Question 294: Can an individual employer make a $12,000 retirement plan contribution for a domestic employee? The employer does NOT have any trade or business. He is actually an 87 year-old retired gentleman.
Answer: Yes, he can make a $12,000 contribution. He can contribute more if he wants. But the issue is somewhat more complex.
Is the gentleman an employer? Yes. You don’t have to have a trade or business to be an employer.
As an employer, can he sponsor a plan covering the domestic employee? Yes. There is nothing that limits plan sponsorship to trades or businesses. Any employer can sponsor a qualified plan.
Can the gentleman deduct his contributions? No. They are personal expenses, just as the domestic’s salary is a personal, nondeductible expense.
Is there a limited to how much the gentleman can contribute? Yes. Within a defined contribution plan, he cannot contribute more than the lesser of $45,000 or 100% of the employee’s compensation. There is no need to be concerned about the 25% of compensation limit on deductible contributions because the contributions aren’t deductible.
So, is there a problem with the gentleman sponsoring a plan? Yes. Not only does he face making the contribution without receiving a deduction, he is also subject to a 10% nondeductible contribution penalty under Code §4972.
The problem is that the nondeductible contribution penalty is forever. You’ve heard of the gift that keeps on giving. This would be the gift that you keep paying for, for the rest of your life. You have to repay the penalty ever year until you can deduct the contribution, which the gentleman will never be able to do.
For example, suppose he sets up a SEP and makes a $12,000 contribution this year. He must pay a $1,200 penalty. Then he makes another $12,000 contribution next year. In 2008, he pays a $2,400 penalty, $1,200 for 2007 and $1,200 for 2008. That’s going to get old awfully quickly. Suppose he doesn’t contribute anything in 2009. He still pays a $2,400 penalty in 2009 to atone yet again for for his generosity in the prior years.
Is there an alternative which allows him to avoid the 10% penalty? Yes. Code §4972(c)(6) allows him to set up a SIMPLE 401(k) or a SIMPLE IRA for the employee. Contributions to the SIMPLE will not be subject to the penalty tax.
Is there a limit to what the gentleman can contribute to the SIMPLE? Yes. A SIMPLE is primarily an elective deferral plan. In 2007, the employee can defer $10,500 (plus a catch-up contribution of $2,500 if the employee is at least 50 years old). The employer would either contribute 2% of the employee’s compensation or a matching contribution. The match would be equal to the lesser of the amount of the employee’s deferrals or 3% of compensation. The employer cannot make any further contribution. So, if the employee’s compensation is $50,000, the gentleman could make a $1,000 nonelective contribution or a match of up to $1,500.
Of course, he could always give the employee a bonus, which his faithful retainer uses to make a SIMPLE deferral. (This must be voluntary on the employee’s part. If he or she wishes to spend it on adult beverages, agreeable companions and iPods, that is the employee’s choice.) Assume the employer gives the domestic a $10,000 bonus, which the employee chooses to defer. (The employee and the employer must each pay $765 in FICA/Medicare taxes on that bonus, even if the employee defers.) Since the employee’s gross pay is $60,000, the employer could make a matching contribution of $1,800. The total cost to the employer is $12,565 to provide a net benefit to the employee of $11,035 (after considering the employee’s payroll taxes).
For further discussion of Code §4972(c)(6), see Q & A 214.