Qualified
Retirement PlansWhy should you sponsor a qualified retirement plan? Qualified retirement plans are considered by most financial planners to be the best tax deferral program available today. Current contributions to the plan are not subject to corporate or personal income tax -- in fact, the plan sponsor gets to deduct the contribution (subject to certain limitations). Funds in the plan accumulate tax deferred, with the plan participants paying the income tax on the money at the time they take the plan benefits as income, at which time they are normally in a lower income tax bracket.
There are two basic types of retirement plans:
1. Defined Benefit Pension Plans
Sponsoring a DB Plan
Requirement and Limits
Special Types of Plans
2. Defined Contribution Plans
Defined
Benefit Pension Plans
Top of Page Sponsoring a DB Plan Requirements and Limits
You're interested in a defined benefit plan but you would like more information. The following is intended to be a broad overview of defined benefit plans. Please contact us for specific questions.
Sponsoring a DB Plan
Top of Section Top of Page Requirements and Limits
How the Plan Works
Each year, an actuary determines the minimum contribution the plan sponsor must contribute. The calculation is based on plan provisions (such as the normal retirement age, the benefit formula, the normal form of payment, and the actuarial equivalence stated in the plan document), the participant data (dates of birth, hire participation and termination, expected retirement age, and annual compensation), the plan's assets and assumptions about future events. We will ask you for employee data and plan asset information each year.
Based on the above factors and assumptions about future events, the actuary determines how much should be deposited each year, so that as participants reach their retirement ages, there is enough money in the plan to pay benefits.
Adding new participants, increases in compensation, amending the plan's benefit formula to increase benefits
and poor investment return will generally increase the required contributions.
More participants than expected terminating their service, good investment
return and
amending the plan's benefit formula to decrease future benefits will decrease the required contributions.
Designing the Plan
Before a plan is set up, a study is generally done to determine
the plan design that best meets the employer's objectives. These objectives may include rewarding long-term, older employees or owners or maximizing
the required contributions. Defined benefit plans are generally more
beneficial to older, long-term and higher-compensated employees. We will ask questions
of you to help design the plan that best meets your need and budget.
Adopting the Plan
Once you have decided upon the DB plan provisions, we or your
attorney will draft a plan document with the desired provisions. You will
need to adopt (sign) the plan document and notify the plan participants
no later than the last day of the fiscal year for which you want the first plan
deduction. If your plan contains language that has not been
pre-approved by the IRS, you will also have to file your plan with the IRS
for a favorable determination letter. The favorable determination
letter states that the IRS has found your plan to be a qualified plan.
Therefore, you are entitled to the tax deductions necessary to fund the
plan. We can assist you with all the paperwork to complete the adoption
of the plan. However, because your plan is a legal document, we always request that you have the plan reviewed
by legal counsel before adoption.
Benefits and Accruals
The projected benefit at retirement is the monthly benefit that a participant is expected to have earned at retirement, assuming the participant will continue to work until retirement age and earn at least the same compensation as in the last year. When a participant retires, he or she will be able to receive the monthly benefit (a life annuity) or may choose (in most plans) to receive a lump sum payment in lieu of the monthly benefit.
The accrued benefit is the portion of the projected benefit that has been earned by the participant as of a particular date. The exact calculation is dependent on the plan's provisions.
The amount of any participant's benefit is NOT directly
affected by investments earnings or the amount of plan assets.
Distributions to Plan Participants
When a participant terminates employment or reaches retirement
age, he or she will be entitled to a benefit from the plan. This
monthly benefit is payable as an annuity at the normal retirement age.
But you don't have to keep track of all the participants you have in your
plan until they reach retirement age. When an employee terminates you may distribute the benefit
in a lump sum payment form. This is the monthly
benefit converted into a single payment of equivalent value. This
is not the same as the accumulated value of the contributions deposited
in to the plan. The lump sum value is essentially the amount of money
that should be placed in an interest bearing account so that when the participant
reaches retirement age, the amount of money in the account would buy an
annuity equal to the monthly accrued benefit.
Terminating the Plan
The process of terminating a plan involves notifying participants, and for plans covered by the PBGC (see below), filing the termination for review with the PBGC. You will also have the option of having the plan termination reviewed by the IRS. Essentially, you are asking the IRS to do a “mini-audit” of your plan to make sure that your plan remains qualified through the plan termination.
The termination process for a PBGC-covered plan may take from 240 days
to more than 365 days. Distributions may be in the form of lump sums or
annuities purchased from an insurance company.
IRS Reporting
All qualified plans must file annual returns with
the IRS. (There is a limited exception for plans with less than $100,000 in
assets). As part of your annual administration, we complete those
forms, and send them to you so that you may file the forms with the IRS.
The Role of the Pension
Benefit Guaranty Corporation (PBGC)
Many defined benefit plans
are also subject to PBGC coverage.
The PBGC is a quasi-governmental agency that guarantees a certain level
of benefits that are payable from DB plans. In exchange
for this guarantee, the plan sponsor must pay an insurance premium each
year. The base premium is a per participant charge (currently $19
per participant). A variable premium based on the funded status of
the plan may also apply. We will calculate the premiums for you and
prepare the necessary filing forms. The PBGC also reviews the plan
termination to make sure participants receive all the benefits to which
they are entitled.
Controlling Required Contribution Amounts
The required contributions are based on the plan's provisions, participant data, funding assumptions and the plan's assets. If the contributions become too large, the plan's benefit formula can be amended or frozen to help contain costs. However, the changes must be adopted no later than 2½ months after the plan year end, and should not be a yearly occurrence. You should contact us as soon as possible if this situation occurs.
Special Types of Plans
Top of Section Top of Page Sponsoring a DB Plan
The comments made above apply to traditional defined benefit
plans and to defined benefit plans in general. There are two types of
specialized defined benefit plans that deserve special comments.
Cash Balance
These plans
define an annual amount to be added to a hypothetical account for each
participant. They also define an interest rate to be credited to these
hypothetical accounts. The "benefit" a participant receives is
based on these hypothetical accounts and is usually the amount in the
account. However, like any other defined benefit plan (except for 412(i)
plans), the annual contribution that an employer makes is the amount calculated
by the actuary as necessary to ensure that the plan accumulates sufficient
assets to pay benefits when due. Unlike defined contribution plans, the
amount of benefit paid to any participant is not affected by actual investment
returns. Instead, investment returns affect the future contributions of
the employer. Because a Cash Balance plan includes features of both
defined benefit and defined contribution plans, there are still many unresolved legal and
regulatory issues in the courts.
Fully Insured Plans
These plans are also known as 412(i) plans, after the section of the Internal Revenue Code in which they are described. In these plans all contributions are invested in life insurance and/or annuity contracts. The annual contribution is whatever is required under these contracts to guarantee the retirement benefit promised by the plan. At any time before retirement, the "accrued benefit" is the cash value of the underlying contracts. Many of the more complex factors for determining the required contribution or the value of benefits do not apply to these plans. There are times when a 412(i) plan may be more suitable than a traditional defined benefit plan.
Requirements and Limits
Top of Section Top of Page Sponsoring a DB Plan Limits Table
Defined benefit plans are plans in which the annual contribution is actuarially determined. The contribution is a “level amortization” of the amount necessary to pay benefits as they become due. The contribution is based on the ages, compensation, and length of service of the participants in the plan, the value of the assets already in the plan and assumptions about future events. At retirement (or termination of employment), the participant is entitled to a monthly benefit. For purposes of payment, the monthly benefit may be “converted” into a lump sum payment. The lump sum payment is based on the monthly accrued benefit and the age of the participant at the time of the distribution -- not how much money is in the plan.
Since the value of the plan's assets are a part of the
calculation of the contribution, good investment returns will help lower
the required contributions, while a less-than-expected returns may increase
the required contribution. Other factors, such as changes in compensation,
new plan participants, and employee turnover will affect the required contribution.
Contribution Requirements
The employer is required to make contributions to fund a defined benefit plan.
The plan may be amended in order to reduce required contribution. Failure to contribute the required amount may result in an excise tax. Contributions for a plan year can be deposited up to 8½ months after the end of the plan year.
Contributions to profit sharing plans are generally discretionary
- the amount of the contribution (if any) is determined annually by the
plan sponsor.
Contribution / Deduction Limits
The employer deduction limit for a DB plan is a function of the contribution calculation, not a percentage of compensation. Frequently, there is a difference between the minimum required amount and the maximum deductible amount. The employer can deposit an amount anywhere within that range. For some plans the minimum and maximum are the same.
The annual employer deduction limit for an employer with a money purchase plan or a target benefit plan is 25% of the eligible compensation of the plan participants. (Eligible compensation is compensation up to $205,000 (as adjusted for inflation) per participant.)
The annual employer deduction limit for an employer with profit sharing plan or a 401(k) profit sharing plan is also 25% of eligible compensation of plan participants. Salary deferrals of the participants no longer count as an employer contribution toward the 25% limit. The eligible compensation for each participant also is before reduction for salary deferrals and is limited to $205,000 (as adjusted for inflation).
The annual employer deduction limit for an employer with
certain combinations of two or more qualified retirement plans is 25% of eligible compensation
of plan participants, or the minimum required contribution to the defined
benefit plan, if greater. Again, eligible compensation for each
participant is limited
to $205,000 (as adjusted for inflation).
Individual Contribution Limits
Since the contribution to a defined benefit plan is not allocated to individuals, there is no individual contribution limit for a DB plan. Instead, there are annual benefit limits (see section on benefit limits for more information).
The annual contribution limit for a participant in a defined contribution plan is the lesser of $41,000 (adjusted for inflation) or 100% of compensation. This limit is not an individual plan limit, but rather applies to the total of all contributions, salary deferrals, matching contributions and forfeitures credited to all of a participant's accounts for all (defined contribution) plans of the employer, except for "catch up" contributions (see below).
In addition, the annual 401(k) deferral limit
is $13,000 per calendar year (adjusted for inflation). The deferral limit applies to
the participant and limits the total he or she may defer in a year, even
if the individual participates in plans sponsored by two or more employers.
Defined contribution plans may allow employees who are at least 50 to defer an additional $3,000 in
2004. These are called "catch up" contributions.
Individual Benefit Limits
Since the contributions to defined contribution plans are limited, there are no benefit limits for these plans.
In a DB plan, the benefit for each participant is limited to the average of the highest three consecutive years of his or her eligible compensation. This may include years before the plan was established. This limit is further reduced if the participant has less than 10 years of service with the plan sponsor. For very highly compensated employees, the benefit is also limited by a monthly dollar limit, which is reduced for a retirement age less than 62 and for less than 10 years of participation in the plan. This limit generally affects only owners and very highly compensated employees. The limit is $13,750 per month in 2004 and is indexed for inflation.
Defined
Contribution Plans
Defined contribution plans are plans in which the annual contribution is generally allocated to participants based on each participant's percentage of compensation. The allocation may be the same percentage of pay for everyone or may vary by age or compensation level (within certain limits). Each participant's account shares pro-rata in the earnings of the plan's investments. At retirement (or termination of employment) the participant is entitled to the balance in his or her account (subject to the vesting schedule.) There are various types of defined contribution plans; profit sharing, 401(k) profit sharing plans, money purchase, and target benefit are the most common.
Good investment returns benefit he plan participants; poor investment returns are also passed on to the participants. The investment return has no bearing on the amount of the required contribution to the plan. However, the trustee is responsible for investing the plan's money in a prudent manner or for making a prudent selection of investment options into which participants direct their own investments.
A profit sharing plan is a defined contribution plan with a discretionary employer contribution. Each year the employer determines the amount of the contribution. It may be anywhere from 0% to 25% of eligible compensation. The contribution may be allocated in one of many ways: pro-rata on eligible compensation, integrated with Social Security, weighted on age and compensation (“age-weighted”) or “cross-tested”. The “cross-tested” allocation method divides the participants into two or more groups, with a different contribution percentage for each group. This type of allocation must pass a special test. The “best fit” allocation method for an employer's objectives will depend on participant demographics.
A 401(k) profit sharing plan is the only plan that allows the participants to contribute some of their own money into the plan. The “salary deferral” is a portion of the participant's salary that is put into the plan rather than paid to the participant. This deferral is not subject to income tax, but is subject to Social Security tax. The 401(k) profit sharing plan may also have an employer matching contribution, and / or a profit sharing contribution. The profit sharing contribution in a 401(k) profit sharing plan may be allocated in any manner described above, including the “cross-tested” method. The 401(k) profit sharing plan must also meet additional non-discrimination requirements.
A money purchase plan is a profit sharing plan with a required contribution. Generally, the required contribution is a percentage of eligible compensation (up to 25% of eligible compensation).
A target benefit plan is a defined contribution plan with some defined benefit plan features. The contribution for each participant is based on a benefit formula (rather than a percentage of compensation), the participant's compensation, age, and some actuarial factors.