Plan Types

Qualified Retirement Plans

A qualified plan must meet a certain set of requirements outlined 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:

• 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.

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. 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.

457(b) Plans

A 457(b) plan is a non-qualified tax-deferred compensation plan that works very much like other retirement plans such as the 403(b) and 401(k). This plan is restricted to the government and certain nonprofits. Employers are not required to make the plan available to all employees. However, any individual who performs service for the employer, including independent contractors, are eligible to participate in the plan. The employer’s plan document should spell out specific rules for contribution and distribution.

457(f) Plans

A 457(f) nonqualified deferred compensation arrangement is a nonqualified retirement plan which gives the tax-exempt employer an opportunity to supplement the retirement income of its select management group or highly compensated employees by contributing to a plan that will be paid to the executive at retirement. All nonqualified plans for tax-exempt employer executives must satisfy 457(f) requirements.

Money Purchase Plans

This plan is a type of defined contribution plan in which the employer's contributions are determined by a specific formula, usually as a percentage of pay. Contributions are not dependent on company profits.

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.

The contribution is usually allocated to employees in proportion to compensation. It may be allocated using a formula that is integrated with Social Security, resulting in more substantial 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. The age-weighted plan allows the company to contribute up to 25% of eligible payroll each year. Unlike the typical profit-sharing plan, the total contribution to an age-weighted plan is allocated based on the employee's age. The older employees will receive a higher contribution than younger employees. This plan type is favorable when the employees targeted to receive larger allocations, are both older and more highly compensated than all other 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. The plan may also permit employees age 50 and older to make additional “catch-up” contributions, up to an annual maximum limit. Employee contributions are 100% vested at all times.

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 the earnings on the employee’s Roth contributions if the distribution meets specific 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. The employer may elect that this group is limited to the top 20% of employees based on compensation.

401(k) Safe Harbor Plans

401(k) plans require special nondiscrimination testing (ADP & ACP) which limit the deferrals of highly compensated employees to the average deferrals of the non-highly compensated employees. Quite often the passing of these tests will limit the deferrals of highly compensated employees; or will require additional contributions from the employer. The employer must provide a safe harbor notice to all employees on a timely basis. The safe harbor may be changed from plan year to plan year with appropriate notice to employees.

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.

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 Plans

Instead of accumulating contributions and earnings in an individual account like defined contribution plans (profit sharing or 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 that want to shelter more than the annual defined contribution limit may want to consider a defined benefit plan since contributions can be substantially higher, resulting in a faster 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 the highest consecutive three-year average) to an indexed maximum annual benefit. A defined benefit plan 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 cause employer contributions to decrease or increase. 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 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.

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.