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Employer
Sponsored Plans
The
Internal Revenue Service provides significant tax
incentives to encourage businesses to establish retirement
plans. Tax-qualified plans enjoy favorable tax treatment
as follows:
-
Tax-deductible contributions to the plan
-
The plan does not pay income taxes on most of its
investment earnings
-
Participants are not taxed on their benefits until
they receive them
Retirement
plans can also help to attract and retain employees.
They can have a very positive effect on employees'
morale by helping them to save for their future.
Designing
the Plan to Meet Company Objectives
Proper
plan design can help to minimize costs and provide
flexibility in the amount of the annual contribution.
Eligibility
Requirements
A
plan is not required to cover all employees. Part-time
employees (less than 1,000 hrs per year) and employees
under age 21 who have worked for less than a year
can be excluded. In certain situations employees
who have worked less than two years can be excluded
if their benefits are fully vested as soon as they
enter the plan.
In
addition certain employees or classes of employees
can be excluded from plan participation regardless
of their age or how long they have worked. The extent
to which this can be done is limited by law.
Vesting
Plans can have vesting (ownership) schedules that
require participants to work a specified number
of years before they "own" 100% of their
benefit. Participants who terminate before becoming
fully vested forfeit the portion of their benefit
that is not vested. The forfeited amount is either
divided among the remaining participants or used
to reduce future employer contributions. Generally
the vesting schedule requires six years of employment
to become 100% vested.
Plan
Types
Profit
Sharing Plans
Profit Sharing Plans are the most flexible qualified
plan available. An employer can contribute and deduct up
to 25%
of the eligible employees' total compensation. The
maximum amount that can be allocated to any
one participant
is the lesser of 100% of the participant’s compensation
or $50,000. The decision to make a contribution
is
made by the employer on an annual basis and it is
not necessary to make a contribution each year.
Advantages
- Contributions
are discretionary and can vary from year to year.
-
Forfeitures from terminating employees can be reallocated
to active plan participants.
- In
certain situations a cross tested allocation
method
can produce the maximum 100%/$50,000 allocation
to an older business owner with a lower allocation
rate to non-owner employees.
401(k)
Plans
The
401(k) Plan is a profit sharing plan that also allows
employees to make contributions with pretax dollars
from their pay checks.
The
maximum amount that an employee can contribute
to
a 401(k) Plan in 2012 is $17,000.
If a person is age 50 or older, a plan may permit
a catch up contribution of $5,500 for 2012.
The
amount that highly compensated employees can contribute
is limited by the amounts contributed by the nonhighly
compensated employees. The law requires the use of
nondiscrimination tests to determine the maximum contribution
levels for highly compensated employees. If a plan
is designed to use a Safe Harbor approach, the discrimination
tests are automatically satisfied.
Advantages
- Under
certain situations no employer contributions are
required.
- The
employer can make discretionary matching and/or
profit sharing contributions.
- Employee
participation is optional.
- Employees'
contributions reduce their taxable income.
Possible
Disadvantages
- Plans
must satisfy nondiscrimination tests and if these
tests are not passed, corrective action must be
taken.
- Administration
and testing can be more complicated than for other
kinds of plans.
Money
Purchase Pension Plans
Since
Profit Sharing Plans now provide the same 25%
of compensation
deduction limits/$50,000 allocation as a Money Purchase
Pension Plan, the mandatory funding requirements
associated
with a Money Purchase Pension Plan are not as attractive
as they once were.
Defined
Benefit Plans/Cash Balance Plans
A
defined benefit plan promises to pay participants
a specified monthly income at retirement. The amount
of monthly benefits is usually based upon the
participant's
compensation and years of service. The maximum amount
of annual retirement income is the lesser of the
highest
consecutive three-year average compensation or $200,000.
Contribution levels are determined by an actuary,
based on actuarial assumptions about future pay increases,
investment performance, years until retirement and
life expectancy after retirement.
Contributions
to a Defined Benefit Plan are mandatory and must satisfy
minimum standards. Larger contributions must be made
on behalf of older participants to fund a specified
benefit level because an older participant has fewer
years remaining until retirement.
Advantages
- Contributions
for older business owners and key employees can
be substantially higher in a defined benefit plan
than in other types of retirement plans.
- Cash Balance Plan can be operated in combination with a 401K plan to provide substantial contributions to business owners and key employees.
Possible
Disadvantages
- The
promised benefit must be provided to all participants
regardless of the actual investment performance
of the plan. Poor investment performance could result
in increased contribution amounts from the employer.
- Termination
of a defined benefit plan that is overfunded could
result in an excise tax to the employer ranging
from 20% to 50% on the amount of excess assets.
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