How Do You Offer A Pension? Simple

A new law eases 401(k) and IRA use at small companies

For years, small employers have searched in vain for the perfect retirement plan. But conventional programs, often tailored with big companies in mind, were always lacking: too expensive, too much paperwork, or too restrictive. Now Uncle Sam may be getting closer to the Holy Grail of pensions for small business. The new federal Savings Incentive Match Plan for Employees (SIMPLE), which goes into effect on Jan. 1, 1997, allows small-business owners to put aside money easily and inexpensively into tax-deferred accounts for both themselves and employees.

That's no small change. Only one in five businesses with 100 or fewer employees now has a retirement plan, according to Access Research Inc. in Windsor, Conn. But SIMPLE advocates expect its user-friendliness and low cost to spur more owners to offer a pension benefit. "I think this is a win-win situation for owners and employees," says Jamie Wickett, a lobbyist for the National Federation of Independent Business.

Indeed, such benefits are increasingly essential to attract and retain employees. "Retirement plans are becoming something that's expected," says Susan Diehl, president of PenServe Inc., a benefits consulting firm in Philadelphia.

One reason many advocates are so enthusiastic: SIMPLE accounts eschew the onerous discrimination testing required of most existing retirement plans. Discrimination tests ensure owners don't get a huge tax break if their employees fail to save. In traditional 401(k) plans, an employer's tax deferral is limited by how much employees put into the plan. For instance, if low-paid employees defer an average of 4% of their salary, owners can only defer 2% more, or 6%.

Keeping track of the constantly shifting contribution ratios often requires costly professional help--causing many businesses to forgo pension benefits. "The incredible complexity of old pension laws were too much for small-business owners to handle," says Wickett.

SIMPLEs come in two forms: a SIMPLE individual retirement account and a SIMPLE 401(k). To be eligible, employers can't have more than 100 employees and can't simultaneously use another retirement plan. Workers must have earned at least $5,000 in any two previous years from the employer and be likely to do so in the current year.

SIMPLE plans allow owners and workers to defer a percentage of their compensation, up to $6,000 per year. Owners choose to contribute to employees' plans in one of two ways: either by matching 3% of a participating worker's annual compensation dollar for dollar up to $6,000, or by contributing 2% of compensation up to $3,000 for all workers, whether they participate or not.

Take an owner earning $200,000 a year with 10 employees each earning $25,000. Under the 3% match, the owner could put into his or her own SIMPLE account a maximum of $12,000 ($6,000 plus 3% of $200,000). If all employees contribute, the match would cost the owner an additional $7,500 (3% of $25,000 times 10). If only half the employees contributed, the owner could put away the same amount for himself, but the employee match would drop to $3,750. Under the 2% option, however, the owner would deduct at most $10,000 for himself, and his required contribution for all employees would total $5,000.

The SIMPLE IRA--but not the SIMPLE 401(k)--has a provision for lean years as well: Employers can reduce the match from 3% to no less than 1% in any two out of five years. Employers who lower the match, or switch between the 3% match and the 2% contribution, must inform employees of the change at least two months before the worker is eligible to participate in the plan--and before the beginning of each subsequent year. Matches and contributions are tax-deductible, and owners have no fiduciary responsibility for how employees invest their cash. All employee money is 100% vested immediately. Workers can alter how much they defer at any time but face a 25% penalty if they withdraw money from a SIMPLE plan in the first two years. Withdrawals made after the two-year period are subject to the same rules as a regular 401(k) or IRA.

A small-business owner will be able to set up a SIMPLE IRA for each employee through a bank or brokerage at little cost, similar to the annual fees often levied for IRAs. SIMPLE 401(k)s are likely to be more expensive, carrying annual administrative costs of about $500 to $1,000, compared with $2,000 or more for traditional 401(k) plans.

WINDFALL? Some worry that a SIMPLE plan could provide a windfall tax deferral for highly paid owners whose employees make too little to contribute or simply choose not to. In this way, SIMPLEs clearly benefit employers more than their workers, notes Karen W. Ferguson, director of the Pension Rights Center in Washington, D.C. Still, it could encourage business owners without retirement plans to adopt one.

But Congress giveth and Congress taketh away. The recently passed minimum-wage bill that begat SIMPLE pensions also abolishes an existing retirement option, the salary reduction simplified employee pension (SARSEP), on Jan 1. This plan is easy and inexpensive, offers a higher maximum contribution, and gives more matching flexibility. But SARSEPs are limited to companies of no more than 25 employees and half must participate in the plan. Owners' deferrals are limited to 125% more than the average employee contribution, although they can make an additional contribution for themselves and each employee of up to 15% of compensation.

Existing SARSEPs will be grandfathered after Jan. 1, so small-business owners who want the option of using one should establish a plan even if they later decide not to use it, advises Susan Jacksack, a small-business analyst for CCH Inc., a leading provider of tax and business law information.

Employers who want to save more for retirement--and take a bigger deduction--may find SIMPLE's maximum contribution confining. Current plans such as Keoghs allow employers to deduct as much as 25% of their salary, up to $30,000. "By using a combination of Keoghs, you could put away up to $30,000 a year and still exclude a fair number of employees--such as anyone who's been with you less than a year or is part-time," says Martin Nissenbaum, an Ernst & Young partner. "Even though it costs more [to administer], you would get more value."

Another potential drawback of SIMPLE plans: Since SIMPLE money is fully vested right away and the accounts are portable, the plan provides little incentive for employee loyalty. "Owners are giving 3% of salary to a guy who can walk away in a year," says Dick Joss, a senior actuary with benefits consultant Watson Wyatt Worldwide. With most traditional plans, contributions are 100% vested only after an employee has been at the company for five years.

So business owners still must study their worker turnover rates and compare different retirement savings options before embracing the new accounts. Otherwise, they may find them not so simple after all.

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