If you are thinking about setting up a retirement plan for yourself and your employees, but are concerned about the financial commitment and administrative burdens involved in providing a traditional pension or profit-sharing plan, an alternative program you may want to consider is a "simplified employee pension," or SEP.

SEPs are intended as an alternative to "qualified" retirement plans, particularly for small businesses like yours. The relative ease of administration and the complete discretion you, as the employer, are permitted in deciding whether or not to make annual contributions, are features that are especially attractive. Here's how these plans work.

If you don't already have a qualified retirement plan, you can set up a SEP simply by using the IRS model SEP, Form 5305-SEP. By adopting this model SEP, which doesn't have to be filed with the IRS, you will have satisfied the requirements for tax qualification. This means that you, as the employer, will get a current income tax deduction for contributions you make on behalf of your employees. Your employees will be taxed not when the contributions are made, but at a later date when distributions are made, usually at retirement. Depending on your specific needs, an individually-designed SEP—instead of the model SEP—may be appropriate.

When you set up a SEP for yourself and your employees, you will make these deductible contributions to each employee's IRA, called a SEP-IRA, which must be IRS-approved. You may contribute the lesser of 15 percent of compensation, or $30,000, to an employee's SEP-IRA. Because of the limits on the amount of compensation that can be taken into account, the maximum contribution is $22,500 for '96, and $24,000 for '97. The deduction ceiling applicable to an individual's own contribution to an IRA doesn't apply to your contributions to employees' SEP-IRAs. Your employees control their individual IRAs and IRA investments, the earnings on which are tax-free.

There are other requirements which you have to meet to be eligible to set up a SEP. Essentially, all regular employees must elect to participate in the program, and contributions can't discriminate in favor of the highly compensated employees. But these requirements are minor compared to the bookkeeping and other administrative burdens connected with traditional pension and profit-sharing plans. The detailed records that traditional plans must maintain to comply with the complex nondiscrimination regulations aren't required for SEPs. And employers aren't required to file annual reports with IRS—Forms 5500—which, for a pension plan, could require the services of an actuary. What record-keeping is required would be done by a trustee of the SEP-IRAs—usually a bank or mutual fund.

Beginning in `97, another option for a business with 100 or fewer employees is a "savings incentive match plan for employees" (i.e., a "simple" plan). Under a simple plan, an IRA is established for each eligible employee, with the employer making matching contributions based on contributions elected by participating employees under a qualified salary reduction arrangement. The simple plan is subject to much less stringent requirements than traditional qualified retirement plans. Or, an employer can adopt a "simple" 401(k) plan, with similar features to a simple plan, and automatic passage of the otherwise complex nondiscrimination test for 401(k) plans.

"SIMPLE" retirement plans for tax years beginning after 1996. "SIMPLE" is an acronym for "savings incentive match plan for employees." This new type of plan was introduced by the Small Business Jobs Protection Act of 1996. It's targeted at businesses with 100 or fewer employees, and is designed to offer greater income deferral opportunities than individual retirement accounts (IRAs), with fewer restrictions and administrative requirements than traditional pension or profit-sharing plans.

Under a SIMPLE plan, any employee with compensation of at least $5,000 must be permitted to enter a "qualified salary reduction arrangement." Under this arrangement, an employee can elect to have a percentage of compensation (not in excess of $6,000 for the year, as indexed for inflation) set aside in an IRA, instead of receiving it in cash. Amounts taken out of the employee's salary for this purpose are not taxed to the employee until withdrawn from the SIMPLE IRA. Early withdrawals may be subject to a 10% penalty (25%, if the withdrawal is made within the first two years).

Under a qualified salary reduction arrangement, the employer must make "matching" contributions to the SIMPLE IRA. That is, the employer must make contributions to an employee's SIMPLE IRA in the same amount as the employer contributed under the employee's salary reduction election, up to 3% of the employee's compensation. For example, if an employee with compensation of $50,000 elects to have 10% of his pay contributed to the plan ($5,000), the employer must contribute an additional $1,500 (3% of $50,000). For these purposes, an employee's compensation is the amount reported on his Form W-2, plus the amount of elective deferrals (e.g., the amount of the salary reduction contributed to the SIMPLE IRA). But the matching contribution cannot exceed $6,000 (as indexed for inflation).

If an employer wishes to contribute less than 3%, he can give employees proper notice and drop the contribution to as low as 1% of compensation, as long as this isn't done for more than two years out of the five-year period ending with the year of reduced contributions.

Alternatively, instead of making "matching" employee contributions, the employer can simply contribute a flat 2% of "compensation" (limited to $150,000, as adjusted for inflation), for every employee eligible to participate in the plan, whether the employee elects to reduce his salary or not. Special notice must be given to employees if the employer wishes to take this approach.

Instead of adopting a simple retirement plan, an employer can set up a SIMPLE 401(k) plan. By making matching contributions (or 2% nonelective contributions) and satisfying rules similar to those for simple plans, SIMPLE 401(k) plans will be considered to satisfy the otherwise complex nondiscrimination test for 401(k) plans. The contribution rules for SIMPLE plans apply to simple 401(k) plans, except that if an employer adopts the matching contribution approach (instead of the flat 2% option), the maximum contribution percentage cannot be dropped below 3%. Unlike a SIMPLE plan, a SIMPLE 401(k) plan is part of a qualified plan, and is subject to the qualified plan rules. Under the new law, employer contributions to SIMPLE 401(k) plans are not subject to the 15 percent limits on contributions to profit-sharing or stock bonus plans.

SIMPLE plans have the advantages of simplified reporting requirements and the absence of the qualification rules prohibiting the plan from discriminating against lower-level employees. Some employers may consider the contribution requirements a disadvantage. Additionally, to be eligible to adopt a SIMPLE plan, an employer must not contribute to, or accrue benefits under, any qualified retirement plan for services provided during the year (or in any year after the qualified salary reduction arrangement takes effect). But, under the new law, employers that maintain a plan for collectively bargained employees can maintain a SIMPLE plan for noncollectively bargained employees. A restriction similar to the "exclusive plan requirement" applies to SIMPLE 401(k) plans, but only for services provided by employees eligible to participate in the SIMPLE 401(k) plan.

Several changes have been made to the "SIMPLE" retirement plan rules. SIMPLE plans (SIMPLE is an acronym for "savings incentive match plan for employees") were introduced in 1996 and are targeted at businesses with 100 or fewer employees. They are designed to offer greater income deferral opportunities than individual retirement accounts (IRAs), with fewer restrictions and administrative requirements than traditional pension or profit-sharing plans.

Here is a brief description of the changes:

(1) Employers that maintain a plan for collectively bargained employees can maintain a SIMPLE plan for noncollectively bargained employees.

Under prior law, if an employer's collectively bargained employees were covered under a qualified plan, the employer was prevented from maintaining a SIMPLE plan not only for employees covered under the collectively bargained plan, but for employees not covered under any qualified plan. The new law says that employers who maintain a plan for collectively bargained employees can maintain a SIMPLE plan for noncollectively bargained employees.

RIA observation: Employees in the collective bargaining unit who are not covered under the collectively bargained plan cannot be eligible to participate in the SIMPLE plan.</logo>

(2) Limit on contributions to SIMPLE 401(k) plans will be adjusted for changes in the cost of living.

Under a SIMPLE 401(k) plan, an employee must be able to elect to have the employer make contributions on his behalf in an amount not to exceed $6,000 for the year. Although under prior law there was no cost-of-living adjustment on the SIMPLE 401(k) contribution limits, the parallel $6,000 limit on elective contributions to SIMPLE IRAs was subject to a cost-of-living adjustment. Under the new law, the $6,000 annual limit on the amount of elective contributions that may be made under a SIMPLE 401(k) plan will be adjusted for changes in the cost of living, in the same manner as for contributions under a SIMPLE plan.

(3) Employer contributions to SIMPLE 401(k) plans are not subject to the 15 percent limits on contributions to profit-sharing or stock bonus plans.

SIMPLE 401(k) plans are not subject to the nondiscrimination tests or the top-heavy rules, but they are subject to other qualified plan rules. Contributions paid by an employer to a profit-sharing or stock bonus plan are deductible by an employer only to the extent that the contributions do not exceed 15 percent of the compensation otherwise paid or accrued during the tax year to all employees participating in the plan. An employer that pays contributions to a profit-sharing or stock bonus plan that are not deductible because they are in excess of the 15 percent limit is subject to a 10 percent excise tax. The new law clarifies that employer contributions to SIMPLE 401k) plans are not subject to the 15 percent limits on contributions to profit-sharing or stock bonus plans.

(4) Employers must provide timely notice of SIMPLE 401(k) plan elective contribution rules to eligible employees.

An employer maintaining a SIMPLE 401(k) plan had only to notify employees of the employer's election to make nonelective two-percent contributions, rather than matching contributions of up to three percent of compensation for employees making elective contributions. In contrast, an employer maintaining a SIMPLE plan is required to notify each employee of the employee's opportunity to make or modify salary reduction contributions, as well as the contribution alternative chosen by the employer, within a reasonable period of time before the employee's election period. The new law extends the employer notice and employee election requirements of SIMPLE IRAs to SIMPLE 401(k) arrangements.

If you serve as a director for one or more corporations, you may well be earning significant fees which are, of course, currently taxable. There is a way you may be able to defer taxes on some of this income which you may want to consider.

Directors fees are considered by IRS to be self-employment income. This means that this income can be the source of deductible contributions to a so-called Keogh plan. A Keogh plan is a retirement plan—either a pension plan or a profit-sharing plan for self-employed individuals. There are some special rules that apply to Keogh plans, but essentially deductible contributions of up to 20% of this income—up to a maximum of $30,000—may be made to one type of Keogh plan. Keogh pension plans are funded in much the same manner as employee pension plans. The amount of income that can be set aside under these plans is substantially the same as under regular employee pension and profit-sharing plans.

Another important point—participation in a Keogh plan would be in addition to any qualified pension and profit-sharing plan you may be presently participating in as an employee. Participation in an employee plan would not limit the amount you could contribute and deduct under a Keogh plan.

There have been some attempts in the past to treat fees earned by a director who is also an employee of the corporation—an "in-house" director as opposed to an "outside" director—as part to the compensation earned by an employee and not as self-employed income. But IRS has pulled back from this position, at least for the time being.

An important change in the tax law that may affect your company's pension plan. The maximum amount of compensation taken into account for pension plan purposes is $150,000. This seemingly technical change can sharply reduce the value of your company's plan. But there are steps you can take to limit the impact of the new rules.

The problem is that, under the $150,000 cap, either the employees who earn more than $150,000 will have to accept smaller pension plan contributions, or else greater contributions will have to be made for lower-paid employees.

Say, for example, that your company has a profit-sharing plan. Employees earning more than $150,000 had been used to receiving the maximum allocation of $30,000. This won't be possible under the $150,000 cap, because the deduction can't be more than 15% of salary, and 15% of $150,000 is only $22,500. You could make up the missing $7,500 by adding a money purchase plan to the existing profit-sharing plan, but this would require making additional contributions on behalf of lower-paid employees.

The $150,000 cap may also play havoc with 401(k) plans. Those plans must meet a statistical test, based on the percentage of salary deferred, to make sure that they don't favor highly-paid employees. Since only the first $150,000 of salary earned by those employees is taken into account, plans are more likely to fail the test. Any reductions in 401(k) contributions that are needed to correct the problem will fall most heavily on employees earning between $66,000 and $90,000, because their deferral percentages are the highest.

Here, the best solution may be enhancing the 401(k) plan to make it more attractive to rank-and-file employees. For example, the plan could provide matching contributions, add new investment options, or allow plan loans.

There are two tax law changes that my affect your tax planning for your pension plan distributions. We am referring to the repeal of the 15% penalty tax on "excess distributions" from qualified plans and the repeal of the 15% estate tax on excess retirement accumulations. From a tax planning perspective, the upshot of these two changes is that there are no longer any tax reasons to accelerate distributions from a pension plan beyond the normal distribution schedule.

The excise tax on excess distributions was applied to excess distributions from qualified retirement plans, tax-sheltered annuities, and individual retirement arrangements. An excess distribution was the aggregate amount of retirement distributions to an individual, during any calendar year, which exceeded a threshold amount that was adjusted for inflation ($160,000 for '97). For certain lump-sum distributions, the dollar amount was five times the threshold amount ($800,000 for '97). You may recall that the 1996 tax legislation suspended this tax on excess distributions received in 1997, 1998 and 1999. Excess distributions received on or after January 1, 2000 were scheduled to be subject to the excise tax.

For people with large amounts of assets in a pension plan, the logical response to the three-year lifting of the tax on excess distributions was to take steps to accelerate distributions from the plan into the three-year window. By doing so, they not only avoided the potential application of the tax after 1999, but also made it less likely that their estate would be hit with the 15% tax imposed on excess retirement accumulations which have not been distributed by the time an individual dies.

Now, however, both those taxes have been repealed outright, and thus there is no longer a tax rationale for accelerating one's distributions from a pension plan. If you instituted a program of accelerated pension payments to take advantage of the three-year window, it would be appropriate to review that plan and to evaluate whether it would be advantageous to opt for normal distributions instead.

A recent tax law change may have an impact on how you elect to withdraw your retirement benefits in the coming years. Under a provision of the recently enacted Small Business Job Protection Act of 1996, special 5-year averaging rules for lump-sum distributions from retirement plans have been repealed. However, the repeal will only take effect after 1999. Accordingly, it may be advisable for you to consider taking advantage of the rules while they remain in effect.

In general, funds withdrawn from your retirement plan are taxed to you as ordinary income in the year of withdrawal. That is, they will be taxed at your regular tax rates. If large amounts are withdrawn, you may be pushed into higher tax brackets. The 5-year averaging rule applies to "lump-sum" distributions. These are distributions of the entire balance in your retirement plan account. Under the rules, to determine the tax on the distribution it is treated as if it were spread equally over a five-year period. Depending on the tax rates involved in your particular situation, electing 5-year averaging can save a substantial amount of tax.

(Taxpayers who reached age 50 before 1986 can elect an even more favorable ten-year averaging technique. The '96 Act did not repeal this provision.)

If you were planning to pull your retirement benefits out in a lump sum in the coming years (and do not qualify for ten-year averaging), please be advised that 5-year averaging will not be available after 1999. In many cases, it may be advisable to rethink your plans either to (1) accelerate your lump-sum distribution (if feasible) to a pre-2000 year, (2) switch your approach to take your distributions in installments instead of a lump-sum, or (3) roll the lump-sum over into an individual retirement account (IRA) to defer tax consequences until the funds are withdrawn.

There are new requirements for your group health plan recently introduced by the Health Reform Act of 1996 and the following will outline them broadly for you. The requirements include "portability" rules restricting the plan's ability to exclude individuals based on preexisting conditions, and "access" rules prohibiting plans from excluding individuals based on their health status. The requirements generally take effect for plan years beginning after June 30, 1997. (Thus, if your plan is on the calendar year basis, the first year to which the rules apply will be 1998.)

Portability. The portability rules are designed to make it easier for an employee to retain health coverage in the event of a job switch. Under the rules, a group health plan may only impose a "preexisting condition exclusion" (defined below) on an individual if: (1) the exclusion is for a mental or physical condition, regardless of cause, for which medical advice, diagnosis, care, or treatment was recommended or received within the 6-month period ending on the enrollment date, (2) the exclusion does not extend for more than 12 months, and (3) the exclusion period is reduced by the length of coverage credited to the individual as of the enrollment date ("creditable coverage"). The 12-month exclusion period in (2) above is 18 months for an individual enrolling "late," i.e., other than during the first period the individual is eligible to enroll or a special enrollment period.

A "preexisting condition exclusion" means a limitation or exclusion of benefits relating to a condition based on the fact that it was present before the date of enrollment, regardless of whether medical advice, treatment, etc., was recommended or received.

"Creditable coverage" means coverage under a group health plan, or other health insurance coverage or governmental benefit plan. In determining how long the individual had coverage, time preceding a 63-day break in coverage is not counted. A waiting period is not counted as part of a break in coverage.

Example: Donna seeks to enroll in her employer's group health plan when she is first eligible on May 1, 1998. She had received treatment for a heart condition in February of 1998. Donna had health coverage for 5 years but then lost her job and went 90 days with no coverage. She then obtained health insurance on January 1, 1998 (i.e., she has held it for four months as of the enrollment date).

Under the new portability rules, Donna can be excluded from the plan because of her heart condition because she received treatment within 6 months of the enrollment date. However, she can only be excluded for 8 months: the 12-month maximum reduced by the 4 months of creditable coverage she had before the enrollment date. (Her 5 years of coverage did not qualify as "creditable" because she had a break in coverage lasting at least 63 days.)

Group health plans will have certain record keeping duties and will be required to provide certification of credited coverage.

Access. In addition to the above requirements regarding specific preexisting conditions, a group health plan is precluded from establishing rules for eligibility (including for continued eligibility) based on any of the following factors: health status, medical condition (physical or mental), claims experience, receipt of health care, medical history, genetic information, evidence of insurability, or disability.

The plan also is not permitted to charge higher premiums to particular individuals based on any of these factors.

Penalties. Employers will be liable for the failure of a group health plan to meet these portability and access requirements and can incur substantial tax penalties for any failure about which it knew or should have known.

Exceptions. The portability and access rules outlined above do not apply to governmental plans or to plans that, as of the first day of the plan year, have less than 2 participants who are current employees.

Please bear in mind that the intent of this letter is to outline for you in broad terms the above recent significant legislative actions. Of course, there are many technical requirements and details involved

There has been an important development in the tax law which may be of interest to you. Up until recently, a profit-sharing plan traditionally allocated employer contributions to the plan to participants under a formula based on the employee's compensation for the year. Age or length of service have not been a consideration.

IRS rules, however, now make it possible for an employer to set up a qualified profit-sharing plan in which an employee's age is considered when allocating the employer's contributions. What this means is that significantly larger amounts may be provided to older employees than to younger employees. This means that more money can be set aside for an older employee nearing retirement age, without running afoul of the nondiscrimination rules.

Age-weighted profit-sharing plans combine the best features, from an employer's point of view, of other types of plans. First, it is a profit-sharing plan which is the most flexible of all plans. Employer contributions can vary from year to year at the employer's discretion, and there is no requirement that any contribution be made in a given year. Since contributions are allocated among participating employees on the basis of age as well as compensation, age-weighted plans are like defined benefit plans, but with the flexibility of a profit-sharing plan.

The important point to remember here is that age-weighted profit-sharing plans are particularly well-suited to businesses where the owner or owners are significantly older than the rank-and-file employees. An age-weighted plan reduces the cost of deferred compensation for younger employees who would generally be more interested in current cash compensation as opposed to deferred compensation. Older employees, often the owners of the business, approaching retirement are probably more concerned about deferred compensation and the age-weighted plan makes it possible for an employer to respond to these different needs.

Wages generally are subject to FICA taxation when they are paid. However that's not the case for nonqualified deferred compensation. It is generally subject to FICA when the services for which it is paid are performed, or when the right to the deferred comp is no longer subject to a substantial risk of forfeiture, whichever is later. Often that means that deferred comp is subject to FICA in the year it's deferred.

Until recently, this wasn't cause for major concern because most people with deferred comp arrangements were over the FICA wage base when the services were performed. Now that the Hospital Insurance part of FICA is owed on all wages, however, there's no escaping paying at least some FICA tax on all deferred comp. Although the issue has now been important for a few years, no one had any guidance on the trickier aspects of exactly when deferred comp was subject to FICA or how to value the amount that would be taxed.

IRS finally issued detailed proposed regulations that address many of the uncertainties. As a result, all nonqualified deferred comp arrangements should now be reviewed to determine if any action should be taken. The new rules are quite complicated and failure to adhere to them could result much larger FICA taxes in the future. If deferred comp that should be taxed (or should have been taxed) under the new rules isn't, it will be subject to FICA when paid. If that occurs after retirement, when the recipient has no other wages subject to FICA, both employer and employee would be liable for full FICA taxes on the entire payout, including earnings credited on the amounts deferred. (Reporting the payouts under the new rules avoids much or all of FICA liability on earnings credited to deferred comp). Not paying FICA under the new rules also could subject future payouts to potentially higher FICA tax rates and a higher OASDI wage base.