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.
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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.
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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.
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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.
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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.
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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.
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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), 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.
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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. |
