Simple Retirement Plan – Section 408(p)
There are several different retirement plans available to the small business owner. But no plan offers so many advantages to small business as the Simple retirement plan. The positive attributes include: 1) Easiest to understand, 2) Least amount of paperwork, 3) No compliance reporting and 4) Plenty of flexibility. If you are in business and have less than 25 employees, this is your best option to include a great benefit for your employees. This article describes this form of a retirement plan and Section 408 of the Internal Revenue Code, identifies the advantages, and concludes with a comprehensive example. In addition, I explain how to fill out the proper document to begin the plan.
This is a plan within an allowed set of plans under Section 408 of the Internal Revenue Code. All of us have heard of Section 401(k) plan. The Internal Revenue Code dedicates Sections 401 through 408 to codifying retirement plans. Within Section 408 are the easier to understand retirement plans. They include Simplified Employee Plans (SEPs), Salary Reduction Simplified Employee Plans (SARSEPs) and the Savings Incentive Match Plan for Employees (SIMPLE). Section 408(p) addresses the SIMPLE.
Form of a Retirement Plan
There were two goals for Congress when creating the 408 types of plans. First, make the documentation easier for employers giving them incentive to provide retirement plans and secondly, get greater employee participation in saving for retirement. The Simple retirement plan achieves those two goals. How?
The primary problem for most small businesses in providing retirement plans is the filing of second tax return. In effect, most retirement plans provided by employers are separate legal entities. Thus, this legal entity must file a tax return. The most common form of a return for a retirement plan is Form 5500 – Annual Return/Report of Employee Benefit Plan. To make matters worse, once filed, the document is open for public inspection. This means others can see your information about your plan.
Most employers cannot afford to hire the skill sets it takes to properly manage a plan and file the necessary reports. For those plans with filing requirements, most employers hire a Third Party Administrator (TPA). In addition, the company hires an accounting firm to audit the plan each year adding additional costs (at least $2,500 and upwards of $30,000). The costs are prohibitive and go directly against the goal of the retirement plan which is to get money into the employee accounts.
Section 408 plans including the Simple do not require a separate tax return nor an annual audit contingent on using an approved plan. Most of these approved plans are provided by the large brokerage firms or financial institutions (banks, insurance companies, payroll processing firms) in the United States. Once signed, the employer only needs to comply with the contribution rules per the plan.
Greater employee participation is gained by qualifying more employees via reduced thresholds of earnings and minimum time on the job. How so?
- Threshold of Earnings – any employee who earns at least $5,000 per year from your business is eligible. Many other types of plans have higher earning requirements and some separate those earnings in management from the traditional wage earnings. In addition to the current year $5,000 of earnings, if this employee earned at least this amount in any two prior years, (s)he is eligible to participate. As the employer, you may reduce this amount of threshold to any level you deem fit. You cannot discriminate as it relates to meeting this threshold. For example, if you reduce the threshold of earnings to $1,000 and state that only those within this category of workers can qualify, then you will fail the test. It must be an across the board reduction in the threshold of earnings.
- Minimum Time – there is no minimum requirement of service time for an employee, however, based on a minimum threshold of earnings, an employee would have to serve a minimum number of hours to earn the threshold level. This will be different for each employee based on their respective compensation.
All other non 408 retirement plans have greater or more definitive restrictions to participate. Section 408 plans are designed for the small business world. If you have less than 100 employees and do not anticipate exceeding 100 employees for several years, then a Section 408 plan is your best option.
Advantages of the Simple Retirement Plan – Section 408(p)
The plan has two options for an employer. The employer may elect to match employee contributions up to 3% or may make non-elective contributions of a flat 2% of the employee’s compensation. The following sections describe in detail the two different options:
- Matching Contributions – this is a straight forward option. As the employer, you may elect to match up to 3% of your employee’s contributions to their respective retirement account. If an employee decides to have 1.5% of his compensation withheld from his paycheck and transferred to the financial institution providing the approved plan, you must match his contribution. You may reduce the matching limit in the forthcoming calendar year to as low as 1% as long as you provide proper notification to employees.
- Non-Elective Contributions – as an alternative, the employer may elect to contribute 2% of an employee’s compensation. You may set the minimum level of earnings but this threshold cannot be greater than $5,000 as identified in the participation issues for Section 408 plans. This is an easy to understand option. If you have a high turnover of employees that rarely exceed $5,000 in earnings (such as the car wash industry, fast food sales, etc.) than this is good option to select to hire team leaders and management personnel. This way, you do not have to make the first contribution until the employee has earned $5,000 in compensation. As in the matching option above, you must provide proper notification to the ranks of employment that the company is electing this option.
The advantages of the Simple are straight forward:
- Easy to set up
- No cost to maintain federal compliance (no tax return, audit fees, and minimum paperwork)
- Decide on an earnings threshold up to $5,000
- Select the contribution option:
- Match up to 3% of earnings, OR
- Make a flat 2% contribution of earnings
Sign the form and you are done! It is that Simple.
Now that I have explained the simplicity of the Simple, I am going to walk you through a comprehensive example for your business.
You own a small business with 18 employees. 10 of the employees have been with you for at least a year and several for many years. You generally fire and rehire about 6 employees per year due to the nature of the age of employees. Your industry requires younger workers for physical purposes and the longer term workers are either in management or are accustomed to the physical nature of your business. Almost all the employees live from paycheck to paycheck. You have become concerned about the older staff and desire to provide some form of longer term benefit for them, specifically some benefit with a low cost and easy to document and maintain. You have decided on a Section 408 plan and have chosen to go with the Simple.
Now that the situation is set, let’s walk through the example. The first step is complete; you have decided to go with the Simple plan. Now you must decide the earnings threshold.
Step 1 – Earnings Threshold Decision – This one should be easy for you. I know I stated that there is little paperwork involved, but there still is paperwork. One of the requirements is some form of notification to employees. Do you really want to deal with those individuals that are only there for a week or two? NO. By raising the threshold of earnings to $5,000, those employees that come and go or are there only for the summer, you don’t have to deal with them. In my scenario presented, I stated that your goal is to provide for those employees that continue to work for you. By setting the minimum earnings threshold to $5,000, you achieve one of your goals and you reduce your paperwork.
Step 2 – Select the Contribution Option – There are only 2 options. You either match up to 3% or make a flat contribution. Go back to my scenario above, I stated the nature of the industry leads to a high turnover rate, generally low pay (living paycheck to paycheck) and you want to provide a benefit with a low cost. By electing to make a flat 2% contribution, you achieve a set goal, ‘…desire to provide a longer term benefit…’ to your staff. In the scenario above, I stated that the staff generally lives from paycheck to paycheck. By electing the 2% flat contribution, you are in effect providing a benefit without additional costs. If you increase their respective wages by the same amount, you will have to match the FICA taxes associated with this additional 2% pay increase. By utilizing the retirement plan, no FICA taxes are required on the contribution to the plan.
Employees are still allowed to make an elected deferral to the plan from their wages, but you are not required to match that elected deferral. Just for technical understanding, the elected deferral is after the FICA tax issue and before the income tax is calculated for the employee. It is to their benefit to contribute money to their respected account within the plan. There is no benefit for you as the employer for their personal contribution.
Step 3 – Decide on the Financial Institution – Believe it or not, the plan does cost money. Mostly the plan costs money to the employees and there is generally a plan establishment fee (set-up cost) to the employer. The prices vary dramatically and some providers do not charge a fee if a minimum number of employees exist in your company. The key is to compare several, and I mean several providers of plans. There are annual costs charged to each account within the plan, typically a flat rate plus a percentage of the balance. I have seen a $25 fee with a ½% annual fee. This can be very expensive in the long run. Look for plans that are cost effective to the employees for the long run. Sometimes it is worth the company shelling out a larger up-front fee to save the employees higher annual charges on their respective accounts. Review at least 5 providers of plans. Let them know up front, it is about the fee structure and not much more. The agents get it, they are not stupid and they generally shy away from discussing the costs because of sticker shock to the client. The agents focus on the performance of the investment portfolios to convince the business owner to choose them over the other providers. In general, many of the financial institutions provide access to more than just one or two plans that carry several different investment portfolios within the plan. THE KEY IS THE ANNUAL COST OF THE PLAN TO THE PARTICIPANTS!
Step 4 – Do the Paperwork – The financial institution you select will have all the paperwork involved. They generally have you sign a plan agreement and Form 5305 – SIMPLE which is an IRS document. I have one here: Form 5305 – SIMPLE . Further below, I walk you through this simple form and how to fill it out. The final piece of paperwork is the employee notification (part of Form 5305) and the employee salary reduction agreement (another part of Form 5305). The employee notification copy is kept in the employee’s files and the employee salary reduction agreement is copied to the employee’s file. The original is sent to the financial institution. In addition, the payroll service provider gets a copy to begin the process of withholding at the agreed upon date.
That is pretty much it, SIMPLE.
Form 5305 – Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) – for Use With a Designated Financial Institution
Please open a copy of the form in another tab, right click on this Form 5305 – SIMPLE select ‘Open Link in New Window’. By using your ALT and TAB key together, you can flip between this document and the form. Hold the ALT key down with your thumb, and use your middle finger on the same hand to touch the tab key. Do it again and you will find yourself flipping between these two screens.
Notice on Page One the document is divided into sections referred to as ARTICLES. First off, in the first line, insert your company’s legal IRS name and EIN number. In ARTICLE I, you choose the threshold eligibility as I described above. If we follow the comprehensive example I outlined above, you would check box ‘b’ and write in $5,000 of compensation. In (ii) you would also write in $5,000 and I would insert ZERO in the look back period. I don’t encourage the look back concept because it just complicates matters significantly. I really believe in keeping it SIMPLE. You just ignore item 2 as just about every small employer doesn’t deal with collective bargaining. If you do deal with collective bargaining, then check the box to keep it SIMPLE.
ARTICLE II is straight forward and in general you need to do nothing there. If you desire to allow more frequent employee salary reduction changes, then in 2b, you may change the verbiage to monthly, quarterly, or semi-annually. I suggest you leave it blank and only allow the employees an annual change. I’ve seen this before; invariably you have one employee who changes their amount monthly. This means they show up to the human resources director and spend about 20 minutes refilling out the form(s). This takes up the human resources director’s time and you end up with lost production time from the employee. Really, just leave it blank and stick to the annual opportunity for the employee to modify their contribution. Remember, keep it SIMPLE.
In ARTICLE III you are identifying the earnings threshold for the 2% non-elective contribution if you decide to go with a no match plan. Insert $5,000 into the blank. Just remember, if you go with a lower threshold, more employees become eligible and your paperwork increases. Keep it SIMPLE and insert $5,000.
ARTICLES IV through VI is for information purposes only and they are short and informative.
ARTICLE VII identifies the beginning date of the plan. I strongly encourage you to start at the beginning of the new calendar year. If not, go with the beginning of the next full quarter after a full quarter. This eases the burden of the payroll processing department and your accountant. DON’T START IMMEDIATELY! All plans require proper notification to employees and time for the financial institutions to set up the individual accounts. Really, keep this SIMPLE and easy for everyone and start either on Jan 1, April 1, July 1 or Oct 1 (the four quarter starting dates). If you are in the middle or anywhere in the part of a quarter, start the plan at least one quarter later than the next quarter. If you decide on Feb 18th to go with the plan, start the withholding and transfer of funds on July 1. This allows for one full quarter of payroll (April through June) as a time for proper notification and documentation for compliance purposes.
Sign the form.
You will notice that on Page 3, there are two sections. The first is the notification section to the employees. This is the document you hand out to all employees and any new employees as they are hired. The first line is the name of the plan and the corresponding financial institution. Part II of the Notification Section tells the employee whether you are electing a matching format and the percentage amount or providing a flat 2% for those earning in excess of the threshold (which hopefully you elected $5,000).
The second section is what the employee fills out and returns to you. Make a copy for their file, a copy to the payroll service or accounting department and the original to the financial institution.
You are done, SIMPLE.
Summary – Simple Retirement Plan
Section 408 of the Internal Revenue Code allows for employers to establish easy to understand and low documentation retirement plan. The easiest of this group is the 408(p) SIMPLE plan. It establishes individual retirement accounts for your employees to contribute money to via payroll contributions. These contributions may include an employer match up to 3% or a flat rate contribution by the employer of 2% of compensation. In addition, employees may contribute on their via payroll deduction if the employer elects to go with a flat rate contribution.
For the employees, once any funds are transferred to their account, the employee has full control over those funds. They control what investment portfolio to use and the percentages in the different available funds. Any withdrawals are tax and/or penalized in accordance with the rules related to Individual Retirement Accounts (penalties are punitive in nature, most are up to 50% of the withdrawal amount).
For the employer, the benefit is easy to set up and operate. It is a low cost benefit and the best part is: low documentation and compliance requirements. Act on Knowledge.
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.