Qualified Retirement Plans
A qualified plan must meet a certain set of requirements in
the Internal Revenue Code such as minimum participation, vesting
and funding requirements. In return, the IRS provides
significant tax advantages to encourage businesses to establish
retirement plans including:
- Employer contributions to the plan are tax deductible.
- Earnings on investments accumulate tax-deferred which
allows 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.
- Ongoing plan expenses are tax deductible.
In addition, sponsoring a qualified retirement plan has the
following advantages:
- Attract experienced employees in a very competitive job
market: Retirement plans are fast becoming a key part of
the total compensation package.
- Retain and motivate good employees: A retirement plan has
the ability to keep 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 sponsored 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.
top of page
Defined Contribution Plans
A defined contribution plan defines the contribution the
company will make to the plan and how the contribution will be
allocated among the eligible employees. Separate account
balances are maintained for each 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 account at
the time the distribution is payable.
Employer account balances may be subject to a vesting
schedule. Non-vested account balances forfeited by terminating
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 $45,000 for 2007 and $46,000
for 2008.
The maximum employer tax deduction limit 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 2007 would
have a maximum deductible employer contribution of $25,000 (25%
of $100,000). However, the employee could also make a $15,500
401(k) contribution to the plan. As a result the total amount
credited to his account for the year would be $40,500 (40.5% of
his compensation), and he would satisfy the 2007 maximum annual
limit since total contributions are less than $45,000.
top of page
Profit Sharing Plans
The profit sharing plan is one of the most flexible qualified
plans 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, the company
contribution cannot exceed 25% of the total compensation of all
eligible employees.
The contribution is usually allocated to employees in
proportion to compensation and may be integrated with Social
Security which results in larger contributions for higher paid
employees.
Age-Weighted Profit Sharing Plans:
Profit sharing plans may also use 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 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.
top of page
401(k) Plans
More and more employees perceive 401(k) plans as a valuable
benefit which have made them the most popular retirement plans
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 ($15,500 in 2007 and 2008).
The plan may also permit employees age 50 and older to make
additional "catch-up contributions" up to an annual maximum
limit ($5,000 in 2007 and 2008).
Often the employer will 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. Many employers offer
employees the opportunity to take hardship withdrawals or borrow
from the plan.
Employee and employer matching contributions are subject to a
special nondiscrimination test which limits how much the group
of employees referred to as "Highly Compensated Employees" can
defer based on the amount deferred by the "Non-Highly
Compensated Employees." In general, employees who fall into the
following two categories are considered to be Highly Compensated
Employees:
- A more than 5% owner 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 in the preceding plan year ($100,000 for 2007).
The employer may elect that this group be limited to the top
20% of employees based on compensation.
401(k) Safe Harbor Plans:
The plan may be designed to satisfy "401(k) Safe Harbor"
requirements (certain minimum employer contributions and 100%
vesting of employer contributions) which can eliminate
nondiscrimination testing. The benefit of eliminating the
testing is that Highly Compensated Employees can defer up to the
annual limit ($15,500 in 2007 and 2008) without concern for what
the Non-Highly Compensated Employees defer.
top of page
New Comparability Plans
These plans, sometimes referred to as "cross-tested plans,"
are usually profit sharing plans that 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
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.
top of page
Money Purchase Pension Plans
A money purchase pension plan operates like a profit sharing
plan. The major difference is that, unlike profit sharing plans
where employers are permitted to make discretionary
contributions each year, the employer has a set contribution
rate which is stated in the plan document. These mandatory
contributions must be made each year regardless of the
employer's profits. Failure to make a contribution can result in
the imposition of penalties.
Contributions are generally based on a fixed percentage of
each employee's compensation. For tax deduction purposes, the
company contribution cannot exceed 25% of compensation to a
maximum annual limit ($45,000 in 2007 and $46,000 in 2008). The
contribution may be integrated with Social Security which
results in larger contributions for higher paid employees.
Prior to the Economic Growth and Tax Relief Reconciliation
Act of 2001 ("EGTRRA"), profit sharing plans were limited to 15%
of compensation while money purchase plans were permitted to
make contributions as high as 25%. A combination money purchase
pension plan and profit sharing plan was sometimes used to limit
mandatory contributions while retaining the ability to make
larger contributions in good years. The increased profit sharing
deduction limit gives employers the ability to make larger
contributions to profit sharing plans and may render the money
purchase pension plan obsolete.
top of page
Defined Benefit Plans
Instead of accumulating contributions and earnings in an
individual account like defined contribution plans (profit
sharing, 401(k), money purchase), 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 ($45,000 in 2007 and $46,000 in 2008), 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
($180,000 in 2007 and $185,000 in 2008). 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.
top of page
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. |
