A qualified plan must meet a certain set of requirements set forth in the Internal Revenue Code such as minimum coverage, minimum participation, vesting and funding requirements. In return, the IRS provides tax advantages to encourage businesses to establish retirement plans including:
Employers can choose between two basic types of retirement plans: defined contribution and defined benefit. Both a defined benefit and defined contribution plan may be designed to maximize benefits. Our consultants can help you choose the right plan for your company. Listed below is a description of the types of plans that are available.
Under a defined contribution plan, the contribution that the company will make to the plan and how the contribution will be allocated among the eligible employees is defined. Individual account balances are maintained for each eligible employee. The employee’s account grows through employer contributions, investment earnings and, in some cases, forfeitures (amounts from the non-vested accounts of terminated participants). Some plans may also permit employees to make contributions on a before-and/or after-tax basis.
Since the contributions, investment results and forfeiture allocations vary year by year, the future retirement benefit cannot be predicted. The employee’s retirement, death or disability benefit is based upon the amount in his or her account at the time the distribution is payable.
More and more employees perceive 401(k) plans as a valuable benefit and this has made them the most popular type of retirement plan today. Employees can benefit from a 401(k) plan even if the employer makes no contribution. Employees voluntarily elect to make pre-tax contributions through payroll deductions up to an annual maximum limit.The plan may also permit employees age 50 and older to make additional “catch-up contributions” up to an annual maximum limit.
The employer will often match some portion of the amount deferred by the employee to encourage greater employee participation, i.e., 25% match on the first 4% deferred by the employee. Since a 401(k) plan is a type of profit sharing plan, profit sharing contributions may be made in addition to or instead of matching contributions.
Employee and employer matching contributions are subject to special nondiscrimination tests which limit how much the group of employees referred to as “Highly Compensated Employees” can defer based on the amounts deferred by the “Non-Highly Compensated Employees.” In general, employees who fall into the following two categories are considered to be Highly Compensated Employees:
The plan may be designed to satisfy “401(k) Safe Harbor” requirements which eliminate nondiscrimination testing. The Safe Harbor requirements include certain minimum employer contributions and 100% vesting of employer contributions that are used to satisfy the 401(k) Safe Harbor Requirements. The benefit of eliminating the testing is that Highly Compensated Employees can defer up to the annual limit without concern for what the Non-Highly Compensated Employees defer.
The profit sharing plan is generally the most flexible type of qualified plan that is available. Company contributions to a profit sharing plan are usually made on a discretionary basis. Each year the employer decides the amount, if any, to be contributed to the plan. For tax deduction purposes, company’s contribution cannot exceed 25% of the total compensation of all eligible employees. The maximum eligible compensation that can be considered for any single employee for 2012 is $250,000.
The contribution can be allocated to eligible employees in proportion to compensation and may be allocated using a formula that is integrated with Social Security, resulting in larger contributions for higher paid employees.
Profit sharing plans with New Comparability allocation formulas, sometimes referred to as “cross-tested plans,” are tested for nondiscrimination as though they were defined benefit plans. By doing so, certain employees may receive much higher allocations than would be permitted by standard nondiscrimination testing. New comparability plans are generally utilized by small businesses who want to maximize contributions to owners and higher paid employees while minimizing those for all other eligible employees. Employees are separated into two or more identifiable groups such as owners and non-owners. Each group may receive a different contribution percentage. For example, a higher contribution may be given to the owner group than the non-owner group, as long as the plan satisfies the nondiscrimination requirements.
Instead of accumulating contributions and earnings in an individual account like defined contribution plans (profit sharing, 401(k)), a defined benefit plan provides the employee a specific monthly benefit payable at the retirement age specified in the plan. Defined benefit plans are usually funded entirely by the employer. The employer is responsible for contributing enough funds to the plan to pay the promised benefits regardless of profits and earnings. Employers who want to shelter more than the annual defined contribution limit, may want to consider a defined benefit plan since contributions can be substantially higher resulting in fast accumulation of retirement funds.
The plan has a specific formula for determining a fixed monthly retirement benefit. Benefits are usually based on the employee’s compensation and years of service which rewards long term employees. Benefits may be integrated with Social Security which reduces the plan’s benefit payments based upon the employee’s Social Security benefits. The maximum benefit allowable is 100% of compensation (based on highest consecutive three-year average) to an indexed maximum annual benefit. Defined benefit plans may permit employees to elect to receive the benefit in a form other than monthly benefits, such as a lump sum payment.
An actuary determines yearly employer contributions based on each employee’s projected retirement benefit and assumptions about investment performance, years until retirement, employee turnover and life expectancy at retirement. Employer contributions to fund the promised benefits are mandatory. Investment gains and losses decrease or increase the employer contributions. Non-vested accrued benefits forfeited by terminating employees are used to reduce employer contributions.
A cash balance plan is a type of defined benefit plan that resembles a defined contribution plan. For this reason, these plans are referred to as hybrid plans. A traditional defined benefit plan promises a fixed monthly benefit at retirement usually based upon a formula that takes into account the employee’s compensation and years of service. A cash balance plan looks like a defined contribution plan because the employee’s benefit is expressed as a hypothetical account balance instead of a monthly benefit.
Each employee’s “account” receives an annual contribution credit, which is usually a percentage of compensation, and an interest credit based on a guaranteed rate or some recognized index like the 30 year treasury rate. This interest credit rate must be specified in the plan document. At retirement, the employee’s benefit is equal to the hypothetical account balance which represents the sum of all contribution and interest credits. Although the plan is required to offer the employee the option of using the account balance to purchase an annuity benefit, employees generally will take the cash balance and roll it over into an individual retirement account (unlike many traditional defined benefit plans which do not offer lump sum payments at retirement).
Serving Your Retirement Planning Needs - click here to watch
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
To providing our clients with a distinct experience providing guidance you can rely on.