefits. But, typically the difference between Social Security wages and gross wages are the pre-tax benefits such as health insurance, qualified health savings accounts, flexible spending arrangements and other benefits (dental care, child care, and cafeteria plans).
A retirement plan contribution is a tax deferred item. This means that the amount between Social Security wages and taxable wages equals the amounts identified as tax deferred items which are identified on the W-2 form. In effect an employee’s Social Security wages and taxable wages can be reconciled on the W-2. This information should match the reported amount on the employee’s tab in the master payroll spreadsheet and the benefits spreadsheet.
The following is an example of employee MEC for 2016 and the respective lines on the W-2 for him at the end of 2016.
MEC Payroll Summation – 2016 Amount Where Reported
Gross Wages for 2016 $149,740 Labor on the Income Statement
Employee’s Share of Pre-Tax Benefits:
– Health Insurance (8,602) Accrued Payroll/Benefits
– Dental Plan (1,951) Accrued Payroll/Benefits
– Child Care (4,180) Accrued Payroll/Benefits
Medicare Wages 135,007 W-2/Medicare Wages
Medicare Tax (1,957.60) W-2/Medicare Taxes
Social Security Wages 118,500.00 W-2/Social Security Wages
Social Security Taxes (7,347.00) W-2/Social Security Taxes
SIMPLE Plan Contribution (9,000.00) W-2/Tax Deferred Contributions
Taxable Wages *Note’A’ 126,007.00 W-2/Taxable Wages
Federal Income Taxes (21,703.00) W-2/Federal Taxes Withheld
State Income Taxes (9,201.00) W-2/State Income Taxes Withheld
NET PAY $85,798.40 Not Reported
Note ‘A’ – Taxable wages equals Medicare wages less tax deferred items, in MEC’s case, it is $9,000 for his retirement contribution.
Notice in MEC’s case that Social Security wages are $118,500 and not equal to Medicare wages. This is because Social Security wages are capped at $118,500 in 2016 and $124,800 in 2017. Medicare wages are not capped at all. In effect it is possible for an employee to have four different wages:
(3) Social Security AND
The key is to reconcile the employee’s tab on the master payroll spreadsheet. The benefits are also reconciled to the benefits spreadsheet and the respective amounts for each employee.
Reconciliation to Form 941
Reconciliation to the Form 941 is similar to the W-2 except now it is completed once a quarter in the aggregate, i.e. all employees are included. All values are added up and reported as one sum amount for taxable, Social Security and Medicare wages. In addition, total federal income taxes withheld are reported too. Both the employee’s share of FICA and the employer’s matching amount is reported on the form broken out for OASDI (Social Security) and HI (Medicare). This amount should match what the employer physically paid for these taxes as reported in the check register.
Reconciliation to W-3
The reconciliation to the W-3 will match the summation of all W-2’s and the four 941 reports. The W-3 is filed with the Social Security Administration along with a copy of the W-2’s. The W-3 report includes the tax deferred amounts so as to reconcile taxable wages to Social Security wages.
Again all of the reports should reconcile to the respective expense and current liability amounts paid for the year. In addition, they should reconcile to both the master payroll spreadsheet and the benefits worksheet.
Summary – Employer Provided Retirement Plans
Retirement plans consist of three types of contribution plans: profit-sharing, stock bonus and IRA based retirement plans. For most really small employers (< 100 employees) it is both more cost-effective and easier (documentation and legal compliance) to use the IRA based plans. The IRA based plans allow the employer to contribute a sum and for the employee to voluntarily contribute a portion of their wages. The employer is allowed to deduct as an expense their portion and the employee may defer paying income taxes on their elective amounts paid. The employee does not gain an advantage in regard to avoiding payment for FICA taxes but does control 100% of both their’s and the employer’s contribution to the retirement account. It is the responsibility of the accountant to reconcile the retirement contributions made to all federal reports, the master payroll spreadsheet, the benefits worksheet and the amounts reported in the books of record. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.