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. |
