Retirement Plans

Qualified Retirement Plans

A qualified plan must meet a certain set of requirements set forth in the Internal Revenue Code such as minimum coverage, participation, vesting and funding requirements. In return, the IRS provides tax advantages to encourage businesses to establish retirement plans including:

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  • 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.

Qualified plan assets are protected from creditors of the employer and employee. Employers can choose between two basic types of retirement plans: defined contribution and defined benefit. Both a defined contribution and a defined benefit 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.

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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 can 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 $54,000 in 2017.

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 2017 would have a maximum deductible employer contribution of $25,000 (25% of $100,000). However, the employee could also make an $18,000 401(k) contribution to the plan. As a result the total amount credited to his account for the year would be $43,000 (43% of his compensation), and the contributions would meet the 2017 maximum annual limit since total contributions are less than $54,000.

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 $270,000 in 2017.

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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.

Amounts contributed to the plan accumulate tax deferred and are distributed to participants at retirement, after a fixed number of years or upon the occurrence of a specific event such as disability, death or termination of employment.

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 provide benefits in favor of older employees.

401(k) Plans

More and more employees view 401(k) plans as a valuable benefit which 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 can voluntarily elect to make pre-tax contributions through payroll deductions up to an annual maximum limit ($18,000 in 2017). The plan may also permit employees age 50 and older to make additional “catch-up” contributions, up to an annual maximum limit ($6,000 in 2017). Employee contributions are 100% vested at all times.

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The plan may also permit employees to make after-tax Roth contributions through payroll deductions instead of pre-tax contributions. Roth contributions allow an employee to receive a tax-free distribution of the contributions and of the earnings on the employee’s Roth contributions if the distribution meets certain requirements.

The employer will often match some portion of the amount deferred by the employee in order to encourage greater employee participation (e.g., 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 to 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 business at any time during the current plan year or immediately preceding plan year (ownership 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 $120,000 in 2017). 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 ($18,000 in 2017) without concern for how much 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 that want to maximize contributions for owners and higher paid employees, while minimizing contributions for all other eligible employees.

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Employees are divided into groups based on valid business classifications, e.g., owners and non-owners. Each group may receive a different contribution percentage. For example, a higher contribution percentage may be given for the owner group than for the non-owner group, as long as the plan satisfies the nondiscrimination requirements.

Defined Benefit Pension Plan (DBPP)

A tax qualified plan which regulates the amount of tax deductible contribution made by an employer each year by the means of a formula that “defines” the benefit to be paid to a Participant at their retirement is a defined benefit plan. This type of plan requires an independent arbiter, called an enrolled actuary, to verify the annual funding of the plan meets legal requirements. One way to think of this is to say that the employer promises to have enough at retirement to pay for a set monthly benefit. From current day until retirement the employer will make a contribution so that it will grow sufficiently to reach that set benefit.

DBPP Combo Plan

If an employer wishes to, they may adopt more than one plan type. Many choose to adopt both a defined contribution and a defined benefit plan. The current laws covering tax qualified plans allow for a “meshing” of the two disparate plans, in a manner that is beneficial to a business owner. An employer can use both plans to meet a pre-determined benefit for each participant. In essence, the defined benefit plan will have part of its benefit obligations met by the defined contribution plan. This is not a requirement, but it is available to an employer.

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 that is 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.

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Each employee’s “account” receives an annual contribution credit, which is usually a percentage of compensation, and an interest credit based on a guaranteed fixed rate or some recognized index like the 30 year U.S. Treasury bond rate which could vary. 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 contributions and interest credits. Although the plan is required to offer the employee the option of using the account balance to purchase an annuity benefit, most employees will take the cash balance and roll it over into an individual retirement account (unlike in many traditional defined benefit plans which do not offer lump sum payments at retirement).

As in a traditional defined benefit plan, the employer bears the investment risks and rewards in a cash balance plan. 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 they 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.

Prevailing Wage

Prevailing Wage is part of a 401(k) plan

An Employer will make a Prevailing Wage Contribution for Participants who perform Prevailing Wage service based on the hourly contribution rate for the Participant’s employment classification.

For this purpose, Prevailing Wage service is any service performed by an Employee under a public contract subject to the Davis-Bacon Act or to any other federal, state or municipal prevailing wage law. The Employer will make an Employer Contribution based on the hourly contribution rate for the Participant’s employment classification. Special restrictions may apply in order for Prevailing Wage Contributions to be taken into account for purposes of satisfying the applicable federal, state or municipal prevailing wage laws. The Employer may attach an Addendum to the Adoption Agreement setting forth the hourly contribution rate for the employment classifications eligible for Prevailing Wage Contributions. The Employer will make a contribution for each Participant’s Prevailing Wage Service.

403(b) Plans

403(b) plan, is a retirement plan for certain employees of public schools, employees of certain tax-exempt organizations, and certain ministers. Plan sponsor: Not-For-Profit Organization (as well as Public schools, Colleges and Universities).

Cash Balance Combo Plans

A cash balance plan is a defined benefit plan and:

  • Allows the same large deductions as a defined benefit plan
  • Requires actuarial certification
  • Follows all defined benefit rules as to disclosure, et cetera
  • Easily understood and operated, but –

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  • Owners and employees receive an account statement each year
  • Statement has opening balace, contributions, interest credits and closing balance
  • Participants always know the value of their account
  • No requirement to actuarially convert monthly benefit to lump sum. The account balance is the lump sum
  • Interest credits can be a flat amount (i.e. 5%) or tied to other indices
  • Plan termination liability is sum of account balances

Defined Benefit Combo Plans

Profit Sharing plan can have a 401(k) feature or not.

The advantages of a combo plan include:

  • Each owner/partner/participant can generally have an individualized annual contribution amount
  • Contributions to the Profit Sharing Plan reduce the amount of contributions that would otherwise be required in the Cash Balance Plan, minimizing employee costs

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  • All employees generally can get the same annual contribution as a percent of pay or a Flat $$ amount
  • An older employee WILL NOT require a high contribution as in a defined benefit plan
  • Flexibility in contributions from year to year due to:
  • Ability to develop and use credit balanced in Cash Balance Plans
  • Ability to timely amend Cash Balance Plan
  • Inherent flexibility in the Profit Sharing contribution
  • Ability to develop individual investment strategies for each plan
  • Conservative for Cash Balance (since IRS limits ultimate cash benefit – currently around $2.75 Million)
  • More growth-oriented for Profit-Sharing/401(k) since there is no limit on the ultimate benefits from the plan
  • Plan administration fees generally take into account that asset and participant information comes from one source