- 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.
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.
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.
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.
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.
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.
- 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
- 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