After SEP and SIMPLE plans, a third type of retirement plan aimed at small businesses is a qualified plan. Qualified plans include Keogh plans, named after the congressman who sponsored the legislation that led to their adoption in 1962.
Just like other tax-advantaged retirement plans, your contributions to a qualified plan grow tax-deferred. Employees pay income taxes on the contributions, and earnings on those contributions, when they take distributions from the plan. (Note: if you are self-employed, you can contribute to your account if you have net earnings from self-employment.)
Qualified plans are more complex than SEP or SIMPLE plans but may offer your business some advantages. For example, qualified plans give you more flexibility in designing a plan than SEPs or SIMPLE plans. Qualified plans also often have higher limits for plan contributions and deductions.
Qualified plans include defined-benefit and defined-contribution plans:
Defined-benefit plans.
Defined-benefit plans provide a fixed retirement benefit amount to vested employees. The employer is entirely responsible for making contributions to a defined-benefit plan. For 2003, the limit to a defined-benefit qualified plan is the lesser of $160,000 or 100% of the employee's average compensation over a consecutive three-year period that spans his or her highest compensation.Defined-contribution plans
. Employees are responsible for funding a large part of a defined-contribution plan. Employers may elect to make matching contributions. For 2003, the limit to a defined-contribution qualified plan is the lesser of 25% of annual compensation or $40,000. The amount of annual compensation subject to the limit is $200,000. The two main types of defined-contribution qualified plans are profit-sharing and money purchase pension plans:Profit-sharing plans
. A profit-sharing plan sets aside a share of profits to employee accounts as deferred compensation (i.e., retirement benefits). Contributions do not have to come from net profits, which means that you may contribute in years that you have losses. Contributions with a profit-sharing plan do not require a formula. However, if you don't use a formula, the IRS requires that you contribute on a systematic basis and that amounts contributed are considered as substantial.You can deduct up to 25% of paid or accrued employee compensation in contributions made to a profit-sharing plan. If you are self-employed and contribute to your own account, your deduction will be lower. The self-employed rate on net earnings governs the amount of contributions that you can deduct. For additional information, see IRS Pub. 560.
Money purchase pension plans. A money purchase pension plan also sets aside a share of profits as deferred compensation. Contributions are not based on profits from your business, which means that -- once the plan is established -- you must contribute to the plan even in years of losses.
You can deduct up to 25% of paid or accrued employee compensation in contributions made to a money purchase pension plan. If self-employed and contributing to your own account, the self-employed rate governs the amount of contributions you can take.
You are required to put a qualified plan in writing and make it available to all eligible employees. The IRS offers master plans to help you set up a qualified plan expediently. A master plan uses a custodial account that is jointly used by other employers for their qualified plans. Most banks and financial institutions offer IRS-approved master plans. You can also elect to write your own plan, subject to IRS approval.
Some qualified plans offer a salary-reduction feature such as a 401(k) plan that allows employees to contribute to their own retirement accounts on a pretax basis. Contributions to these accounts are called elective deferrals, which are subject to yearly limits. For 2003, the allowable amount of elective deferrals to all defined-contribution plans is $12,000.
The Economic Growth and Tax Relief Reconciliation Act of 2001 authorized the following increases in elective deferrals to defined-contribution plans over the next several years. The table also shows catch-up amounts for persons age 50 or older:
Year Yearly limit Catch-up limit
2002 $11,000 $12,000
2003 $12,000 $14,000
2004 $13,000 $16,000
2005 $14,000 $18,000
2006 $15,000 $20,000
You can take a tax deduction for most of your contributions to a qualified plan. In order to take a tax deduction for a qualified plan, you must set up the plan by the end of the tax year in which you take the deduction. For example, if your accounting year-end is December 31, you must set up a qualified plan by that date in order to take the deduction in the same year. Deductions may be restricted in some cases. The limit on employee compensation for purposes of calculating contributions for 2003 is $200,000.
Contributions that you make that are in excess of allowable contributions in a single year are called nondeductible contributions. You may be liable for an excise tax of 10% of the amount of nondeductible contributions if not corrected.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, contact Bannon Ohanesian & Lecours by clicking the icon below.
