401(k) superior to SIMPLE or SEP IRA even for tiny businesses?

[Guest Eric Cernyar]

I am a small business owner (S-corp) w/ only myself & my wife as employees. I'm looking into SIMPLE IRA, SEP IRA, and 401(k) options. The first two are easy to administer & book. The 401(k) takes more time, and can be expensive, but I've learned of a fairly cheap option (401keasy -- $500 setup + $495/yr). So is the 401k worth it? I'm not sure.

Assume that my S-corp offers my wife and I a compensation package worth $40,000, comprising the base salary plus retirement benefits. Assume that we want to see $14,000 of that go into retirement accounts (IRA or 401(k)). The corp. can accomplish this with either the SIMPLE IRA or, starting 2002, with a 401(k) plan.

SIMPLE IRA option (assume self and wife each get $20K pkgs):

$19,420 base salary

Take home pay = $13K - income taxes - FICA on base salary

Elective deferral = $6,420 (max is $6500 in 2001).

Employer matches = $580 (~3% of $19,400)

2002 401(k) plan:

$16K base salary

Take home pay = $13K - income taxes - FICA on base salary

Elective deferral = $3K (new limit is 100% of base salary)

Employer matches & non-elective contributions = $4000 (because employer can match more than dollar for dollar (right?) and, starting 2002, can deduct contributions up to 25% of the employees' compensation)

In both cases, we end up with $14K in retirement savings. But because there are no FICA/employment taxes on employer matches and contributions (correct me if I am wrong), choosing the 2002 401(k) plan would result in the combined FICA/employment tax savings of 2*($19.42K-$16K)*0.153, or $1046.52.

If so, then the benefits of a 2002+ 401k plan may exceed the dollar costs of administering it. However, administering a 401k will probably take a lot more time (even w/ 401keasy, so it prob. still isn't worth it).

Any thoughts?

Eric

[Tom Poje]

Eric:

Given the conditions you cited, I am not sure why it would take significnatly longer to admin the 401(k) over a SIMPLE. It doesn't sound like you are talking having loans, hardships, etc. Only you and your wife so census collection is not much. No ADP test to pass since you are both HCE. The only extra I see is the 5500, which I think can be the EZ if I am not mistaken.

So, the big difference would seem to be the admin cost vs the potential to put away a larger sum (or smaller sum) in a given year. (required match in the SIMPLE vs. discretionary match / or profit sharing contribution in the 410(k))

[Jon Chambers]

What if any plans do you have for growth? If you intend to stay the same size, it probably doesn't matter, I'd go with the 401(k) for the reasons that Tom notes. If you will add just a few employees, the simpler plans may be better, because they are simpler. If you intend to grow even more (say 20+ employees), the advantages of a 401(k) will be even more apparent.

Note that under EGTRRA (the new tax act taking effect in 2002), the advantages of the 401(k) are even greater than under current law.

For various technical reasons, I believe that 401 plans (like a 401(k) are materially superior to 408 plans (like SIMPLE IRAs and SEP IRAs). If the cost difference is marginal, go with the better program.

[Guest LTurner]

Eric,

Check again with the FICA taxes. Your example shows you reducing your gross by the deferral before calculating FICA (and presumable Medicare). However, FICA and Medicare ARE calculated before the deferrals. Hence, the 401k deferral, or the SIMPLE salary deferral, would still be subject to these taxes. The State and Federal Income taxes are calculated after the deferral is taken out of the gross.

[Guest Eric Cernyar]

I appreciate everybody's input on my confusing hypothetical. Looking back at my hypothetical, only the "base salary" should be considered "compensation" for purposes of FICA. Matching and non-elective employer contributions (as opposed to elective employee deferrals) are not, as I understand it, included in the taxable wage base.

The point I am trying to make and confirm is that employer contributions are treated more favorably for tax purposes than elective employee deferrals. Elective employee deferrals are subject to FICA, but employer contributions are not.

Assuming that this is the case, it makes sense for a small family business to structure its retirement plan to maximize employer contributions.

Now that Congress passed the EGTRRA, 401(k) plans are a far more compelling opportunity than SEPs or SIMPLEs. Beginning Jan. 1, an employer can (deductibly) contribute up to 25%, up to a limit of $35,000, of an employee's base salary, and the employee can defer up to 100%, up to a limit of $11,000, of his/her salary, provided that the total employee deferrals plus employer contributions do not exceed the lesser of 100% of the employee's base salary or $35,000.

By comparison, with a SEP, employer contributions will remain limited to 15% in 2002, and employees cannot defer any portion of their salary under a SEP if they are already maxing out their IRA/Roth IRAs.

Also by comparison, with a SIMPLE, employer contributions are limited to 3%, and the employee's elective deferrals are limited to $7000 (in 2002).

Apparently, beginning 2002, there will be no reason, other than administrative expense and efficiency, to choose a SIMPLE or SEP over a 401(k).

[Guest LTurner]

You're on the mark.... Seems like you have a handle on this and the new legislation. In reading your post, I was unclear how you were representing this - I simply would look at the employer match and/or profit sharing as a company expense.

Keep in mind, the SIMPLEs have some of the same oversight for compliance that 401k plans have, however, you do not have to administratively 'prove' this and file any type of return. But, it still must be operated compliantly.

The new legislation also includes alot of other "neat" items, one of which is the 'catch up' provisions for individuals age 55 and above...yada yada yada. May not apply to your situation, but is also something to certainly look at.

Having worked with all three of the plans your looking at (SEP,SIMPLE, and 401k) I believe your best choice is a 401k; but I might be biased - as the investment sponsors that provide these plans all have different levels of recordkeeping and reporting. I have found that the service, recordkeeping, and reporting (both to the employer and the employees) is of a much higher level with the 401k plans. But then again, sometimes you pay for this.

If initially the plan will cover just you and your wife - might I suggest that you find a small TPA for the trust document to establish the plan, and then use your financial advisor (if you have one, if not find one that is also a certified financial planner) to invest the assets for you in a pooled asset investment account in the name of the trust. This would be an easy and less expensive approach. Your TPA will need to do the annual administration and reporting at the end of your plan year, at which time the assets in the account would be reported by participant (you and your wife).