Qualified Retirement Plans
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:
- Employer contributions to the plan are tax deductible.
- Earnings on investments accumulate tax-deferred, allowing
contributions and earnings to compound at a faster rate.
- Employees are not taxed on the contributions and earnings until
they receive the funds.
- Employees may make pretax contributions to certain types of
plans.
- Employees may make Roth elective deferral contributions to
401(k) plans, if the plans permit.
- Ongoing plan expenses are tax deductible.
In addition, sponsoring a qualified retirement plan offers the
following advantages:
- Attract experienced employees in a very competitive job market:
Retirement plans have become a key part of the total compensation
package.
- Retain and motivate good employees: A retirement plan could
prevent employees from moving over to your competitors.
- Help employees save for their future since Social Security
retirement benefits alone will be an inadequate source to support a
reasonable lifestyle for most retirees.
- Plan assets are protected from creditors.
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.
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Defined Contribution Plans
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.
Employer account balances may be subject to a vesting schedule.
Non-vested account balances that are forfeited by former employees can
be used to reduce employer contributions or be reallocated to active
participants.
The maximum annual amount that may be credited to an employee's
account (taking into consideration all defined contribution plans
sponsored by the employer) is limited to the lesser of 100% of
compensation or $49,000 for 2010 and 2011. Catch-up contributions,
limited to $5,500 and permitted under 401(k) plans, are not included
in the $49,000.
Tax deduction limits must also be taken into consideration.
Employer contributions cannot exceed 25% of the total compensation of
all eligible employees. For example, a company with only one employee
earning $100,000 in 2011 would have a maximum deductible employer
contribution of $25,000 (25% of $100,000). However, the employee could
also make a $16,500 401(k) contribution (described below) to the plan.
As a result the total amount credited to his account for the year
would be $41,500 (41.5% of his compensation), and the contributions
would meet the 2011 maximum annual limit since total contributions are
less than $49,000.
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401(k) Plans
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
($16,500 in 2010 and 2011).
The plan may also permit employees age 50 and older to make
additional "catch-up contributions" up to an annual maximum limit
($5,500 in 2010 and 2011).
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:
- An employee who owns more than 5% of the employer at any time
during the current plan year or preceding plan year (stock
attribution rules apply which treat an individual as owning stock
owned by his spouse, children, grandchildren or parents); or
- An employee who received compensation in excess of the indexed
limit during the preceding plan year ($110,000 for 2010 and 2011).
The employer may elect that this group be limited to the top 20% of
employees based on compensation.
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401(k) Safe Harbor Plans
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 ($16,500 in 2010 and 2011) without concern for what the
Non-Highly Compensated Employees defer.
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Profit Sharing Plans
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 2011
is $245,000.
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.
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Age-Weighted Profit Sharing Plans
Profit sharing plan
contributions may also be allocated using an age-weighted allocation
formula that takes into account each employee's age and compensation.
This formula results in a significantly larger allocation of the
contribution to eligible employees who are closer to retirement age.
Age-weighted profit sharing plans combine the flexibility of a profit
sharing plan with the ability of a pension plan to skew benefits in
favor of older employees.
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New Comparability Profit Sharing Plans
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.
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Defined Benefit Plans
Instead of accumulating contributions and earnings in an individual
account like defined contribution plans (profit sharing, 401(k)), a
defined benefit plan promises 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 ($49,000 in 2010 and 2011), 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 ($195,000 in 2010 and 2011). 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.
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Cash Balance Plans
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).
As in a traditional defined benefit plan, the employer in a cash
balance plan bears the investment risks and rewards. An actuary
determines the contribution to be made to the plan, which is the sum
of the contribution credits for all employees plus the amortization of
the difference between the guaranteed interest credits and the actual
investment earnings (or losses).
Employees appreciate this design because they can see their
"accounts" grow but are still protected against fluctuations in the
market. In addition, a cash balance plan is more portable than a
traditional defined benefit plan since most plans permit employees to
take their cash balance and roll it into an individual retirement
account when they terminate employment or retire. |
