Qualified Retirement Plans

A qualified plan must meet a certain set of requirements in the Internal Revenue Code such as minimum participation, vesting and funding requirements. In return, the IRS provides significant tax advantages to encourage businesses to establish retirement plans including:

Employer contributions to the plan are tax deductible.
Earnings on investments accumulate tax-deferred which allows 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.

In addition, sponsoring a qualified retirement plan has the following advantages:

Attract experienced employees in a very competitive job market: Retirement plans are fast becoming a key part of the total compensation package.
Retain and motivate good employees: A retirement plan has the ability to keep employees from moving over to your competitors.
Help employees save for their future since Social Security retirement benefits alone will be an inadequate source to support a reasonable lifestyle for most retirees.
Plan assets are protected from creditors.
Employers can choose between two basic types of retirement plans: defined contribution and defined benefit. Both a defined benefit and defined contribution 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.

Types of Plans

There are two basic types of employer plans; defined contribution and defined benefit. While there are a number of different types of each, two types of plans dominate the small employer market; 401(k) plans and, to a lesser extent, defined benefit plans.

Defined Contribution Plans

A defined contribution plan defines the contribution the company will make to the plan and how the contribution will be allocated among the eligible employees. Separate 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 account at the time the distribution is payable.

Employer account balances may be subject to a vesting schedule. Non-vested account balances forfeited by terminating employees can be used to reduce employer contributions or 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 $49,000 for 2011.

The maximum employer tax deduction limit 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 2011 would have a maximum deductible employer contribution of $25,000 (25% of $100,000). However, the employee could also make a $16,500 401(k) contribution to the plan. As a result the total amount credited to his account for the year would be $41,500 (41.5% of his compensation), and he would satisfy the 2011 maximum annual limit since total contributions are less than $49,000.

Profit Sharing Plans

The profit sharing plan is one of the most flexible qualified plans 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. For tax deduction purposes, the company contribution cannot exceed 25% of the total compensation of all eligible employees. The contribution is usually allocated to employees in proportion to compensation and may be integrated with Social Security which results in larger contributions for higher paid employees.

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 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 skew benefits in favor of older employees.

401(k) Plans

More and more employees perceive 401(k) plans as a valuable benefit which has made them the most popular retirement plans today. Employees can benefit from a 401(k) plan even if the employer makes no contribution. Employees voluntarily elect to make pre-tax contributions through payroll deductions up to an annual maximum limit ($16,500 in 2011). The plan may also permit employees age 50 and older to make additional "catch-up contributions" up to an annual maximum limit ($5,500 in 2011).

Often the employer will match some portion of the amount deferred by the employee to encourage greater employee participation, i.e., 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 borrow from the plan.

Employee and employer matching contributions are subject to a special nondiscrimination test which limits how much the group of employees referred to as "Highly Compensated Employees" can defer based on the amount deferred by the "Non-Highly Compensated Employees." In general, employees who fall into the following two categories are considered to be Highly Compensated Employees:

A more than 5% owner of the employer at any time during the current plan year or preceding plan year (stock attribution rules apply which treat an individual as owning stock owned by his spouse, children, grandchildren or parents); or

An employee who received compensation in excess of the indexed limit in the preceding plan year ($110,000 for 2011). The employer may elect that this group be limited to the top 20% of employees based on compensation.

401(k) Safe Harbor Plans: The plan may be designed to satisfy "401(k) Safe Harbor" requirements (certain minimum employer contributions and 100% vesting of employer contributions) which can eliminate nondiscrimination testing. The benefit of eliminating the testing is that Highly Compensated Employees can defer up to the annual limit ($16,500 in 2011) without concern for what the Non-Highly Compensated Employees defer. The majority of 401(k) plans that we manage are safe harbor plans.

New Comparability Plans

These 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 who want to maximize contributions to owners and higher paid employees while minimizing those for all other employees.

Employees are separated into two or more identifiable groups such as owners and non-owners. Each group may receive a different contribution percentage. For example, a higher contribution may be given to the owner group than the non-owner group, as long as the plan satisfies the nondiscrimination requirements.

Defined Benefit Plans

This type of plan offers much larger potential benefit and tax deductible contributions than defined contribution plans. The limit on tax deductions is based on the benefit coming out of the plan in retirement rather than a percentage of current compensation. Therefore, employers may often make much larger tax deductible contributions than a defined contribution plan allows.

Instead of accumulating contributions and earnings in an individual account like defined contribution plans (profit sharing, 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 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.

Business owners or professionals who want to shelter more than the annual defined contribution limit ($49,000 in 2011), may want to consider a defined benefit plan since contributions can be substantially higher resulting in fast 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. The maximum benefit allowable is 100% of compensation (based on highest consecutive three-year average) to an indexed maximum annual benefit ($195,000 in 2011). Defined benefit plans 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 decrease or increase the employer contributions. 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 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 rate or some recognized index like the 30 year Treasury rate. 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 contribution and interest credits. Although the plan is required to offer the employee the option of using the account balance to purchase an annuity benefit, employees generally will take the cash balance and roll it over into an individual retirement account (unlike many traditional defined benefit plans which do not offer lump sum payments at retirement).

As in a traditional defined benefit plan, the employer in a cash balance plan bears the investment risks and rewards. 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 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.

Combined Plans

Some employers will choose to maintain both a defined contribution and a defined benefit plan. This provides the maximum available tax deductable contribution and the greatest retirement benefit available through qualified plans.

The most common combined plans arrangement is the combination of a 401(k) plan with a defined benefit (or cash balance) plan. Under the rules, the business may deduct the full defined benefit contribution plus 6% of salaries in the 401(k) plan. So, participants can make salary deferral contributions from their own pay while receiving up to 6% of pay in the 401(k) plan along with the full defined benefit accrual.

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