BY KENNETH A. HOROWITZ
A Simplified Employee Pension Individual Retirement Arrangement (SEP-IRA) or a Profit Sharing Plan (PSP): Which plan is right for your client or business?
Both plans allow similar contribution limits, the lesser of 25 percent of compensation or $51,000 (indexed for 2013). However, differences exist in several aspects such as eligibility, vesting, design ability and other points discussed below.
Business owners are often advised to go the route of SEPs for their simplistic design, low startup costs and ease of administration.
An SEP is an individual retirement account or qualified annuity. All contributions are made directly to each participant”™s account or IRA by the employer. A profit-sharing plan (PSP) is a plan trust that holds all the plan assets also funded by the employer.
For a newly established business with few employees, an SEP design is attractive since there are no plan documents to be filed with the IRS. Nor are there annual administration and IRS 5500 filings required. There are no reporting requirements with a one-person (or participant and spouse) PSP until assets exceed $250,000.
An additional benefit of a SEP is being able to establish and fund plans up until the date the tax return is filed, including extensions. So for example, an SEP can be established and funded through October of the following year in which the deduction is taken. PSPs have the ability to be funded until extensions are filed.
From a pure cost standpoint, SEPs may be more suitable in situations with a few employees. However, as a company grows and becomes more profitable and adds employees, the increased cost efficiencies from a more customized plan design can favor profit-sharing plans. These benefits can potentially outweigh the “simplicity” and convenience of the SEP design.
The following compares several differences between the profit sharing and SEP plan design:
Maximize Contribution
Both plans have similar funding formulas ”“ the lesser of $51,000 or 25 percent of annual compensation (indexed for 2013).
However, only a PSP allows for the inclusion of a 401k arrangement. With that comes an additional $5,500 contribution if participant is over age 50 resulting from a catch-up provision and annual contributions of $56,500.
Permitted Disparity/Integration and 401K Design
Permitted disparity or integration can lower the required contribution an employer needs to fund for plan participants.
SEPs allow for integration under section 408k (3)(d). However, it applies to all employees, owners included. Which means the maximum annual plan contribution will lower by $6,480 from $51,000 to $44,519 (5.7 percent of $113,700 tax wage base). Integration in a SEP actually penalizes highly compensated employees. Importantly, integration in a SEP reduces the maximum contribution for those employees who would otherwise receive a contribution of $51,000.
There is no reduction in the maximum contribution in PSP due to integration.
Permitted disparity in a PSP allows those earning more than the Social Security taxable wage base to receive a higher contribution rate than those employees earning below the taxable wage base. Moreover, the owner may continue to receive a contribution of $51,000 unlike the SEP. For example, an owner earning in excess of $255,000 may receive a contribution of $51,000 in the PSP at an employee cost of approximately 16.8 percent of employee compensation for those employees earning less than the taxable wage base. This is compared with a contribution rate of 20 percent of pay if the PSP did not have permitted disparity or integration.
Further reduction in rank and file cost is possible from incorporating “new comparability” design to a profit sharing plan. This technique is not available in SEPs. New comparability is most effective when the demographics are such that the owners and or key people are older and earn more than the rest of the employees.
Adding 401(k) Design
The ability to add a 401(k) feature to the PSP not only produces an opportunity to add $5,500 if over age 50, it can potentially lower employee costs.
The actuary can now use lower a lesser funding formula needed to fund an owner”™s maximum contribution because the first $17,500 ($23,000 if over 50) comes from salary deferrals of the 401(k ) component. As a result of funding part of the $51,000 from $17,500 means now the balance or $33,500 can come from profit-sharing cost. This lowers the percentage of pay rate from 20 percent to 13 percent used to calculate employee
contributions. Incorporating “new comparability” can further drive employee allocation rate between 5 percent to 7 percent.
Next week: Individual designs, part time workers, last-day requirements and loans.
Kenneth A. Horowitz is a registered representative and financial adviser of Park Avenue Securities L.L.C., doing business in Rye Brook, N.Y., as Integrated Benefit Consultants. He can be reached at (914) 288-8946.
