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 the IRS rules are constantly changing, using a retirement plan consultant is the best way to make sure you select the best qualified plan, or plans, for your company – large or small.
Definition of a Qualified Plan:
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:
Sponsoring a qualified retirement plan offers the following advantages:
Employers can choose between two basic types of retirement plans: defined contribution and defined benefit. Both defined benefit and a defined contribution plan may be sponsored to maximize benefits.
As your retirement plan consultant, we can help you choose the right plan for your company and your employees.
Defined Benefit Plan
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 for 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 Plan
A defined contribution plan, on the other hand, does not promise you a specific benefit 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 pre-tax or after-tax (Roth) deductions. Your employer may add to your account 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, investments gains or losses, and any fees charged against your account.
A traditional 401(k) plan is when salary deferrals are deducted on a pre-tax basis. The plan can add a 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’t exceed the non-highly compensated employees contributions by “ than 2%. Any amount exceeding this 2% limit, will be returned to the highly compensated employees and taxed. Utilizing a safe harbor 401(k) plan will prevent this from occurring.
Safe Harbor 401(k)
A safe harbor 401(k) plan is when salary deferrals are deducted on a pre-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 to contribute the maximum contribution (see Contribution Limit for Retirement Plans and IRAS).
A Roth 401(k) plan is when the salary deferrals are deducted on an after tax-basis. The contributions are segregated from the 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).
Profit Sharing Plan
A retirement plan option that allows you to contribute from 0% up to 25% of compensation on a discretionary basis and it can be different for every year. 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. The contribution can use a formula that is integrated with Social Security, resulting in a larger contribution for higher paid employees. Vesting can be applied to these contributions when they are distributed. For participants not fully vested, they are contributed to a forfeitures account. Non-vested account balances (forfeitures) can be used to reduce employer contributions or can be reallocated to active participants.
New Comparability (cross-tested) Plan
A type of profit sharing plan that allows different contribution rates between tier groups (such as owners and non-owners) 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 benefit tests can be passed before this type of plan can be utilized.
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 (defined benefit plan) to provide benefits in favor of older employees.