Qualified Retirement Plans Defined
Understanding all of the Qualified Retirement Plans currently available can be a confusing task. Here is a brief primer on the various plans that are most commonly used. But because IRS rules are constantly changing, using a retirement plan consultant is the best way to make sure you select the best qualified retirement plan for your company - large or small.
Here is a brief definition of the major qualified retirement plans:
Defined Benefit Plans
A defined benefit plan, funded by the employer, promises you a specific monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or more often, it may calculate your benefit through a formula that includes factors such as your salary, age, and the number of years you worked at the company. For example, your pension benefit might be equal to 1 percent of your average salary for the last 5 years of employment times your total years of service.
Defined Contribution Plans
A defined contribution plan, on the other hand, does not promise you a specific benefit amount at retirement. Instead, you and /or your employer contribute money to your individual account in the plan. In many cases, you are responsible for choosing how these contributions are invested, and deciding how much to contribute from your paycheck through pretax deductions. Your employer may add to your account in some cases by matching a certain percentage of your contributions. The value of your account depends on how much is contributed and how well the investments perform. At retirement, you receive the balance in your account, reflecting the contributions, investment gains or losses, and any fees charged against your account.
401(k) Plan
Traditional 401(k) plan is when salary deferrals are deducted on a pre-tax basis. The plan can add match at a discretionary level. A traditional plan is required to perform non-discrimination tests on the plan. The highly compensated employees and the non-highly compensated employees’ contributions are averaged and compared. The highly-compensated employees contributions can not exceed the non-highly compensated employees contributions by more than 2%. The match contribution can be subject to a vesting schedule.
Roth 401(k) Plan
Roth 401(k) plan is when the salary deferrals are deducted on an after-tax basis. The contributions are segregated from pre-tax deferrals and a counter is used to see if the contributions have been made for 5 years. The earnings on the after-tax contributions are also received tax free at distribution if the distribution is taken after the 5th year. A Roth 401(k) plan can be combined with a traditional 401(k) or a safe harbor 401(k) plan.
Safe Harbor 401(k)
Safe harbor 401(k) plan is when salary deferrals are deducted on a prê-tax basis. The plan sponsor must commit to a 3% nonelective contribution to all eligible employees or a 4% matching contribution to all employees that salary defer. If the matching contribution is used, it is matched on a basis of 100% of the first 3% and 50% of the next 2% for a total of 4%. The match must be 100% vested. These formulas automatically pass the nondiscrimination tests that are required of the traditional 401(k) plan and the top heavy test. This allows the highly compensated employees to contribute the maximum contribution – for 2008, this is $15,500 ($20,500 if the participant is the age of 50 or higher).
Profit Sharing Plan
A retirement plan option that allows you to contribute from 0% up to 25% of compensation on a discretionary basis. The company does not have to have profits in order to make this contribution. The same contribution rate must be given to all eligible employees. Vesting can be applied to these contributions when they are distributed.
New Comparability (cross-tested) Plan
A type of profit sharing plan that allows different contribution rates between tier groups set up in the plan. The discrimination tests are treated as though this was a defined benefit plan. This allows the owner or management group to receive a higher contribution rate than the rank and file employees. A proposal must be completed to make sure that all of the benefits tests can be passed before this type of plan can be utilized.
Money Purchase Pension Plan
A type of defined contribution plan with a stated rate of contribution in the plan document. The contribution must be made each and every year regardless of profits. The rate can be set from 1 to 25% of compensation and is given equally to every eligible participant. When the rules were changed to allow profit sharing plans to contribute up to 25% (up from 15%), the use of a money purchase pension plan became obsolete.
Defined Benefit Plan
As described above, this plan promises a specific benefit at retirement. This plan is ideal for a sole proprietor that would like to contribute more than $46,000 per year (the current limitation for a defined contribution plan in 2008). Depending on the salary over the last three years and any type of defined contribution amount contributed, a proposal can be prepared to show how much can be contributed on an annual basis. A maximum amount can also be set since this contribution amount is required to be funded each and every year. This plan should be kept in force for a minimum of 5 years.
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