Low Cost Qualified Retirement Plans
for Small Businesses

This paper is written and provided by SHARP INVESTMENTS, a Registered Investment Advisor. SHARP INVESTMENTS manages money for individuals and businesses, specializing in small business pension plan management. SHARP INVESTMENTS is a licensed and bonded investment company. For a free consultation on the possibilities of money management, contact Daniel R. Sharp at 503-520-5000.

The following will show the small business owner how to;

- lower business taxes by as much as $15,000 per year

-shelter up to $30,000 per year per employee from personal taxes

-increase retirement income tenfold over conventional retirement plans

-implement a Qualified Retirement Plan for just $25.32 per year

Qualified Retirement Plans are the only tax shelter
open to all businesses

Congress and the Internal Revenue Service have left only four ways for businesses to cut their taxes. They are;

1. Income splitting
2. Investing dividends in stock
3. Leaving profits in the corporation
4. Qualified Retirement Plans

Unfortunately for small businesses, investing dividends in stock (#2) and leaving profits in the corporation (#3) are methods only available to C corporations. Income splitting (#1) is not available to sole proprietorships or S corporations with a single employee. Therefore, the only tax shelter open to all businesses is the Qualified Retirement Plan (#4).

There are three major benefits to Qualified Retirement Plans;

1. Lowers taxable income (tax shelter)
2. Allows investments to grow tax free toward retirement income
3. Attracts and keeps superior employees

Yet fewer than 1 in 5 businesses with 25 employees or less have any type of qualified retirement plan. Why?

Costs and Complexity of setting up a Pension Fund
discourage most small businesses

Typical Implementation of Qualified Retirement Plan

In a typical small business the owner contacts their financial advisor inquiring about methods to reduce their taxes. The advisor (usually a CPA or lawyer) advises that a retirement plan will reduce business taxes and sends the business owner towards a pension consultant. The pension consultant helps the owner choose an appropriate pension plan then sends the owner to a trustee - typically a bank. The bank implements the chosen plan and then purchases mutual funds or annuities. Sound like too many hands? Often it is. And to make matters worse, each middleman charges a fee.

Fiduciary Fees

Typically, each fiduciary involved charges fees as follows for setting up a pension plan:

1. CPA / lawyer from $500 to thousands of dollars annually
2. Pension consultant several thousand dollars annually
3. Trustee/bank annual percentage of assets under management, typically 1 to 2%
4. Mutual Funds annual percentage of assets under management
-management fees (from 1 to 2%)
-load fees, front end and/or back end (0 to 5%)
-12-b1 fees (0 to .75%)

The fiduciary fees (known as wrap fees) generally discourage small businesses from utilizing qualified retirement plans.

Example 1

A small business owner has $30,000 in profit they wish to shelter in a qualified retirement plan.

Using the fiduciaries previously described, the owner incurs the following costs:

1. CPA/Lawyer* $ 2000
2. Pension Consultant* $ 2000
3. Trustee/Bank** $ 600
4. Mutual Fund Fees** $ 600
  *generally charges fees up front
**generally charges fees quarterly
Total Fees: $5200

If the mutual funds produce an average return (10%), then the investment rate of return after deducting the up front fees can be calculated for the pension fund as follows:

Subtracting the up front fees $30,000 - $4000 = $26,000
Multiplying by the 10% return $26,000 x 1.1 = $28,600
Subtracting the quarterly fees $28,600 - $1200** = $27,400
Initial Investment; $30,000
Year end Assets; $27,400
First Year Return; $ (9.0%) negative nine percent!

Under the same assumptions for the 2nd year, the 2 year return becomes:

10% return after up front fees [$26,000 +$27,400] x 1.1 = $58,740
Minus Quarterly Fees - $2349
Year End Assets $56,390
2 year return (2.0%)

As the fund builds up it reaches the industry average for pension fund returns after fees; 4.2% annual return. This return is less than half that available from simple passive stock index investing.

The average return for pension funds is 4.2%
The average return for common stock is 12.0%

This produces dramatically different results for a long term holding period. Compare the end results of two portfolios growing at these two different rates.

Example 2

A pension worth $100,000 growing at 4.2% is worth $344,000 at the end of 30 years.
A pension worth $100,000 growing at 12.0% is worth $2,995,000 at the end of 30 years.

In the next section, we will show why typical pension plans have only returned 4.2% and how you can implement a low cost plan that has had an average return of 12.0% over the last 100 years.

This can result in pension assets ten times larger than in a typical pension plan!

Employers are shifting the responsibility and liability of pension plans from themselves (Defined Benefit) to employees (Defined Contribution)

Industry Standard Pension Plans

There are two types of pension plans used by large and small businesses that fill the requirements of a Qualified Retirement Plan. These allow the business to shelter income.

1. Defined Contribution Plans - these plans are based on contributions from both employers and employees. They are usually the property and responsibility of the employee with little or no vesting period required. Defined Contribution Plans are usually either money purchase plans (401K plans) or profit sharing plans and are a relatively recent phenomena.

2. Defined Benefit Plans - these plans are based on a formula taking into account age, years of service, and salary level. Defined Benefit Plans are the more traditional pension plans that reward long-term employees with good retirement income. Since each employee's payout is known well in advance or "targeted", an employer can end up over- or underfunded - based on the results of the investments. They are liable only for the target amount. Any amount over this the employer can keep; and any amount under this the employer must make up. Therefore, this type of pension plan cannot afford to take as much risk as the Defined Contribution Plan because it is virtually "guaranteeing" the investment results.

Small businesses have the same pension choices under the Keogh umbrella. Keogh plans, while somewhat simpler than their large company counterparts, still require all the fiduciaries and fees previously mentioned (Lawyer, CPA, bank, etc.).

Implementing most pension plans for small businesses requires the use of a CPA, lawyer, pension consultant, and bank, with all their accompanying fees.

Since Keogh pension plans fall under most of the same rules and regulations as large company retirement plans, an entire platoon of expensive consultants is necessary to negotiate the complex world of pension plans. The expertise is needed because of the dual governing and reporting entities, the Department of Labor (DOL) and the Internal Revenue Service. The Department of Labor is responsible for enforcing the ERISA requirements (Employee Retirement Income Security Act) and the IRS for tax compliance. Most pension plan legislation is designed to prevent owners or highly compensated employees from padding their own pensions to the detriment of the average employee. As a result the rules and regulations are one of the more complex pieces of regulation in existence.

The expertise of fiduciaries is needed in four general areas;

1. Complicated set up procedures and initial paperwork for both the IRS and ERISA requirements.

2. Complicated tax reporting to the IRS.

3. Complicated reporting of ERISA requirements to the Department of Labor.

4. Continual changes to rules and regulations of both IRS and ERISA reporting.

On top of this, most trustees (mainly banks) don't actually manage the investments. The trustee's choice of investments are almost always managed mutual funds which imposes yet another set of fees on the assets under management.

Is there any alternative that would allow a small business to implement a retirement plan without the cost and complexity of most pension plans?

YES - SEP Plans!

There is one little known, little used plan created recently by the IRS known as a Simplified Employee Pension plan.

A SEP is a plan designed specifically for small businesses of 25 employees or less that minimizes reporting to the IRS, and completely eliminates reporting to the Department of Labor (ERISA).

The SEP also minimizes the need for fiduciaries, which keeps costs to a minimum.

Employers who have SEPs can:

-Make tax deductible contributions for themselves in any amount they choose up to $30,000 (equivalent to other plans).

-Omit contributions in years when contributions are not affordable.

-Avoid the administrative costs and most of the reporting requirements of non-SEP plans.

SEPs are implemented through the use of Individual Retirement Accounts (IRAs). As a general rule, under a SEP, up to 15% of each employee's pay can be contributed into an IRA, up to a maximum of $30,000 annually. In fact, an employee could put $2000 per year into the IRA as an individual, AND have up to $30,000 per year deposited into their IRA as a SEP contribution from a combination of employer contributions and/or salary deferral.

Example 3
The Power of a SEP

Part A

A small business owner is in the 35% federal tax bracket, 12% state tax bracket, and 8% bracket for local taxes, employment taxes, etc. The owner contributes to a SEP with the maximum $30,000.

This reduces federal taxes $10,500
state taxes $ 3,600
misc taxes $ 2,400
For a total tax reduction of $16,500

While the owner is deferring $30,000 towards retirement, the opportunity cost of doing so is only $13,500.

The owner is buying a $30,000 investment for only $13,500!

This represents an instant return on your investment of 55%!

As a small business owner, wouldn't you like a 55% profit margin on all your sales? You bet you would!

On April 15th, the choice comes down to writing a check to the government or writing a check to an IRA.

Part B

After 3 years, this owner has $100,000 in the IRA.

The funds are managed by an investment manager that generates the same annual return as common stock (12.0%) and charges a 1% fee.

Therefore the fund nets 11% annually after deducting fees, compared to the 4.2% annual growth of conventional plans.

From example 2, the conventional pension would be worth $344,000 after 30 years.

In contrast, the SEP would be worth $2,289,000, almost 7 times the amount of the conventional pension.

An investment manager that could outperform the market by 2% would yield a result more than 10 times ($3.4 million) the value of conventional pensions (the 13% growth rate) with no additions made after the first 3 years!

SEP Advantages for Employers and Employees

Employer Advantages
- Significant source of retirement income
- Tax deductible contributions
- Annual contributions can be varied from year to year
- Once SEP funds are deposited in an IRA, employer is relieved of further responsibility
- Almost zero cost in establishing and operating SEP
- No documents to file with IRS or DOL, one IRS document to file with custodian
- SEPs can be established by sole proprietors, partnerships, S and C corporations
- SEP contributions can be made as late as the day taxes are filed for a particular tax year

Employee Advantages
- SEP contributions belong to employee as soon as deposit is made - no vesting required
- SEP contributions are not taxed for income or social security
- SEP contributions can be made to an employee's existing IRA
- Employee can choose investment manager, or can even self-manage investments
- Employee can still contribute up to $2000 annually to IRA as an individual contribution

The IRS recognizes two types of SEPs as Qualified Retirement Plans

Employer contribution SEP - This type of SEP requires a uniform percentage of pay to be contributed by the employer to all eligible employee's IRA accounts. This SEP is preferred by sole proprietors, partnerships, S or C corporations where the owners are the only employees. Up to the lessor of $30,000 or 15% of salary can be contributed annually per employee. IRS form 5305 - IRS Model SEP, is to be on file with the trustee/custodian.

Employee contribution SEP - This type of SEP is for salary reduction contributions made by the employee, rather than the employer. 50% of eligible employees must participate, and "highly compensated" employees, including owners (regardless of compensation), cannot contribute more than 125% of the average contribution of the other eligible employees. Up to the lessor of $9240 (indexed each year to inflation) or 15% of deferred salary can be contributed annually. IRS form 5305A - IRS Model Salary Reduction SEP, is to be on file with the trustee/custodian.

A employer may have both types of SEP implemented simultaneously as long as the 15% - $30,000 limit per employee is not violated by the combined plans.

What defines an eligible employee?

All employees are considered eligible unless they meet any of these five exclusions;

1. Employees who have not worked for three out of the last five years for the employer.
2. Employees who earn less than $396 per year (indexed for inflation).
3. Employees that have not reached age 21 during the calendar year for which the contributions are being made.
4. Employees covered by a collective bargaining agreement
5. Non-resident aliens

Employers may grant eligibility to any employee regardless of exclusions.

What is the difference between a Model and Non-Model SEP?

Model SEPs are IRS pre-approved, prototype qualified retirement plans, such as the 5305 and 5305A. A business may submit to the IRS a non-model SEP, specifically designed for that company. This requires the use of an additional fiduciary, such as a pension lawyer or pension consultant, to draft a suitable plan. Some financial institutions have canned non-model SEPs available to businesses, but again using them involves paying the fiduciary fees of the bank and their mutual funds.

Frankly, a non-model SEP defeats the purpose of lowering costs and complexity and is only appropriate in special situations.

What is the role of the custodian and investment manager in a SEP?

You cannot hold the SEP funds yourself, a custodian is required to legally establish the IRA that holds the SEP fund. The most cost effective SEP custodian is a discount broker, who will only charge a nominal fee (perhaps $25) to establish and maintain the SEP-IRA. You can save even more money by combining IRAs for a specific individual that would hold both SEP funds and individual contribution funds for one nominal fee. The custodian holds the funds in an insured account, completes investment transactions, and provides monthly statements of transactions and account balances.

For most small businesses, time is a precious commodity. Most small business people don't have the time to continually manage their own investments and make investment decisions, even if they have the knowledge and aptitude. The investment manager makes the investment decisions and manages the portfolio. They are paid a small percentage of assets (Sharp Investments charges from .4% to 2% annually dependent on fund type and size) and can be paid out of the IRA proceeds rather than from your after tax dollars.

Typical pension plans are administered by banks which act both as custodian and investment manager. However, banks generally charge the going rate for their investment management services, and then purchase mutual funds as their investment of choice. Mutual funds then also charge fees against your IRA proceeds. This causes the small business owner to pay at least double the fees of the discount broker and investment manager.

Non-SEP pensions incur fees of 4 to 6% annually, while SEP pensions, with a discount broker and an investment manager can incur fees as low as .4 to 2% annually.

What are the steps in establishing a SEP?

There are six simple steps to setting up a SEP account. You can do it yourself, or call Sharp Investments to set it up for you - for free.

1. Decide which of the two types of SEP you wish to use, Employer Contribution SEP (Model SEP), Employee Contribution SEP (Salary Reduction SEP), or both.

2. Choose a financial institution as custodian/trustee. Discount stock brokerages will set up a SEP for an extremely nominal fee, or sometimes even free. Most brokers will also have forms 5305 and 5305A. Fill out the forms and return to the custodian. If employees wish they may roll their pre-existing IRA into a SEP-IRA as well as make up to $2000 annual contribution as individuals completely separate from their SEP contributions.

3. Provide each eligible employee with a completed copy of form 5305(A).

4. If a discount broker is chosen, select an investment manager to manage funds, or manage them yourself.

5. Mail contributions to custodian.

6. Individuals deduct contributions on IRS form 1040, line 27.

The employer out-of-pocket costs in implementing a SEP are a $25 annual fee to the discount broker/trustee and a single postage stamp to mail in the annual contribution for a grand total of $25.32.

Are there any restrictions to a SEP?

There are a few prohibited transactions and restrictions of SEP plans;

1. Loans cannot be taken out against SEP funds.

2. If a business has a non-SEP Qualified Retirement Plan, they are ineligible for a SEP.

3. In addition, if a business has ever had a defined benefits plan, they are also ineligible.

4. Businesses with more than 25 employees are ineligible.

Are there any disadvantages to SEPs?

1. Employees cannot take out loans against funds, as in some other retirement plans.

However, loans against retirement funds are generally a bad idea. Funds pledged against assets in most qualified retirement plans generally give up the rights of interest, dividends and capital gains during the time it is used as loan collateral. Some employers also preclude an employee from further contributions while a loan is outstanding. This means one is actually paying a tax deferred 10% (average stock return) for the loan, which means an equivalent after tax loan rate of 12-15%. Unless inflation is rampant, it would seem wiser to obtain a loan through other means.

2. Lump sum distributions are not subject to special tax treatment, 5 or 10 year averaging, as are some other qualified retirement plans.

While this is a disadvantage, it is still outweighed by the numerous advantages of SEPs as seen in the following example.

Example 3 - Part C

Assume the non-SEP fund of example 2 is eligible for 10-year tax averaging.

Assume the tax break lowers the tax rate from the highest bracket (39.6%) to the lowest (15%).

The after-tax distribution of this fund would be
$344,000(1- .15) = $292,400.

The SEP fund would be taxed at the highest rate, leaving an after-tax distribution of
$2,289,000(1-.396) = $1,382,600.

Even with an unfavorable tax treatment, the after-tax value of the SEP pension is quadruple the value of the non-SEP pension.

The longer the pension plan exists, the less important the tax treatment of the distribution.


Qualified Retirement Plans are the only tax break available to all businesses.

Conventional Retirement Plans are complex and costly.

Simplified Employee Pension plans (SEPs) are neither costly or complex.

SEPs provide a double tax shield:

-taxes eliminated on up to $30,000 of income per year,


-retirement funds compound tax free, dramatically improving investment results.

On April 15th, all small businesses will write out a check - either to the IRS or to their own retirement pension - the choice is up to you.

Sharp Investments will set up a SEP fund for you at no cost, and will manage your investment portfolio for as little as .4% per year annual fee, dependent on type and amount of assets. For a copy of "Investing for Your Retirement" or "Investing in Common Stocks" contact Sharp Investments at 503-520-5000.


Available Publications on SEPs

1. SEPs - What Small Businesses Need to Know, A Joint Publication of the Small Business Administration and the Department of Labor 1-800-U-ASK-SBA

2. IRS Publication 560 - Retirement Plans for the Self Employed 1-800-TAX-FORM

3. IRS Publication 590 - Individual Retirement Arrangements (IRAs) 1-800-TAX-FORM

Forms needed to establish SEP

1. IRS form 5305 or form 5305A