Retirement plans are known by many different names. You may have heard the terms 401(k), profit sharing plan, a pension, TSA or 403(b). These are all types of retirement plans with many different characteristics but also with some similarities. All retirement plans are actually divided into two categories: Defined Benefit and Defined Contribution.
A defined benefit pension plan promises to pay a fixed monthly benefit upon retirement. A formula or benefit level is defined. Employer contributions are determined actuarially on the basis of benefits payable, mortality, work force turnover and other factors. Certain benefits may be insured by the Pension Benefit Guaranty Corporation (PBGC), a government agency. These plans do not offer “individual accounts”. However, while a cash balance plan may appear to have "accounts", it is technically a defined benefit pension plan subject to minimum funding standards.
A defined contribution plan, also known as an “individual account plan”, provides for a separate account for each participant. Contributions are made by the employer under a specified formula. Employees may also be permitted to voluntarily contribute a portion of their salary under a cash or deferred arrangement. Contributions accumulate along with investment earnings, in the employee’s account. There are several different types of defined contribution plans – profit sharing, 401(k), 403(b), money purchase, stock bonus and ESOP, target benefit, SIMPLE and SEPs.
Retirement plans are excellent tax shelters regulated by the Internal Revenue Service. It is highly recommended that employers and employees utilize these plans to take charge, to save and to prepare for retirement with “Tax Deferred Savings”.
What is a Retirement Plan?
“Qualified” Retirement Plan Defined
The term “qualified” means the plan is afforded special tax treatment by meeting requirements defined by the Internal Revenue Code (the laws). The Employee Retirement Income Security Act of 1974 (ERISA) is a technical piece of legislation enacted in the early 1970’s. It deals with the establishment, operation and administration of employee benefit plans. ERISA defines an “employee pension benefit plan” or “pension” as any plan, fund or program which provides retirement income to employees or results in a deferral of income by employees for periods extending to the termination of employment.
Advantages and Benefits
A qualified retirement plan is one of the best ways to take charge and prepare to save for an employee's retirement. There is no better way for a company to accumulate a retirement benefit for its loyal employees—and the business owners—than to establish a tax deferred retirement plan.
There are numerous benefits for employers to establish retirement plans for their company.
A company is allowed a current tax deduction for its contributions to the plan. An employee pays no taxes on money contributed until a distribution is made. Earnings from the investments made with funds in the plan accumulate tax-free. Distributions from the plan may be afforded favorable income tax treatment.
New Employee Recruitment
A qualified retirement plan assists an employer in attracting and recruiting employees. It provides an incentive for current employees to be more productive for the good of the company. It helps to decrease employee turnover by giving employees the opportunity to accumulate funds over time for their retirement and for the security of their loved ones in the future.
Working Owners and Self-Employed Individuals
A qualified retirement plan is very attractive to working owners of closely held corporations and to self-employed individuals. It gives them the best opportunity to accumulate large sums through tax free buildup of contributions.
Retirement Plans Protected
Plans are always protected from creditors such as bankruptcy, the courts, liens, etc.
How a Plan Works
The administration and enforcement of ERISA is complex. The Department of Labor (DOL), the Treasury (Internal Revenue Service) and the Pension Benefit Guaranty Corporation (PBGC) divide jurisdiction over plans. Hence, each government agency has its own rules and regulations.
There are four basic rules all retirement plans must meet to “qualify” for favorable tax treatment:
The plan must be a definite written program.
The plan must be communicated to the employees.
The plan must be permanent.
The plan must prohibit the use or diversification of funds for purposes other than the exclusive benefit of the employees or their beneficiaries.
There are rules related to minimum coverage, minimum participation, discrimination, vesting, minimum distributions, minimum benefits, joint and survivor annuity rights, commencement of benefit payments, limitations on benefit accrual and contributions, compensation limits, defined benefit assumptions, plan loans, domestic relations orders, reporting, as well as many other compliance related issues.
Therefore, it is important to understand your role in a retirement plan. Plan sponsor, plan administrator, trustee, administrative committee member, participant, party-in-interest, fiduciary, highly compensated employee, member of controlled group or affiliated service organization, enrolled actuary, officer, owner, key employee, beneficiary, etc. Each role is important and has to comply with the rules that govern it. Would you consider yourself any one of these? If so, ABA is here to assist you in the operational aspects of the plan.
In summary, it is very important to keep your team of advisors involved in your retirement plan. In the establishment and administration of your retirement plan, the assistance of an independent Third Party Administrator (TPA) can greatly contribute to the success of your plan. ABA is a professional independent TPA that is ready and willing to take a hands-on approach in helping you maintain the “qualified” status of your plan. We will assist you in performing all testing, required reporting to interested parties and adherence to federal regulations. Changes to the laws governing qualified plans occur regularly. We will keep you abreast of these changes and assist you in the continued qualification of your plan.
Types of Qualified Plans
Qualified plans provide you the opportunity to offer a retirement program for you and your employees. They enhance your competitive position in the marketplace, provide tax deductions through contributions and administrative expenses, motivate employees to take more interest in the company’s success and provide for an improved lifestyle at retirement.
Profit Sharing Plans
Profit sharing plans are the most flexible plan with respect to the amount of the contribution made each year. Contributions are generally discretionary but the company must agree to make “substantial" and “recurring” deposits. In years when the company does not make profits, it could elect to forgo or limit the amount of contribution to be made for a particular year.
These plans involve the sharing of company profits with the employees each year. The plan must define the formula for allocating these contributions to employees. There are various methods in which profit sharing contributions can be allocated to eligible participants:
Compensation to total compensation (pro-rata)
Permitted Disparity (Integration)
Tiered approach with “cross-testing”
Units such as years of services
The maximum contribution that may be made by the company each year is 25% of eligible compensation. In some cases individual participants may receive an amount greater than 25% due to the allocation formula, but in no event, can the funding/deductibility of the employer contribution exceed 25% on a company level. In certain situations safe harbor plans provide an excellent opportunity for retirement savings for the highly compensated employee while assuring the non-highly are benefiting.
401(k) Plans and 403(b) Plans
Currently, 401(k) plans are the most popular type of plan with employees and employers. There are many similarities between a 401(k) plan and a 403(b) plan. Yet, there are many differences as well. In 2001, IRS regulated less differences and more similarities.
403(b) plans are only available to certain types of employers. Examples of eligible 403(b) employers are: certain non-profit organizations, public education organizations, hospital service organizations and self-employed ministers.
Both types of plans allow for pre-tax employee contributions and Roth. Plans may include matching employer contributions and non-elective contributions. The employee's contribution is called a deferral and it is deducted from the employee's pay. These deferrals are limited by law to an annual amount. In 2017, the maximum is $18,000. This amount may be increased by the government each year. The sum of all employee and employer contributions for a given participant in any year cannot exceed the lesser of $54,000 or 100% of the participant’s compensation. Employees age 50 and above may also make additional deferrals in excess of the $18,000 annual limit. For the employees over the age of 50, these extra deferrals are called catch-up contributions. The maximum catch-up contribution for 2017 is $6,000. Deferrals can be pre-tax or after-tax. An after-tax deferral is also known as a Roth contribution.
401(k) Plans can also provide for various safe harbor provisions. 403(b) plans that only contain employee deferrals are not considered ERISA plans.
Defined Benefit Pension and Cash Balance Plans
A defined benefit pension plan pre-defines the monthly benefit amount an employee will receive beginning at normal retirement age. The employer is required in most cases to provide the minimum funding requirements, regardless of profitability. The annual contribution is calculated utilizing actuarial methods. These plans require additional government reporting.
A newer trend in plan design is to combine some aspects of defined benefit plans with some aspects of a defined contribution plan. This plan type is called a cash balance plan. In choosing this type of plan design, employers are able to maximize the amount they can contribute to their own accounts while reducing employee costs and also giving their employees the opportunity to defer and receive contributions to their own accounts.
Money Purchase Pension Plans
Company contributions are mandatory and usually based solely on each participant’s compensation. The obligation to fund this plan is what makes it different from a profit sharing plan. If the company fails to make a contribution, a penalty tax to the company is imposed.
Retirement benefits are based upon how much is in the participant’s account at the time of retirement—whatever pension the money can purchase. The maximum formula allowed under this plan is also 25% of compensation.
Target Benefit Pension Plans
A target benefit plan type is a cross between a defined benefit pension plan and a money purchase pension plan. It is like a defined benefit plan in that contribution allocations are based upon an amount needed to accumulate a fund sufficient to pay a projected retirement benefit (the target benefit) to each participant at retirement age. It is like a money purchase plan because in no event will a participant receive more than a money purchase plan will allow. This is why it is a “target” and not a “defined” benefit. This plan is not very popular.
Employee Stock Ownership Plans (ESOP)
An ESOP allows employees to become stockholders in the company through employer contributions of cash and/or company stock. These plans are governed by many complex rules. Plans may be leveraged or non-leveraged.
Stock bonus and employee stock ownership plans provide benefits similar to those of profit sharing plans, except that the contributions by the employer are not necessarily dependent on profits. Contributions to these plans must primarily be made in shares of company stock.
A stock plan can be used as a market for company stock, as a method of increasing the cash flow of the company, a means of financing the company’s growth or an estate planning vehicle for the owner of a closely held corporation.
SIMPLE 401(k) Plans
SIMPLE stands for Savings Incentive Match Plan for Employees. These types of plans are advantageous for employers because they eliminate most of the reporting requirements imposed on other qualified plans. To qualify, an employer must have 100 employees or less who earned at least $5,000 in compensation during the previous year. Also, the employees cannot maintain any other type of employer sponsored retirement plan. For 2017, and employee can defer up to $12,500. Each year the employer is required to make an employer non-elective or matching contribution.
Simplified Employee Pension (SEP)
SEPs are intended to encourage small employers to setup retirement plans for their employees by removing much of the expense and paperwork associated with pension plans. An employer may contribute up to the lesser of $54,000 in 2017, or 25% of compensation to individual retirement accounts (IRAs) for each employee.
SEPs have slightly different rules related to eligibility, vesting, testing, contribution limits and withdrawals.
Health and Welfare Benefit Plans
A health and welfare benefit plan is not a retirement plan. It is a benefit plan that provides non-retirement benefits such as medical, dental, life insurance, apprenticeship and training, scholarship funds, severance pay, disability, etc. Benefits are provided through insurance contracts or policies issued by an insurance company. Plans that cover at least 100 employees are subject to ERISA reporting. Hence, they must file Form 5500 annually and provide each employee with a Summary Annual Report each year.
Offering a Qualified Retirement Plan for your employees enhances your competitive position in the marketplace, provides tax deductions of the contributions and administrative expenses, motivates employees to take more interest in the company's success and can provide for an improved lifestyle at retirement for you and your employees.
ABA can help you design a custom retirement plan that meets the needs of your business and employees.
EVERY QUALIFIED PLAN IS UNIQUE. EACH PARTICIPANT'S GOALS ARE UNIQUE.