Defined Defined Contribution Plans
Profit Sharing Plans
New Comparability Plans
Defined Contribution Plans
Under a defined contribution plan, the contribution that the company makes to the plan and how the contribution will be allocated among the eligible employees is defined. Individual 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 or her account at the time the distribution is payable.
Employer account balances may be subject to a vesting schedule. Non-vested account balances forfeited by former 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—$53,000 in 2015 & 2016.
Tax deduction limits 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 2016 would have a maximum deductible employer contribution of $25,000 (25% of $100,000). However, the employee could also make a $18,000 401(k) contribution to the plan. As a result the total amount credited to his account for the year would be $43,000 (42% of his compensation), and the contributions would meet the 2015 & 2016 maximum annual limit since total contributions are less than $53,000.
Profit Sharing Plans
The profit sharing plan is generally the most flexible qualified plan 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 maximum eligible compensation that can be considered for any single employee is $265,000 in 2015 & 2016.
The contribution is usually allocated to employees in proportion to compensation and may be allocated using a formula that is integrated with Social Security, resulting 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 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 to skew benefits in favor of older employees.
More and more employees perceive 401(k) plans as a valuable benefit. This 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—$18,000 in 2015 & 2016.
The plan may also permit employees age 50 and older to make additional “catch-up contributions” up to an annual maximum limit of $6,000 in 2015 & 2016.
The employer will often 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 special nondiscrimination tests that limit how much the group of employees referred to as “Highly Compensated Employees” can defer based on the amounts deferred by the “Non-Highly Compensated Employees.” In general, employees who fall into the following two categories are considered to be Highly Compensated Employees:
- An employee who owns more than 5% 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 (indexed limit is $120,000 for 2015). 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 that can eliminate nondiscrimination testing. The Safe Harbor requirements include certain minimum employer contributions and 100% vesting of employer contributions that are used to satisfy the Safe Harbor requirements. The benefit of eliminating the testing is that Highly Compensated Employees can defer up to the annual limit of $18,00 0in 2015 & 2016. without concern for what the Non-Highly Compensated Employees defer.
New Comparability Plans
New comparability 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 that want to maximize contributions to owners and higher paid employees while minimizing those for all other eligible 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.
For more information on Defined Contribution Plans, contact us today.
Defined Benefit Plans
Cash Balance Plans
Defined Benefit Plans
Instead of accumulating contributions and earnings in an individual account like defined contribution plans (profit sharing, 401(k), etc.), a defined benefit plan promises the employee a specific monthly benefit payable at the retirement age specified in the plan. Defined benefit plans are usually 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.
Employers who want to shelter more than the annual defined contribution limit ($53,000 in 2015 & 2016), 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. Benefits may be integrated with Social Security, which reduces the plan’s benefit payments based upon the employee’s Social Security benefits. The maximum benefit allowable is 100% of compensation (based on highest consecutive three-year average) to an indexed maximum annual benefit ($210,000 in 2015 & 2016). 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 that 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.
For more information on Defined Benefit Plans, contact us today.