Publication 225: Farmer's Tax Guide; Retirement Plans

This is archived information that pertains only to the 2003 Tax Year. If you
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Table of Contents

Important Changes
for 2003

Elective deferrals. The limit on elective deferrals increases to $12,000 for tax years beginning in 2003 and then increases $1,000 each tax year thereafter until it reaches $15,000 in 2006. These new limits will apply for participants in SARSEPs, 401(k) plans (excluding SIMPLE plans), and deferred compensation plans of state or local governments and tax-exempt organizations. The $15,000 figure is subject to cost-of-living increases after 2006. Catch-up contributions. A plan can permit participants who are age 50 or over at the end of the calendar year to also make catch-up contributions. The catch-up contribution limit for 2003 is $2,000. This limit increases by $1,000 each year thereafter until it reaches $5,000 in 2006. The limit is subject to cost-of-living increases after 2006. The catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts.

The catch-up contribution limit.
The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.

SIMPLE plan salary reduction contributions. The limit on salary reduction contributions to a SIMPLE plan increases to $8,000 beginning in 2003 and then increases $1,000 each tax year thereafter until it reaches $10,000 in 2005. The $10,000 figure is subject to adjustment after 2005 for cost-of-living increases. Catch-up contributions. A SIMPLE plan can permit participants who are age 50 or over at the end of the calendar year to make catch-up contributions. The catch-up contribution limit for 2003 is $1,000. This limit increases by $500 each year thereafter until it reaches $2,500 in 2006. The limit is subject to cost-of-living increases after 2006. The catch-up contributions a participant can make for a year cannot exceed the lesser of the following amounts.

The catch-up contribution limit.
The excess of the participant's compensation over the salary reduction contributions that are not catch-up contributions.

Introduction

This chapter discusses retirement plans you can set up and maintain for yourself and your employees. Retirement plans are savings plans that offer you tax advantages to set aside money for your own and your employees' retirement.

In general, a sole proprietor or a partner is treated as an employee for retirement plan purposes.

SEP, SIMPLE, and qualified plans offer you and your employees a tax favored way to save for retirement. You can deduct contributions you make to the plan for your employees. If you are a sole proprietor, you can deduct contributions you make to the plan for yourself. You can also deduct trustees' fees if contributions to the plan do not cover them. Earnings on the contributions are generally tax free until you or your employees receive distributions from the plan.

Under certain plans, employees can have you contribute limited amounts of their before-tax pay to a plan. These amounts (and the earnings on them) are generally tax free until your employees receive distributions from the plan.

In general, individuals who are employed or self-employed can also set up and contribute to individual retirement arrangements (IRAs).

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An individual retirement arrangement (IRA) is a personal savings plan that allows you to set aside money for your retirement. You may be able to deduct your contributions, depending on the type of IRA and your circumstances. Generally, amounts in an IRA, including earnings and gains, are not taxed until they are distributed. In certain cases, your earnings and gains may not be taxed at all if they are distributed according to the rules. For more information on IRAs, see Publication 590.

A simplified employee pension (SEP) is a written plan that allows you to make deductible contributions toward your own and your employees' retirement without getting involved in more complex retirement plans. A corporation also can have a SEP and make deductible contributions toward its employees' retirement. But certain advantages available to qualified plans, such as the special tax treatment that may apply to lump-sum distributions, do not apply to SEPs.

Under a SEP, you make the contributions to a traditional individual retirement arrangement (called a SEP-IRA) set up by or for each eligible employee.

SEP-IRAs are set up for, at a minimum, each eligible employee. A SEP-IRA may have to be set up for a leased employee, but need not be set up for an excludable employee. For more information, see Publication 560.

Contributions you make for 2003 to a common-law employee's SEP-IRA are limited to the lesser of $40,000 or 25% of the employee's compensation. Compensation generally does not include your contributions to the SEP, but does include certain elective deferrals unless you choose not to include them.

The most you can deduct for employer contributions (other than elective deferrals) for a common-law employee is 25% of the compensation (limited to $200,000 per participant) paid to him or her during the year from the business that has the plan.

Deduction of contributions for yourself.

When figuring the deduction for employer contributions made to your own SEP-IRA, compensation is your net earnings from self-employment which takes into account both the following amounts.

The deduction for one-half of your self-employment tax.
The deduction for contributions to your own SEP-IRA.

The deduction for contributions to your own SEP-IRA and your net earnings depend on each other. For this reason, you determine the deduction for contributions to your own SEP-IRA indirectly by reducing the contribution rate called for in your plan. See Figuring your deduction under Deduction Limits under Qualified Plan, later.

If your SEP contribution is more than the deduction limit (nondeductible contribution), you can carry over and deduct the difference in later years. However, the contribution carryover, when combined with the contribution for the later year, is subject to the deduction limit for that year.

An employer is no longer allowed to set up a SARSEP. However, participants in a SARSEP set up before 1997 (including employees hired after 1996) can continue to have their employer contribute part of their pay to the plan.

A SARSEP is a SEP set up before 1997 that includes a salary reduction arrangement. Under the arrangement, employees can choose to have you contribute part of their pay to their SEP-IRAs rather than receive it in cash. This contribution is called an elective deferral because employees choose (elect) to set aside the money and the tax on the money is deferred until it is distributed.

The SARSEP was set up before 1997.
At least 50% of the eligible employees choose the salary reduction arrangement.
There were 25 or fewer eligible employees (or employees who would have been eligible if you had maintained a SEP) at any time during the preceding year.
Each eligible highly compensated employee's deferral percentage each year is no more than 125% of the average deferral percentage (ADP) of all nonhighly compensated employees eligible to participate (the ADP test). See Publication 560 for the definition of a highly compensated employee and information on how to figure the deferral percentage.

Catch-up contributions.

A SEP can permit participants who are age 50 or older at the end of the calendar year to also make catch-up contributions. The catch-up contribution limit for 2003 is $2,000 ($3,000 for 2004). Elective deferrals are not treated as catch-up contributions for 2003 until they exceed the limit discussed earlier under Limit on elective deferrals, the SARSEP ADP test (see Publication 560), or the plan limit (if any). However, the catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts.

The catch-up contribution limit.
The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.

Catch-up contributions are not subject to the limit discussed under Limit on elective deferrals, earlier.

Your contributions to an employee's SEP-IRA are excluded from the employee's income. Do not include these contributions in your employee's wages on Form W–2 for income, social security, or Medicare tax purposes. However, your SEP contributions under a salary reduction arrangement are included in your employee's wages for social security and Medicare tax purposes.

Example.

Jim's salary reduction arrangement calls for 10% of his salary to be contributed by his employer as an elective deferral to Jim's SEP-IRA. Jim's salary for the year is $30,000 (before reduction for the deferral). The employer chose not to treat deferrals as compensation under the arrangement. To figure the deferral, the employer multiplies Jim's salary of $30,000 by 9.0909%, the reduced rate equivalent of 10%, to get the deferral of $2,727.27. (This method is the same one you, as a self-employed person, use to figure the contributions you make on your own behalf. See Figuring your deduction under Deduction Limits under Qualified Plan, later.)

On Jim's Form W–2, his employer shows total wages of $27,272.73 ($30,000 - $2,727.27), social security wages of $30,000, and Medicare wages of $30,000. Jim reports $27,272.73 as wages on his individual income tax return.

If his employer does not make the choice explained above, Jim's deferral would be $3,000 ($30,000 x 10%). In this case, the employer uses the rate called for under the arrangement (not the reduced rate) to figure the deferral and the ADP test. On Jim's Form W–2, the employer shows total wages of $27,000 ($30,000 - $3,000), social security wages of $30,000, and Medicare wages of $30,000. Jim reports $27,000 as wages on his return.

In either case, the maximum deductible contribution would be $6,000 ($30,000 x 20%).

A Savings Incentive Match Plan for Employees (SIMPLE plan) is a written arrangement that provides you and your employees with a simplified way to make contributions to provide retirement income. Under a SIMPLE plan, employees can choose to make salary reduction contributions to the plan rather than receiving these amounts as part of their regular pay. In addition, you will contribute matching or nonelective contributions.

A SIMPLE IRA plan is a retirement plan that uses SIMPLE IRAs for each eligible employee. Under a SIMPLE IRA plan, a SIMPLE IRA must be set up for each eligible employee. For the definition of an eligible employee, see Who Can Participate in a SIMPLE IRA Plan, later.

Employee limit.

You can set up a SIMPLE IRA plan only if you had 100 or fewer employees who received $5,000 or more in compensation from you for the preceding year. Under this rule, you must take into account all employees employed at any time during the calendar year regardless of whether they are eligible to participate. Employees include self-employed individuals who received earned income and leased employees.

Once you set up a SIMPLE IRA plan, you must continue to meet the 100-employee limit each year you maintain the plan.

Grace period for employers who cease to meet the 100-employee limit.

If you maintain the SIMPLE IRA plan for at least 1 year and you cease to meet the 100-employee limit in a later year, you will be treated as meeting it for the 2 calendar years immediately following the calendar year for which you last met it.

A different rule applies if you do not meet the 100-employee limit because of an acquisition, disposition, or similar transaction. Under this rule, the SIMPLE IRA plan will be treated as meeting the 100-employee limit for the year of the transaction and the 2 following years if both the following conditions are satisfied.

Coverage under the plan has not significantly changed during the grace period.
The SIMPLE IRA plan would have continued to qualify after the transaction if you had remained a separate employer.

The grace period for acquisitions, dispositions, and similar transactions also applies if, because of these types of transactions, you do not meet the rules explained under Other qualified plan or Who Can Participate in a SIMPLE IRA Plan, below.

Eligible employee.

Any employee who received at least $5,000 in compensation during any 2 years preceding the current calendar year and is reasonably expected to receive at least $5,000 during the current calendar year is eligible to participate. The term “employee” includes a self-employed individual who received earned income.

You can use less restrictive eligibility requirements (but not more restrictive ones) by eliminating or reducing the prior year compensation requirements, the current year compensation requirements, or both. For example, you can allow participation for employees who received at least $3,000 in compensation during any preceding calendar year. However, you cannot impose any other conditions on participating in a SIMPLE IRA plan.

Compensation.

Compensation for employees is the total wages required to be reported on Form W–2. Compensation also includes the salary reduction contributions made under this plan, compensation deferred under a section 457 plan, and the employees' elective deferrals under a section 401(k) plan, a SARSEP, or a section 403(b) annuity contract. If you are self-employed, compensation is your net earnings from self-employment (line 4 of Short Schedule SE (Form 1040)) before subtracting any contributions made to the SIMPLE IRA plan for yourself.

You can use Form 5304–SIMPLE or Form 5305–SIMPLE to set up a SIMPLE IRA plan. Each form is a model savings incentive match plan for employees (SIMPLE) plan document. Which form you use depends on whether you select a financial institution or your employees select the institution that will receive the contributions.

Use Form 5304–SIMPLE if you allow each plan participant to select the financial institution for receiving his or her SIMPLE IRA plan contributions. Use Form 5305–SIMPLE if you require that all contributions under the SIMPLE IRA plan be deposited initially at a designated financial institution.

The SIMPLE IRA plan is adopted when you (and the designated financial institution, if any) have completed all appropriate boxes and blanks on the form and you have signed it. Keep the original form. Do not file it with the IRS.

Other uses of the forms.

If you set up a SIMPLE IRA plan using Form 5304–SIMPLE or Form 5305–SIMPLE, you can use the form to satisfy other requirements, including the following.

Meeting employer notification requirements for the SIMPLE IRA plan. Page 3 of Form 5304–SIMPLE and Page 3 of Form 5305–SIMPLE contain a Model Notification to Eligible Employees that provides the necessary information to the employee.
Maintaining the SIMPLE IRA plan records and proving you set up a SIMPLE IRA plan for employees.

Deadline for setting up a SIMPLE IRA plan.

You can set up a SIMPLE IRA plan effective on any date from January 1 thru October 1 of a year, provided you did not previously maintain a SIMPLE IRA plan. This requirement does not apply if you are a new employer that comes into existence after October 1 of the year the SIMPLE IRA plan is set up and you set up a SIMPLE IRA plan as soon as administratively feasible after your business comes into existence. If you previously maintained a SIMPLE IRA plan, you can set up a SIMPLE IRA plan effective only on January 1 of a year. A SIMPLE IRA plan cannot have an effective date that is before the date you actually adopt the plan.

Setting up a SIMPLE IRA.

SIMPLE IRAs are the individual retirement accounts or annuities into which the contributions are deposited. A SIMPLE IRA must be set up for each eligible employee. Forms 5305–S, SIMPLE Individual Retirement Trust Account, and 5305–SA, SIMPLE Individual Retirement Custodial Account, are model trust and custodial account documents the participant and the trustee (or custodian) can use for this purpose.

A SIMPLE IRA cannot be designated as a Roth IRA. Contributions to a SIMPLE IRA will not affect the amount an individual can contribute to a Roth IRA.

If you adopt a SIMPLE IRA plan, you must notify each employee of the following information before the beginning of the election period.

Election period.

The election period is generally the 60-day period immediately preceding January 1 of a calendar year (November 2 to December 31 of the preceding calendar year). However, the dates of this period are modified if you set up a SIMPLE IRA plan in mid-year (for example, on July 1) or if the 60-day period falls before the first day an employee becomes eligible to participate in the SIMPLE IRA plan.

A SIMPLE IRA plan can provide longer periods for permitting employees to enter into salary reduction agreements or to modify prior agreements. For example, a SIMPLE IRA plan can provide a 90-day election period instead of the 60-day period. Similarly, in addition to the 60-day period, a SIMPLE IRA plan can provide quarterly election periods during the 30 days before each calendar quarter, other than the first quarter of each year.

Contributions are made up of salary reduction contributions and employer contributions. You, as the employer, must make either matching contributions or nonelective contributions, defined later. No other contributions can be made to the SIMPLE IRA plan. These contributions, which you can deduct, must be made timely. See Time limits for contributing funds, later.

Salary reduction contributions.

The amount the employee chooses to have you contribute to a SIMPLE IRA on his or her behalf cannot be more than $8,000 for 2003 ($9,000 for 2004). These contributions must be expressed as a percentage of the employee's compensation unless you permit the employee to express them as a specific dollar amount. You cannot place restrictions on the contribution amount (such as limiting the contribution percentage), except to comply with the $8,000 limit.

If an employee is a participant in any other employer plan during the year and has elective salary reductions or deferred compensation under those plans, the salary reduction contributions under a SIMPLE IRA plan also are elective deferrals that count toward the overall $12,000 annual limit on exclusion of salary reductions and other elective deferrals.

Catch-up contributions.

A SIMPLE plan can permit participants who are age 50 or older at the end of the calendar year to make catch-up contributions. The catch-up contribution limit for 2003 is $1,000. This limit increases by $500 each year thereafter until it reaches $2,500 in 2006. The limit is subject to cost-of-living increases after 2006. The catch-up contributions a participant can make for a year cannot exceed the lesser of the following amounts.

The catch-up contribution limit.
The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.

Employer matching contributions.

You are generally required to match each employee's salary reduction contributions (other than catch-up contributions) on a dollar-for-dollar basis up to 3% of the employee's compensation. This requirement does not apply if you make nonelective contributions as discussed later.

Example.

In 2003, your employee, John Rose, earned $25,000 and chose to defer 5% of his salary. You make a 3% matching contribution. The total contribution you can make for John is $2,000, figured as follows.

Salary reduction contributions ($25,000 × .05)	$1,250
Employer matching contribution ($25,000 × .03)	750
Total contributions	$2,000

Nonelective contributions.

Instead of matching contributions, you can choose to make nonelective contributions of 2% of compensation on behalf of each eligible employee who has at least $5,000 of compensation (or some lower amount of compensation that you select) from you for the year. If you make this choice, you must make nonelective contributions whether or not the employee chooses to make salary reduction contributions. Only $200,000 of the employee's compensation can be taken into account to figure the contribution limit.

If you choose this 2% contribution formula, you must notify the employees within a reasonable period of time before the 60-day election period (discussed earlier) for the calendar year.

Example 1.

In 2003, your employee, Jane Wood, earned $36,000 and chose to have you contribute 10% of her salary. You make a 2% nonelective contribution. Both of you are under age 50. The total contributions you can make for her are $4,320, figured as follows.

Salary reduction contributions ($36,000 × .10)	$3,600
2% nonelective contributions ($36,000 × .02)	720
Total contributions	$4,320

Example 2.

Using the same facts as in Example 1, above, the maximum contribution you can make for Jane if she earned $75,000 is $9,500, figured as follows.

Salary reduction contributions (maximum amount)	$8,000
2% nonelective contributions ($75,000 × .02)	1,500
Total contributions	$9,500

You can deduct SIMPLE IRA contributions in the tax year with or within which the calendar year for which contributions were made ends. You can deduct contributions for a particular tax year if they are made for that tax year and are made by the due date (including extensions) of your federal income tax return for that year.

Deduct contributions you make for your common-law employees on your tax return. For example, sole proprietors deduct them on Schedule C (Form 1040) or Schedule F (Form 1040), partnerships deduct them on Form 1065, and corporations deduct them on Form 1120, Form 1120–A, or Form 1120S.

Sole proprietors and partners deduct contributions for themselves on line 30 of Form 1040. (If you are a partner, contributions for yourself are shown on the Schedule K-1 (Form 1065) you receive from the partnership).

You can deduct your contributions and your employees can exclude these contributions from their gross income. SIMPLE IRA contributions are not subject to federal income tax withholding. However, salary reduction contributions are subject to social security, Medicare, and federal unemployment (FUTA) taxes. Matching and nonelective contributions are not subject to these taxes.

Distributions from a SIMPLE IRA are subject to IRA rules and generally are includible in income for the year received. Tax-free rollovers can be made from one SIMPLE IRA into another SIMPLE IRA. A rollover from a SIMPLE IRA to a non-SIMPLE IRA can be made tax free only after a 2-year participation in the SIMPLE IRA plan.

Early withdrawals generally are subject to a 10% additional tax. However, the additional tax is increased to 25% if funds are withdrawn within 2 years of beginning participation.

If you need more help to set up and maintain SIMPLE IRA plans, see the following IRS notice and revenue procedure.

A qualified retirement plan is a written plan you can set up for the exclusive benefit of your employees and their beneficiaries. It is sometimes called a Keogh or H.R. 10 plan.

You, or you and your employees, can make contributions to the plan. If your plan meets the qualification requirements, you can generally deduct your contributions to the plan. For more information, see Publication 560.

Your employees generally are not taxed on your contributions or increases in the plan's assets until they are distributed. However, certain loans made from qualified plans are treated as taxable distributions. For more information, see Publication 575.

Qualification requirements.

To be a qualified plan, the plan must meet many requirements. They include requirements that determine the following.

Who must be covered by the plan.
How contributions to the plan are to be invested.
How contributions to the plan and benefits under the plan are to be determined.
How much of an employee's interest in the plan must be guaranteed (vested).

For more information, see Publication 560.

There are two basic kinds of qualified retirement plans: defined contribution plans and defined benefit plans.

This plan provides for a separate account for each person covered by the plan. Benefits are based only on amounts contributed to or allocated to each account.

There are two types of defined contribution plans: profit-sharing and money purchase pension.

This is any plan that is not a defined contribution plan. In general, contributions to a qualified defined benefit plan are based on what is needed to provide definitely determinable benefits to plan participants. Your contributions to the plan are based on actuarial assumptions. Generally, you will need continuing professional help to administer a defined benefit plan.

The plan can be an IRS-approved master or prototype plan offered by a sponsoring organization. Or it can be an individually designed plan.

Master or prototype plan.

The following sponsoring organizations generally can provide IRS-approved master or prototype plans.

Trade or professional organizations.
Banks (including savings and loan associations and federally insured credit unions).
Insurance companies.
Mutual funds.

Adoption of a master or prototype plan does not mean your plan is automatically qualified. It must still meet all the qualification requirements stated in the law.

Individually designed plan.

If you prefer, you can set up an individually designed plan to meet specific needs. Although advance IRS approval is not required, you can apply for approval by requesting a determination letter. You may need professional help with this. The following revenue procedure and announcement will help you decide whether to apply for approval.

Revenue Procedure 2003-6 in Internal Revenue Bulletin 2003-1.
Announcement 2001-77 in Internal Revenue Bulletin 2001-30.

The deduction limit for contributions to a qualified plan depends on the kind of plan you have.

In figuring the deduction for contributions to these plans, you cannot take into account any contributions or benefits that are more than the limits discussed under Limits on Contributions and Benefits in Publication 560. However, your deduction can be as much as the plan's unfunded current liability.

Defined contribution plans.

The deduction for contributions to a defined contribution plan profit sharing plan (or money purchase pension plan) cannot be more than 25% of the compensation paid (or accrued) during the year to the eligible employees participating in the plan. You must reduce this limit in figuring the deduction for contributions you make for your own account. See Deduction of contributions for yourself, later.

When figuring the deduction limit, the following rules apply.

Elective deferrals (discussed in Publication 560) are not subject to the limit.
Compensation includes elective deferrals.
The maximum compensation that can be taken into account for each employee is $200,000.

Limit on deduction.

If the qualified plan is a profit-sharing plan, your deduction for yourself is limited to the lesser of $40,000 or 20% (25% reduced as discussed later under Net earnings reduced by adjusting contribution rate) of your net earnings from the trade or business that has the plan. If the plan is a money purchase pension plan, the deduction is limited to the lesser of $40,000 or 20% (25% reduced as discussed later under Net earnings reduced by adjusting contribution rate) of your net earnings.

Net earnings.

Your net earnings must be from self-employment in a trade or business in which your personal services are a material income-producing factor. Your net earnings do not include items excluded from income (or deductions related to that income), other than foreign earned income and foreign housing cost amounts.

Your net earnings are your business gross income minus the allowable deductions from that business. Allowable business deductions include contributions to SEP and qualified plans for common-law employees and the deduction for one-half of your self-employment tax.

Net earnings include a partner's distributive share of partnership income or loss (other than separately stated items such as capital gains and losses) and any guaranteed payments. If you are a limited partner, net earnings include only guaranteed payments for services rendered to or for the partnership. For more information, see Partnership Income or Loss under Figuring Earnings Subject to Self-Employment Tax in Publication 533.

Net earnings do not include income passed through to shareholders of S corporations.

Retirement Plans

Important Changes for 2003

Introduction

Topics - This chapter discusses:

Useful Items - You may want to see:

Important Changes
for 2003