IRS Publication 560: Retirement Plans for Small Business

IRS Publication 560 is the official guide for small business owners and self-employed individuals looking to establish a retirement plan. It details the rules for setting up a plan, contribution limits, and how to manage it from year to year. This publication translates the technical language of the tax code into a more understandable format. This article will focus on the practical steps and requirements for choosing, implementing, and administering a plan.

Types of Retirement Plans

A Simplified Employee Pension (SEP) IRA is a common choice due to its straightforward structure where only the employer makes contributions. These are made to traditional IRAs set up for each eligible employee, including the owner. Eligibility generally includes employees who are at least 21, have worked for the business in at least three of the last five years, and earned at least $750 in compensation for the year. Employers may also offer a Roth SEP IRA for after-tax contributions.

The Savings Incentive Match Plan for Employees (SIMPLE IRA) is available to businesses with 100 or fewer employees that do not offer another retirement plan. Unlike a SEP, a SIMPLE IRA allows contributions from both the employee, via salary reductions, and the employer. Employers can also offer a Roth SIMPLE IRA, which permits employees to make after-tax contributions.

Publication 560 also covers qualified plans, such as 401(k)s, profit-sharing plans, and defined benefit plans. These plans must meet specific Internal Revenue Code requirements to receive tax-favored status. While offering more flexibility, they also have more significant administrative burdens and stricter rules than SEP and SIMPLE IRAs.

Establishing a Retirement Plan

The first step is selecting a plan type that best fits the business’s financial situation and goals. This decision involves weighing the features of plans like the employer-funded SEP IRA against the shared contribution model of a SIMPLE IRA or the greater complexity of a qualified plan.

A formal written plan document must be adopted to establish the plan. The IRS provides model documents to simplify this, such as Form 5305-SEP for SEP IRAs and Forms 5304-SIMPLE or 5305-SIMPLE for SIMPLE IRAs. These forms serve as the legal agreement and specify details like employee participation criteria and the contribution formula. The signed document should be retained by the employer and not filed with the IRS.

After adopting the plan, all eligible employees must be notified. For a SIMPLE IRA, employees must receive a notice with a copy of the plan document before the annual 60-day election period, which generally runs from November 2 to December 31. The notice must explain the plan’s terms and how contributions will be made.

Contribution Rules and Limits

SEP Contributions

Only the employer contributes to a SEP IRA, and they have discretion each year on whether to contribute. If a contribution is made, it must be a uniform percentage of compensation for every eligible employee. The annual contribution for each employee is limited to the lesser of 25% of their compensation or $70,000 for 2025.

SIMPLE IRA Contributions

SIMPLE IRA plans involve contributions from both employees and employers. Employees can contribute up to $16,500 for 2025 through salary deferrals, with additional catch-up contributions for those aged 50 and over. For 2025, the standard catch-up is $3,500, with a higher limit of $5,250 for participants aged 60 to 63. Employers must either match employee contributions up to 3% of compensation or make a 2% non-elective contribution for all eligible employees.

Qualified Plan Contributions

Qualified plans like 401(k)s also combine employee and employer contributions. Employees can defer up to $23,500 for 2025, with catch-up contributions for those 50 and over. The 2025 standard catch-up is $7,500, with a higher limit up to $11,250 for participants aged 60 to 63. Total combined contributions cannot exceed 100% of compensation or the annual limit of $70,000 for 2025.

Self-Employed Compensation Calculation

Calculating the maximum retirement contribution for a self-employed individual is a specific process. The calculation starts with net earnings from self-employment, which are then reduced by one-half of the self-employment tax and the retirement contribution itself. Because the contribution amount depends on a figure derived after subtracting the contribution, this creates a circular calculation.

The IRS provides worksheets and rate tables in Publication 560 to resolve this. For example, if a plan’s stated contribution rate is 25%, the effective rate for the self-employed individual is 20%. This lower rate is applied to the net earnings after subtracting one-half of the self-employment tax to find the maximum contribution.

Ongoing Plan Administration and Reporting

Deducting Contributions

The deadline for making and deducting contributions is the due date of the business’s federal income tax return, including extensions. For a calendar-year business with an extension, contributions for 2024 can be made as late as October 15, 2025. This timing allows businesses to finalize profit numbers before committing to a contribution amount.

Prohibited Transactions

Plan fiduciaries, including the business owner, must follow strict rules under the Employee Retirement Income Security Act (ERISA) to prevent self-dealing, conflicts of interest, and other prohibited transactions. Examples include borrowing money from the plan, selling property to the plan, or using plan assets as security for a loan. Engaging in a prohibited transaction can lead to significant penalties and may disqualify the plan.

Annual Reporting Requirements

SEP and SIMPLE IRA plans are generally exempt from filing annual Form 5500-series returns. Most qualified plans, like 401(k)s, must file a Form 5500 annually, with the specific version depending on the number of participants. Plans with fewer than 100 participants may file Form 5500-SF, while larger plans file the standard version.

One-participant plans, covering only the business owner or owner and spouse, must file Form 5500-EZ if total plan assets exceed $250,000 at year-end. If an employer has multiple one-participant plans, the assets are combined to determine if the threshold is met, and a form must be filed for each plan if the total exceeds $250,000. The filing deadline is the last day of the seventh month after the plan year ends, typically July 31.

Terminating a Retirement Plan

To terminate a retirement plan, a business must take formal action, such as a corporate resolution, to amend the plan document. This amendment establishes an official termination date, ceases all future contributions, and ensures the plan is updated for any recent law changes. All participants must be notified of the termination.

As of the termination date, all participants become 100% vested in their account balances. The business must make any final, outstanding employer contributions to fully fund all accounts before closure.

All plan assets must be distributed to participants as soon as administratively feasible, generally within 12 months of the termination date. Participants must receive rollover notices explaining their options. After all assets are distributed, a final Form 5500-series return, marked as “final,” must be filed for the plan’s last year.