Qualified Retirement Plans
A qualified plan must meet a certain set of requirements set forth in
the Internal Revenue Code such as minimum coverage,
participation, vesting and funding requirements. In return, the IRS
provides tax advantages to encourage businesses to establish retirement
- Employer contributions to the plan are tax deductible.
- Earnings on investments accumulate tax-deferred, allowing
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
- Ongoing plan expenses are tax deductible.
In addition, sponsoring a qualified retirement plan offers the
- Attract experienced employees in a very competitive job market:
Retirement plans have become a key part of the total compensation
- Retain and motivate good employees: You don't want to lose them
to your competitors because of the qualified plans they are
- 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.
- Qualified plan assets are protected from creditors of the
employer and employee.
Employers can choose between two basic types of retirement plans:
defined contribution and defined benefit. Both a defined contribution and
a defined benefit 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.
Defined Contribution Plans
Under a defined contribution plan, the contribution that the company
will make 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 (i.e., 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
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 can 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 $53,000 in 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 an $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
(43% of his compensation), and the contributions would meet the 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
that is 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
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
Amounts contributed to the plan accumulate tax free and are
distributed to participants at retirement, after a fixed number
of years or upon the occurrence of a specific event such as
disability, death or termination of employment.
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 provide benefits in favor of older
More and more employees view 401(k) plans as a valuable benefit
which has made them the most popular type of retirement plan today. Employees
can benefit from a 401(k) plan even if the employer makes no
contribution. Employees can voluntarily elect to make pre-tax contributions
through payroll deductions up to an annual maximum limit ($18,000 in
2016). The plan may also permit employees age 50 and older to make
additional "catch-up" contributions, up to an annual maximum limit
($6,000 in 2016). Employee contributions are
100% vested at all times.
The plan may also permit employees to make after-tax Roth contributions
through payroll deductions instead of pre-tax contributions. Roth
contributions allow an employee to receive a tax-free distribution of the
contributions and of the earnings on the employee's Roth contributions if the
distribution meets certain requirements.
The employer will often match some portion of the amount deferred by
the employee in order to encourage greater employee participation (e.g., 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 to borrow from
Employee and employer matching contributions are subject to special
nondiscrimination tests which 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 business at any time
during the current plan year or immediately preceding plan year (ownership
attribution rules apply which treat an individual as owning stock
owned by his or her 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 in 2016). The employer may elect that this group be limited to the
top 20% of employees based on compensation.
401(k) Safe Harbor Plans
may be designed to satisfy "401(k) Safe Harbor" requirements which 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 ($18,000 in 2016) without concern for
how much the Non-Highly Compensated
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 for owners and higher paid employees, while minimizing
for all other eligible employees.
Employees are divided into groups based on valid business
classifications, i.e., owners and non-owners. Each group may receive a different contribution
percentage. For example, a higher contribution percentage may be given
for the owner
group than for the non-owner group, as long as the plan satisfies the
Defined Benefit Plans
Instead of accumulating contributions and earnings in an individual
account like defined contribution plans (profit sharing or 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 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 that want to shelter more than the annual defined
contribution limit ($53,000 in 2016) may want to
consider a defined benefit plan since contributions can be substantially
higher, resulting in a faster 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 the highest
consecutive three-year average) to an indexed maximum annual benefit
($210,000 in 2016). A defined benefit plan 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 cause employer contributions
to decrease or increase. 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 that is 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 fixed rate or some recognized index like the 30 year
U.S. Treasury bond rate which could vary. 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
contributions and interest credits. Although the plan is required to
offer the employee the option of using the account balance to purchase
an annuity benefit, most employees will take the cash balance and
roll it over into an individual retirement account (unlike in many
traditional defined benefit plans which do not offer lump sum payments
As in a traditional defined benefit plan, the employer bears the investment risks and rewards
in a cash balance plan. 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 they 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.