Whether you are a sole proprietor, partnership or a corporation, there are several types of qualified
retirement plans that can meet your needs. A retirement plan can serve many purposes, from tax
sheltering income to attracting and retaining employees. General information about the most popular
types of retirement programs
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.
• 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 can help you maintain key
employees and reduce turnover.
• 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.
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 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 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 $51,000 in 2013 and $52,000 in 2014.
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 2014 would have a maximum
deductible employer contribution of $25,000 (25% of $100,000). However, the employee
could also make a $17,500 401(k) contribution to the plan. As a result the total amount
credited to his account for the year would be $42,500 (42.5% of his compensation), and
the contributions would meet the 2014 maximum annual limit since total contributions
are less than $52,000.
PROFIT SHARING PLANS
The profit sharing plan is generally the most flexible 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, the company contribution cannot exceed 25% of the total
compensation of all eligible employees. The maximum eligible compensation that can be
considered for any single employee is $255,000 in 2013 and $260,000 in 2014.
The contribution is usually allocated to 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.
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 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.
401(k) PLANS
Employees perceive 401(k) plans as a valuable benefit which has 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 ($17,500 in
2013 and 2014). 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 2013 and
2014). 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.
Many employers offer employees the opportunity to take hardship withdrawals or
borrow from the plan. 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 or her spouse, children, grandchildren or parents); or
• An employee who received compensation in excess of the indexed limit in the
preceding plan year (indexed limit is $115,000 in 2013 and 2014). 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 which can eliminate nondiscrimination testing. The Safe Harbor
requirements include certain minimum employer contributions and 100% vesting of
employer contributions that are used to satisfy the Safe Harbor requirements. The
benefit of eliminating the testing is that Highly Compensated Employees can defer up to
the annual limit ($17,500 in 2013 and 2014) without concern for what the Non-Highly
Compensated Employees defer.
NEW COMPARABILITY PLANS
New comparability 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 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.
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 ($51,000
in 2013 and $52,000 in 2014), 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 ($205,000 in
2013 and $210,000 in 2014). 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.
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.
©2013 Benefit Insights, Inc. Source: Preferred Pension Planning Corporation.