Types of Retirement Plans

There are 2 main categories of plans: defined benefit plans and defined contribution plans.

Covering Employees

A plan will be treated as qualified only if it allows employees who meet certain requirements to participate and receive benefits under it. In general, the plan must satisfy one of 3 tests. The first test stipulates that the plan must cover at least 70% of all nonhighly compensated employees. This is called the percentage test.

Alternatively, the plan must cover a percentage of nonhighly compensated employees that is at least 70% of the percentage of highly compensated employees. This second test is called the ratio test. The third alternative is called the average benefit percentage test (ABP test). This test also looks at the percentage of nonhighly compensated employees to be sure that there is no discrimination against them.

Participation

Participation is the right of an employee to be covered by a plan after meeting certain participation requirements. In order to be qualified, the plan must not only meet a coverage test but also meet a participation test. The plan must benefit the lesser of 50 employees or 40% or more of all employees. If an employer maintains more than one plan, participation must be satisfied by each plan individually. The plans cannot be grouped together (aggregated) for this purpose.

There are also age and service requirements. The plan can defer participation until the latter of the employee attaining the age of 21 or completing one year of service. A 2-year service requirement can be used if there is immediate and full vesting (vesting is discussed later in the chapter).

Automatic Enrollment

Employers can adopt an automatic enrollment feature for 401(k)s to increase employee participation and eliminate the need for testing whether the plan is nondiscriminatory. Employers must choose an investment for employees’ automatically deducted salary deferral contributions. You can limit your liability for plan investment losses by choosing default investments for deferrals that meet certain criteria for transferability and safety, such as a life-cycle fund or balanced funds. Your employees must be given an opportunity to change the investment choice.

There are 3 types of automatic enrollment:

1. Basic automatic contribution arrangement. This automatic enrollment option, also called an Automatic Contribution Arrangement (ACA), requires you to automatically enroll eligible employees in the plan unless they elect otherwise. Your plan document must specify the percentage of wages that will be automatically deducted. Employees can elect not to contribute or to contribute a different percentage of pay (within the limit allowed by law).

2. Eligible automatic contribution arrangement. This automatic enrollment option, called an EACA, uniformly applies the plan's default deferral percentage to all employees after giving them the required notice. There are no specified automatic salary deferral contribution levels or any required escalation in contributions (see QACA below).

   The plan may allow employees to withdraw automatic contributions (“a withdrawal election”), including earnings, no earlier than 30 days or later than 90 days of the date of the first automatic contribution is withheld from an employee's wages. There is no 10% penalty on these withdrawals.

   There are no required employer matching or non-elective contributions for participating employees.

3. Qualified automatic contribution arrangement. This automatic enrollment option, called a QACA, also uniformly applies the plan's default deferral percentage to all employees after giving them the required notice. However, this option has additional safe harbor provisions that exempt the plan from annual actual deferral percentage and actual contribution percentage nondiscrimination testing requirements explained earlier in this chapter.

   The default deferral percentage must be at least 3% (but no more than 10%) for the initial period. Elective deferrals (employees’ pre-tax contributions) gradually increase by one percentage point to 6% with each year that an employee participates. Thus, if the percentage for the initial period is 3%, then the contribution rate for year 2 is 4%; it is 5% in year 3, and usually 6% in year 4 and thereafter.

Employees must be 100% vested in the employer's nonelective or matching contributions after no more than 2 years of service. A plan may not distribute any of the required employer contributions (below) due to an employee's financial hardship.

There is a choice of formulas used to figure required employer contributions. You must use the same choice for all participants. Pick either:

• Nonelective contribution: 3% of compensation for all participants, including those who choose not to make any elective deferrals (“Alternative 1 in Table 16.1).
• Matching contribution: 100% match for elective deferrals that do not exceed 1% of compensation, plus 50% match for elective deferrals between 1% and 6% of compensation (“Alternative 2” in Table 16.1).

Distressed employers operating at an economic loss that have safe harbor plans can opt to reduce or suspend their safe harbor nonelective contributions to their 401(k) retirement plans midyear. No IRS request for relief in this case is necessary, but you must give notice to employees about the reduction or suspension in employer contributions and allow employees to change their salary deferral amounts. More details about suspending plan contributions midyear can be found in Treasury Decision 9641, which was issued in 2013.

Employers gain fiduciary protection (employees can't object to investment performance) if they use qualified default investment alternatives (QDIAs). The Department of Labor has specified only 3 types of investments that are QDIAs:

1. A product with a mix of investments that takes into account the individual's age or retirement date (for example, a life cycle or targeted retirement date fund).

2. An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual's age or retirement date (for example, a professionally managed account).

3. A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (for example, a balanced fund).

A capital preservation product is permissible for only the first 120 days of participation (for example, a money market fund). This option enables plan sponsors to simplify administration if workers opt out of participation before incurring an additional tax. After 120 days of participation, the funds must be transferred to one of the options above.

Vesting

While the plan must permit certain employees to participate and have contributions made on their behalf, employers can, if they choose, require a certain number of years in the plan before benefits will belong absolutely to the participants. This delay in absolute ownership of benefits is called vesting. In order for plans to be qualified, employers cannot defer vesting beyond set limits.

For employer contributions, a plan can provide for cliff vesting. Under this type of vesting, there is no ownership of benefits before the completion of 3 years in the plan. At the end of 3 years, all benefits are fully owned by the employee.

The other vesting schedule is called 6-year graded vesting. This permits vesting of 20% of benefits each year after the first year of service. Under this vesting schedule, there is full vesting after 6 years of participation in the plan.

Permitted Disparity

An employer can reduce the cost of covering employees by integrating the plan with Social Security. This means that the employer can take into account the employer contribution to Social Security for each participant. In effect, the employer's contribution to Social Security is treated as the plan contribution so the employer saves the cost of having to make this contribution a second time to a qualified plan. The employer payment of Social Security tax for each participant is deducted as taxes, not as a pension plan contribution.

Ordinarily, the disparity in contributions to employees is viewed as discriminatory. But integrating Social Security contributions with plan contributions is viewed as permitted disparity (i.e., is not discriminatory). The rules for permitted disparity are highly complex, and different rules apply to defined benefit plans and defined contribution plans.

Obtaining and Maintaining Plan Approval

Your plan must be qualified, and only the IRS can tell you if your plan falls within this category. You can use a master or prototype plan for setting up your retirement plan. Plans following these prototypes generally meet IRS requirements, although they are not deemed to have automatic IRS approval. If you design your own plan (or have a professional design one for you), in order to be qualified, the plan must obtain IRS approval. This approval is granted on the basis of how the plan is written and how it will operate. There is no requirement that you obtain approval prior to operating a plan, but it is a good idea to get it. The process is complicated, and the use of a tax or pension professional is advisable.

After initial qualification, your plan may be amended from time to time. For example, you may wish to make changes in how the plan operates—for example, increasing the percentage of compensation upon which your contributions are based. You must amend your plan to reflect law changes that are continually being made.

Compensation Limit

Benefits and contributions are based on a participant's taxable compensation reported on an employee's W-2 form. It does not include tax-free fringe benefits or other excludable wages.

The law limits the amount of compensation that can be taken into account. For 2017, there is a $270,000 limit. If an employee earns $275,000, only the first $270,000 is used to compute benefits and contributions.

When both spouses work for the same employer, each can receive a contribution based on his or her respective compensation (up to the compensation limit). In the past, spouses working for the same employer were treated as one unit.

Contribution Limit

The contribution limit depends on the type of plan involved. For defined contribution plans, the 2017 limit is the lesser of 25% of compensation or $54,000. This percentage is the top limit. Plans can adopt lesser percentages for contributions.

For defined benefit plans, there is no specific limit on contributions. Rather, the limit is placed on the benefits that can be provided under the plan. Contributions are then actuarially determined to provide these benefits. For 2017, the plan cannot provide benefits exceeding $215,000 per year, adjusted annually for inflation.

Borrowing from the Plan

Owners may be able to borrow from the plan without adverse tax consequences. The plan must permit loans, limiting them to the lesser of:

• $50,000, or

• The greater of ½ your accrued benefit or $10,000.

The loan must be amortized over a period of no more than 5 years (except for loans that are used to buy personal residences) and charge a reasonable rate of interest. As an owner, you cannot deduct interest on the loan.

The plan must also allow rank-and-file employees the opportunity to borrow from the plan on the same basis as owners and top executives. The plan must set the rules for repayment when a participant leaves the company. The plan fixes the repayment period, such as 60 days. If the loan is not repaid in this period, it becomes a taxable distribution. The plan may suspend loan repayments for employees performing military service. The plan may also suspend loan repayments during a leave of absence of up to one year. In this situation, however, the returning employee must make up the missed payments so that the term of the loan does not exceed the 5-year limit.

Cost of Plan Maintenance

You may set up your plan at a brokerage firm, mutual fund, or other financial institution. There typically are fees for setting up and maintaining the plan. Fees billed to the company are deductible as an ordinary and necessary business expense.

The U.S. Department of Labor's “fiduciary rule,” which went into effect on June 9, 2017 (with full implementation by January 1, 2018), requires these firms to act as fiduciaries. This rule impacts the fees charged for their services.

Investment Advice

Employers can, but are not required to, provide investment advice to participants and beneficiaries. In the past, doing this was a prohibited transaction that was penalized. Now, it is a way to help staff increase their retirement savings.

Bonding Requirement

To ensure that you will not run off with the funds in your company retirement plan, leaving participants high and dry, you are required to be bonded if you have any control over the plan or its assets. This includes, for example, authority to transfer funds or make disbursements from the plan. The bond must be at least 10% of the amount over which you have control (“currently handled assets”). The bond cannot be less than $1,000, but it need not exceed $1 million.

No bond is required if the plan covers only you as the owner (a self-employed person or a single shareholder-employee) or only partners and their spouses.

Plan Amendments

You are required to keep your plan up to date and operate it in accordance with law changes that are enacted from time to time. The most recent amendment requirements were in Notice 2016-03.

You may incur professional fees for updating plan documents. If your plan is a prototype plan provided by a bank, brokerage firm, mutual fund, or insurance company, however, there may be no charge for required updates.

If you discover errors in your plan (either in how it is written or how it is being operated), you can correct the errors and avoid or minimize penalties. If you do not take the initiative and the IRS discovers the problems, you can be subject to greater penalties, interest, and even plan disqualification. More information is contained later in this chapter under “Correcting Plan Defects.”

Actuarial Costs for Defined Benefit Plans

If you have a defined benefit plan, you must use the services of an enrolled actuary to determine your annual contributions. You must expect to pay for this service year after year.

Pension Benefit Guaranty Corporation Premiums for Defined Benefit Plans

The Pension Benefit Guaranty Corporation (PBGC) is a quasi-federal agency designed to protect employee pension plans in the event that the employer goes under. In order to provide this protection, the PBGC charges annual premiums for each participant in the plan. First, there is a flat-rate premium, which for 2017 is $69 per participant (a different rate applies to multiemployer plans).

Then, for underfunded plans of a single employer (other than “small employers”), there is an additional variable-rate premium (interest rates change monthly) applied to the plan's underfunding. (Underfunding means that the employer has not contributed sufficient amounts to pay all anticipated pensions that have already vested.) In 2017, the variable-rate premium per participant is $34 per $1,000 of unfunded vested benefits, with a cap of $517 per participant. Small employers (those with 25 or fewer employees) have their variable rate premium capped at $5 multiplied by the number of plan participants.

You can find instructions for submitting your 2017 premiums to the PBGC at https://www.pbgc.gov/prac/prem/premium-payment-instructions-and-addresses.html. Any changes for premiums will be noted in the Supplement to this book.

There is a termination premium payable when a company transfers its underfunded pension plan to the PBGC. The premium is $1,250 per participant per year, payable for each of the 3 years after plan termination.

There is an online system, called My Plan Administration Account (PAA), for paying premiums and filing returns. For information, go to www.pbgc.gov.

Plan Start-Up Costs

If you set up a plan, you may be eligible for a special tax credit designed to encourage small business owners to start retirement plans. A small employer eligible for the credit is one with no more than 100 employees who received at least $5,000 of compensation from the company in the preceding year. However, the plan must cover at least one employee who is not a highly compensated employee. Thus, a self-employed individual with no employees who sets up a profit-sharing plan cannot claim a tax credit for any of her start-up costs.

In addition to the employee requirement, to qualify for the credit you must not have had a qualified plan in any of the 3 preceding years.

The credit is 50% of eligible start-up costs, for a maximum credit of $500. The credit can be claimed for 3 years starting with the year in which the plan is effective. However, you can opt to first claim the credit in the year immediately preceding the start-up year based on costs incurred in the preceding year.

The credit applies only to qualified start-up costs. These include ordinary and necessary expenses to set up the plan, run it, and educate employees about the plan and participation in it. Qualified expenses in excess of the $1,000 taken into account in figuring the $500 maximum credit can be deducted as ordinary and necessary business expenses.

The credit is part of the general business credit (see Chapter 23).

Self-Employed Qualified Plans in General

Qualified plans for self-employed individuals are subject to the same requirements as qualified plans for corporations. (Banks, brokerage firms, mutual funds, and insurance companies offering plans for self-employed individuals may generally denominate them as basic plans or simply by the type of plan established, such as a profit-sharing plan.) Like corporate qualified plans, self-employed qualified plans must cover employees of a self-employed person on a nondiscriminatory basis. Also like corporate plans, they are limited in the amount that can be contributed and deducted.

There is an important distinction between self-employed qualified plans and corporate qualified plans: the way in which contributions are calculated on behalf of owner-employees.

Contributions to Self-Employed Qualified Plans

Contributions to all retirement plans are based on compensation. For qualified plans covering employees (including owner-employees), this is simply W-2 taxable wages. For self-employed individuals under self-employed qualified plans, the basis for contributions is a little more complicated. Essentially, the basis for contributions on behalf of owner-employees is net earnings from self-employment. But this is not merely the net profit from your business on which self-employment tax is paid. Net earnings from self-employment must be further reduced by the deduction for the employer portion of the self-employment tax.

To calculate compensation of the owner-employee, start with the profit from Schedule C or Schedule C-EZ (or Schedule F, in the case of farming) or the net earnings from self-employment on Schedule K-1 of Form 1065. For partners, this is essentially your distributive share of partnership income plus any guaranteed payments. Net earnings from self-employment from various activities are totaled on Schedule SE, Self-Employment Tax. After you have your compensation amount, subtract from this amount the employer portion of the self-employment tax computed on Schedule SE. This net amount is the figure upon which contributions to qualified retirement plans are based.

In order to make contributions on your own behalf, you must have net earnings from self-employment derived from your personal services. If you merely invest capital in a partnership while your personal services are not a material income-producing factor, you cannot make a plan contribution. If you are a limited partner, you cannot base a plan contribution on your distributive share of partnership income. Similar rules apply to members in LLCs. Income received from property, such as rents, interest, or dividends, is not treated as net earnings from self-employment.

Simplified Employee Pensions in General

Simplified employee pensions, or SEPs, are another type of retirement plan that self-employed individuals can use to save for retirement on a tax-advantaged basis. (Corporations can use SEPs as well.) The name is a misnomer because the plan does not provide a pension; it merely allows funds to accumulate and be used in retirement. But, as the name implies, these plans do not entail all the administrative costs and complications associated with other qualified retirement plans. There are no annual reporting requirements, as is the case for qualified plans and qualified corporate retirement plans.

Simplified employee pensions are individual retirement accounts set up by employees to which an employer makes contributions, then deducts them. The contributions are a fixed percentage of each employee's compensation. To set up a SEP, an employer need only sign a form establishing the percentage rate for making contributions and for setting eligibility requirements. This is a one-page form, Form 5305-SEP, Simplified Employee Pension-IRA Contribution Agreement (Figure 16.1).

The form is not filed with the IRS. Instead, it serves merely as an agreement under which the employer makes contributions. The employer then instructs employees where to set up SEP-IRAs to receive employer contributions. Banks, brokerage firms, and insurance companies generally have prototype plans designed for this purpose.

The maximum deduction for a contribution under a SEP is essentially the same as for a deferred contribution plan: 25% of compensation or $54,000, whichever is less. For contributions made on behalf of self-employed individuals (called owner-employees), this percentage works out to 20%. As with other qualified plans, no more than $270,000 of compensation in 2017 can be taken into account in computing contributions.

Covering employees in SEPs. You must cover all employees who meet an age and service test. The SEP must cover employees who are 21 or older, earn over $600 in 2017, and have worked for you at any time in at least 3 out of 5 years. You can provide for more favorable coverage (for example, you can cover employees at age 18). The compensation requirement of $600 is adjusted annually for inflation in $50 increments.

Employees over the age of 70½ can continue to participate in a SEP and receive employer contributions. However, required minimum distributions must also be made to these employees.

Salary reduction arrangements for SEPs. Before 1997, a SEP of a small business (with no more than 25 employees who were eligible to participate in the SEP at any time during the prior year) could be designed so that employees funded all or part of their own retirement plans. Employees agreed to reduce their compensation by a set amount. That amount, called an elective deferral, was then contributed to the SEP. Employees were treated as not having received the amount by which their salary was reduced so that they did not pay income taxes on that amount. Salary reduction arrangements in SEPs (SARSEPs), were repealed for 1997 and later years. However, employers that had SARSEPs before 1997 can continue these plans, and employees hired after 1996 may participate in these plans. So, for example, if you had a SARSEP plan in 1996, you can continue to fund it with salary reduction amounts in 2017.

Savings Incentive Match Plans for Employees

Self-employed individuals as well as other small employers have another retirement plan alternative: Savings Incentive Match Plans for Employees (SIMPLE). These plans are open to small employers who want to avoid complicated nondiscrimination rules and reporting requirements. These SIMPLE plans can be used by corporations as well as by self-employed business owners.

Savings Incentive Match Plans for Employees may be set up as either IRAs or 401(k) plans. The rules for both types of SIMPLE plans are similar but not identical. Employees can contribute to the plans on a salary reduction basis up to $12,500 in 2017 (plus an additional $3,000 if age 50 or older by the end of the year). Self-employed individuals can make similar contributions based on earned income.

Employers satisfy nondiscrimination rules simply by making required contributions. Employers have a choice of contribution formulas:

• Matching contributions (dollar-for-dollar) up to 3% of an employee's compensation for the year. For example, in 2017, if an employee under age 50 earning $35,000 makes the maximum salary reduction contribution of $12,500, the employer must contribute $1,050 (3% of $35,000). The maximum matching contribution per employee in 2017 to a SIMPLE 401(k) is $8,100 (100% of the matching employee contribution, which is up to 3% of $270,000). However, there is no limit on compensation taken into account for employer matching contributions to a SIMPLE-IRA.

• Nonelective contributions of 2% of compensation (regardless of whether the employee makes any contributions) for any employee earning at least $5,000. For example, in 2017, if an employee's compensation is $25,000, the employer's contribution is $500 (2% of $25,000). The maximum contribution per employee in 2017 is $5,400 (2% of $270,000, the maximum compensation that can be used to determine contributions).

Contribution reduction for distressed companies. The 3% matching contribution can be reduced at the employer's election, but not below 1%. The reduction cannot be made for more than 2 years of the 5-year period that ends with the year of the election, and you must give notice of the reduced limit to your employees within a reasonable time before the 60-day election period in which employees make their salary reduction agreements.

Self-employed persons can make employer contributions to SIMPLE-IRAs on their own behalf as well as make their own contributions. In effect, they are treated as both employer and employee.

Employee and employer contributions vest immediately. This means that employees can withdraw contributions at any time (although withdrawals prior to age 59½ are subject to a 25% penalty if taken within the first 2 years of beginning participation, and 10% if taken after that period).

Employers who want to let employees choose their own financial institutions can adopt SIMPLE plans merely by completing Form 5304-SIMPLE (Figure 16.2). Employers who want to choose the financial institutions for their employees use Form 5305-SIMPLE. Whichever option is chosen, the form is not filed with the IRS but is kept with the employer's records. This form gives the necessary notification to eligible employees and a model salary reduction agreement that can be used by employees to specify their salary reduction contributions. Employers who use SIMPLE plans cannot maintain any other type of qualified retirement plan.

Individual Retirement Accounts as a Plan Alternative

If the cost of covering employees is prohibitive for a self-employed individual, neither a qualified plan, a SEP, nor a SIMPLE plan may be the answer. Instead, the self-employed individual may want to use an IRA. In this case, the maximum that can be deducted is $5,500 (plus $1,000 if the person is age 50 or older by year-end). However, if a self-employed's spouse is a participant in a qualified plan, the self-employed person may deduct $5,500 (or $6,500) only if the couple's combined adjusted gross income in 2017 does not exceed $186,000. The $5,500 deduction phases out as the couple's adjusted gross income (AGI) reaches $196,000. If a self-employed individual contributes $5,500 (or $6,500) to a Roth IRA, he or she cannot make deductible contributions to an IRA. Individual retirement accounts are discussed later in this chapter.

One-Person 401(k) Plans

If you work alone, with no employees, can you have a 401(k) plan? The answer is yes, even if you are self-employed. This type of plan may enable you to maximize contributions because you can make both employee salary reduction contributions (elective deferrals) and employer contributions.

Designated Roth Accounts

Now, 401(k) plans can offer an option that's like a Roth IRA called a designated Roth account. Contributions to designated Roth accounts are made with after-tax dollars (rather than salary reduction amounts). Thus, there is no tax advantage when the money goes into the plan. However, the benefit to this alternative is that all withdrawals (not merely contributions) can be withdrawn tax free after age 59½ (or on account of disability or death or up to $10,000 for first-time homebuying expenses) as long as they have been in the plan for at least 5 years. The 5-year period starts on January 1 of the year in which designated Roth contributions are first made.

Contribution limits to these accounts are the same as for regular 401(k)s. Contributions can be split between regular and Roth 401(k)s as long as the total does not exceed the annual limit. Plans can permit in-plan rollovers from traditional 401(k)s to designated Roth accounts. There is no 20% mandatory withholding, but those making such a rollover must report the amount as taxable income (it is a conversion from a tax-deferred to a tax-free account). There is no 10% early distribution penalty even if the person making the conversion is under age 59½.

Funds from a designated Roth account can be rolled over tax free to another designated Roth account or to a Roth IRA.

How do designated Roth accounts compare with Roth IRAs? Unlike Roth IRAs, designated Roth accounts cannot be undone once the conversion (called an in-plan Roth rollover) is made. Also, there are lifetime withdrawal requirements on designated Roth accounts that do not apply to Roth IRAs (although this can be avoided by rolling over the designated Roth account into a Roth IRA). But there are no income limits for making contributions to designated Roth accounts as there are for contributing to Roth IRAs.

Loans from 401(k) Plans

The rules governing loans from 401(k) plans are the same as those discussed earlier in connection with loans from corporate plans. However, it should be noted that all participants, not just owners, are prohibited from deducting interest on plan loans. But the interest is really being paid to the participant's own account, so the loss of a deduction is not so important.

Selecting Plan Investments

Generally, a 401(k) plan must offer a menu of investment options to participants. Usually, this is done by opting to have the plan with a family of mutual funds, such as Fidelity or Vanguard. In choosing the mutual fund or other company with which to place the plan, consider:

• Investment choices. The Department of Labor has regulations governing the minimum number and type of investment choices that must be offered by the plan.

• Fees. The Departments of Labor and the Treasury have rules regarding fees and their disclosure. Check on administrative fees (the amount charged for maintaining the plan), asset-based fees (amounts paid for specific types of investments), and service fees (amounts paid for optional services).

Individual Retirement Accounts and Other Retirement Plans

Whether you can make deductible contributions to both an IRA and another retirement plan depends on your overall income. Individuals who are considered active participants in qualified retirement plans cannot deduct contributions to an IRA if adjusted gross income exceeds a certain amount. More specifically, in 2017 no deduction can be claimed by an active participant when adjusted gross income exceeds $72,000 in the case of single individuals, $119,000 for married persons filing jointly and surviving spouses, or $10,000 for married persons filing separate returns. The deduction is phased out for AGI of up to $10,000 less than the phaseout limit (phaseout starts at $62,000 for singles; $99,000 for married persons filing joint returns). The phaseout limits will be indexed for inflation each year.

You are considered an active participant if, at any time during the year, either you or your spouse is covered by an employer retirement plan. An employer retirement plan includes all of the following plans:

• Qualified pension, profit-sharing, or stock bonus plan

• SEP plan

• SIMPLE plan

• Qualified annuity plan

• Tax-sheltered annuity

• A plan established by the federal, state, or political subdivision for its employees (other than a state Section 457 plan)

If you are an active participant (or your spouse is an active participant) and your AGI is over the limit for your filing status, you can make a traditional non-deductible IRA contribution. There is no AGI limit on making this type of IRA contribution.

Alternatively, you may want to make contributions to a Roth IRA. Contributions must be based on compensation (just as they are for traditional IRAs), but there are some important differences between the Roth and a traditional IRA. First, contributions to a Roth can be made regardless of your age. So, for example, if you have a consulting business and you are 75 years old, you can still fund a Roth IRA. Second, there are no required lifetime minimum distributions, as there are for traditional IRAs commencing at age 70½. Third, contributions can be made regardless of whether you (or your spouse) are an active participant in a qualified retirement plan. Fourth, and most significantly, if funds remain in the Roth IRA for at least 5 years, withdrawals after age 59½, or because of disability, or to pay first-time home-buying expenses (up to $10,000 in a lifetime) are completely free from income tax.

The 5-year period starts on the first day of the year in which contributions are made (or to which they relate). So, for example, if you make a 2017 contribution to a Roth IRA on April 17, 2018 (the due date of your 2017 return), the 5-year holding period commences on January 1, 2017, the year to which the first contribution relates. However, you can make full Roth IRA contributions only if your AGI is no more than $118,000, or $186,000 on a joint return. (The contribution limit is reduced if your AGI is between $118,000 and $133,000 if you are single, or $186,000 and $196,000 on a joint return.)

Spousal IRAs. Called Kay Bailey Hutchinson IRAs, these accounts can be opened for a nonworking spouse to enable a couple to double the annual contributions to IRAs and Roth IRAs. If one spouse is age 50 or older, add $1,000 to the contribution limit; if both are age 50 or older, add $2,000 to the contribution limit.

Converting to a Roth IRA. In planning to maximize your retirement funds, you may want to convert your traditional IRAs to a Roth IRA if you did not do so already. This will allow you to build up a tax-free retirement nest egg (provided the funds remain in the Roth IRA at least 5 years and are not withdrawn unless you meet a withdrawal condition). The price of conversion is that you must report all the income that would have resulted had you simply taken a distribution from your IRAs.

There is no 10% penalty on conversion income even if you are under age 59½, as long as the funds remain in the Roth IRA for at least 5 years. This 5-year period is measured from January 1 of the year in which the conversion is made.

In deciding to use a traditional IRA, be aware of certain restrictions designed to encourage savings and prevent dissipation of the account prior to retirement. First, you generally cannot withdraw IRA contributions, or earnings on those contributions, before age 59½. Doing so may result in a 10% early distribution penalty. There are a number of exceptions to the early distribution penalty:

• Disability

• Withdrawals taken in substantially equal periodic payments

• Distributions to pay medical expenses in excess of the applicable percentage of AGI

• Distributions to pay health insurance premiums by those who are unem-ployed (self-employed can be treated as unemployed for this purpose)

• Distributions to pay qualified higher education costs

• Distributions for first-time home-buying expenses (up to $10,000 in a lifetime)

• Involuntary distributions resulting from IRS levies upon IRAs to satisfy back taxes

• Distributions by reservists called to active duty

However, there is no exception to the 10% penalty for economic or financial hardship.

Second, you must begin withdrawals from traditional IRAs no later than April 1 of the year following the year of attaining age 70½. The failure to take certain minimum distributions designed to exhaust the account over your life expectancy results in a 50% penalty tax. The minimum distribution requirement applies as well to qualified retirement plans, SEP-IRAs, and SIMPLE plans.

Setting Up a Plan

You must complete and sign the paperwork, even if you don't contribute a penny, by a set date dependent on the type of plan you use:

• Qualified retirement plans, such as 401(k) plans—December 31, 2017, for a 2017 plan.

• SEPs—extended due date of your return (e.g., October 15, 2018, for a 2017 plan for a sole proprietor with a filing extension).

• SIMPLEs—October 1, 2017, for a 2017 plan. For a new employer coming into existence after October 1, the deadline is as soon as it is administratively feasible in 2017.

• IRAs and Roth IRAs—April 17, 2018, for 2017 contributions.

Making Contributions

Contributions to defined benefit plans must be made on a quarterly basis. In order to avoid a special interest charge, contributions made in quarterly installments must be at least 90% of contributions for the current year or 100% of contributions for the prior year. If contributions are based on the current year, the balance of the contributions may be made as late as the due date for the employer's return, including extensions.

Contributions for defined contribution plans and SEPs can be made at any time up to the due date of the employer's return, including extensions. In fact, contributions can be made even after the employer's tax return is filed as long as they do not exceed the return's due date. In effect, contributions can be funded through a tax refund.

The only way to extend the deadline for making contributions is to obtain a valid filing extension. For example, an owner of a professional corporation on a calendar year who wants to extend the time for making contributions must obtain an extension of time to file Form 1120, the return for that corporation. To do this, Form 7004, Application for Automatic Extension of Time to File Corporation Income Tax Return, must be filed no later than April 15, the due date for Form 1120 for calendar-year corporations.

Filing Form 7004 gives the calendar-year corporation an automatic 6-month filing extension, to October 15 (it was supposed to be only 5 months until after 2025, but the IRS made it 6 months). The corporation then has until October 15 to make its contributions to the plan.

Contributions must generally be made in cash. When cash flow is insufficient to meet contribution requirements (and there are no refunds available for this purpose, as explained earlier), employers may be forced to borrow to make contributions on time. In some instances, contributions can be made by using employer stock.

Watch the timing of making contributions to a SIMPLE plan. While employer contributions can be made up to the extended due date of the employer's return, contributions through elective deferrals must be made no later than 30 days after the end of the month for which the contributions are to be made (e.g., January 30, 2018, for a 2017 plan).

Contributions for 2017 to IRAs and Roth IRAs must be completed no later than April 17, 2018, even if you obtain a filing extension. Contributions to an IRA or a Roth IRA can be made directly or through direct deposit of a tax refund. The deposit is made by providing account information directly on the return or, if directing the refund to 2 or 3 different accounts, on Form 8888, Direct Deposit of Refund to More Than One Account. If you are using a direct deposit to make a 2018 contribution, be sure that the return is filed early enough in 2018 to allow for processing and fund transfer to the IRA before April 17, 2018 (the deadline for 2017 IRA contributions).

Filing Information Returns

Qualified retirement plans (other than some small plans as well as SEPs and SIMPLE IRAs of any size) are required to report their activities annually to the Department of Labor's Employee Benefits Security Administration. For details, see Appendix A.

Monitoring Plan Investments

Check the plan's investment options each year to make sure you are offering those with the lowest fees and charges.

Excess Contributions

If you contribute more than the dollar amount permissible, you have made an excess contribution. The excess contribution is subject to an excise tax (essentially a penalty) of 6% per year, each year, for as long as the excess amount remains in the plan.

You can avoid or limit the tax by withdrawing the funds or applying them to future contributions. No penalty applies if the excess contributions are withdrawn by the due date of the return (including extensions) for the year to which the excess contributions relate.

Plan Errors

Because retirement plan rules are complicated, it's easy to make mistakes. The IRS has this list of common errors:

• Not covering the proper employees

• Not giving employees required information

• Not depositing employee deferrals timely

• Not depositing employer contributions timely

• Not following the terms of the plan document

• Not limiting employee deferrals and employer contributions to the proper maximum limits

You can correct mistakes using the IRS’ Employee Plans Compliance Resolution System (EPCRS). Some mistakes can be self-corrected without penalty; others require IRS approval and entail a penalty. Always consult a benefits expert if you have questions about your plan and possible errors that may exist.

Prohibited Transactions

The tax law has strict rules about what you can and cannot do when it comes to your qualified retirement plans and IRAs. The funds are designed for retirement savings; the rules prevent you from self-dealing and certain other actions that are thought to run counter to the purpose of these plans.

Paraphrasing the Senate Report from 1974, the purpose of prohibited transactions is to prevent taxpayers from using their qualified retirement plans to engage in transactions that could place plan assets and income at risk of loss before retirement. Prohibited transactions are listed in Section 4975 of the Internal Revenue Code. They include any direct or indirect:

1. Sale, exchange, or leasing of any property between a plan and a disqualified person.

2. Lending of money or other extension of credit between a plan and a disqualified person.

3. Furnishing of goods, services, or facilities between a plan and a disqualified person.

4. Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan.

5. Action by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account.

6. Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

The fact that a transaction would qualify as a prudent investment under the highest fiduciary standards does not change the character of the transaction.

Prohibited transactions are subject to excise taxes:

• 15% excise tax. For example, failing to deposit employee contributions into 401(k) plans on time is a prohibited transaction subject to a 15% excise tax. It's a prohibited transaction because the company is holding on to the funds (i.e., a disqualified entity is using funds for its own purposes).
• 100% excise tax if the prohibited transaction is not corrected in time.

In some situations, the prohibited transaction results in the loss of tax-deferred status for the plan or account as of the first day of the year in which the prohibited transaction occurs. This means that all of the funds in the account become immediately taxable to the account owner. And, if the account owner is under age 59½ at the time, there is a 10% early distribution penalty as well.

The best way to avoid problems is to talk with a knowledgeable tax adviser before making any moves with a qualified plan or IRA that could raise questions about self-dealing.

Defined Benefit Plans versus Defined Contribution Plans

Defined benefit plans offer owners the opportunity to slant more contributions to their own benefit, especially if they are older than their employees. However, most small business employers are moving away from defined benefit plans because of the complexities and costs of administration. Defined benefit plans are by far more costly to administer than defined contribution plans. First, there are the costs of plan design. Defined benefit plans may be specially tailored to each employer, whereas defined contribution plans generally use prototypes readily available. Second, there is the cost of the actuary to determine contributions necessary to fund the promised benefits. Third, there are annual premiums paid to the Pension Benefit Guaranty Corporation (PBGC), a federal agency designed to provide some measure of protection for employees (somewhat akin to FDIC insurance for bank accounts). These premiums are calculated on a per-participant basis, with an additional premium for underfunded plans (as discussed earlier in this chapter).

Another factor to consider when deciding between defined benefit and defined contribution plans is the timing of making contributions. Contributions to defined contribution plans can be made at any time during the year to which they relate but can also be made as late as the due date for the employer's return, including extensions. In the case of defined benefit plans, contributions must be made more rapidly than those to defined contribution plans. Defined benefit plans have quarterly contribution requirements, and the failure to make sufficient contributions quarterly can result in penalties.

Qualified Plan versus Simplified Employee Pension

If you use a profit-sharing plan, the contribution limit is the same for both self-employed qualified plans and SEPs. However, there are some reasons for using one or the other type of retirement plan.

A SEP offers a couple of advantages over self-employed qualified plans. A qualified plan must be set up no later than the last day of your tax year, even though contributions can be made up to the due date of the return, including extensions. In contrast, a SEP can be set up as late as the date for making contributions, which is also the due date of your return, including extensions. There is less paperwork involved in a SEP than in a qualified plan. While qualified plans must file information returns with the IRS annually, SEPs have no similar annual reporting requirements.

In the past, qualified plans offered one advantage over SEPs—the ability to use 5-year averaging to reduce the tax cost on distributions. This option no longer applies, and all distributions are taxed the same as distributions from a SEP (i.e., ordinary income).

SIMPLE-IRA versus Self-Employed Qualified Plan or SEP

Business owners with modest earnings may be able to put more into a SIMPLE-IRA than a qualified plan. The reason: The employee contribution (which a self-employed individual can also make) to a SIMPLE-IRA is not based on a percentage of income but rather a dollar amount up to $12,500 in 2017 ($15,500 for those age 50 or older). (The 25% annual compensation limit applies to employee contributions to SIMPLE-401(k)s.)

The bottom line is that business owners who want to maximize their retirement plan contributions need to run the numbers to determine which plan is preferable.

How an ESOP Works

The corporation sets up a trust into which it contributes either shares of its stock or cash to buy shares. Or the corporation can borrow money to buy shares and contribute cash to the trust to repay the loan. Shares are then allocated to plan participants (employees) in a manner similar to a profit-sharing plan; vesting rules apply.

Typically, professional fees and other costs for setting up an ESOP are substantial ($25,000 to $50,000 for even small companies). Thus, such plans are not used for very small companies (e.g., fewer than 50 employees).

Tax Breaks

For the corporation:

• Contributions of cash to buy shares or to repay a loan, or to buy shares of stock are tax deductible. Contribution limits are lower for S corporations than for C corporations.

• In C corporations, once the ESOP owns 30% of all the shares in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain.

• In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually not the state level, either). This means earnings of the S corporation escape federal income tax; they are not taxed to the corporation because it is an S corporation, and they are not taxed to the ESOP because it is an exempt trust. For example, there is no income tax on 40% of the profits of an S corporation that has an ESOP holding 40% of the stock, and no income tax on the profits of an S corporation wholly owned by its ESOP. However, the ESOP must still get a pro-rata share of any distributions the company makes to owners.

• Dividends used to repay an ESOP loan, passed through to employees, or reinvested by employees in company stock are tax-deductible.

For employees:

• Employees are not taxed on contributions made to the plan on their behalf.

• For stock in C corporations, departing employees can roll over the shares to an IRA or other qualified retirement plan. If they opt to report the income, then any future appreciation on the shares will be taxed at capital gains rates when the shares are eventually sold. No rollover of S corporation stock is allowed.

Uses for ESOPs

ESOPs are a way to shift ownership to employees. This is viewed as an important employee benefit.

ESOPs can also be used to buy out the interest of a departing owner. For example, say an owner wants to retire but has no obvious person, such as a son or daughter, to be the successor-owner; the employees become the owners through the ESOP. From the owner's perspective, a sale of 30% or more of an interest in a closely held business enables the owner to defer tax on the gain from the sale by buying so-called replacement securities; gain is recognized when and to the extent that replacement securities are sold.

ESOPs can borrow money and effectively convert repayments of both interest and principal into tax-deductible amounts. The borrowed funds are used to buy company shares or shares from existing owners. The corporation then makes tax-deductible contributions to the ESOP to repay the loan.

How a Nonqualified Plan Works

Suppose you want to allow your key employees the opportunity to defer bonuses or a portion of their compensation until retirement. To do this, you set up a nonqualified plan. These employees can defer specified amounts until termination, retirement, or some other time or event. The employees in the plan must agree to defer the compensation before it is earned. They generally have no guarantee that the funds they agree to defer will, in fact, be there for them upon retirement. If your business goes under, they must stand in line along with all your other creditors. Employees should be made to understand the risk of a deferred compensation arrangement.

Once you set up the terms of the plan, you simply set up a bookkeeping entry to record the amount of deferred compensation. You may also want to credit each employee's deferred compensation account with an amount representing interest. In the past, there had been some controversy on the tax treatment of this interest. One court allowed a current deduction for the interest. The IRS, on the other hand, had maintained that no deduction for the interest could be claimed until it, along with the compensation, was paid out to employees and included in their income. However, that court changed its view and now agrees with the IRS. As long as receipt of the interest is deferred, so, too, is your deduction for the interest.

Rabbi Trusts

This is a special kind of nonqualified deferred compensation that got its name from the original employees covered by the plan—rabbis. The plans provide a measure of security for employees without triggering current taxation on contributions under the plan. Employers are still prevented from claiming a current deduction. These plans have now been standardized, and the IRS even provides model rabbi trust forms to be used in setting them up.

Deferred Compensation Plans

These are explained in Chapter 7.