Introduction
The primary goal of most employers in establishing any type of retirement savings
program is to provide retirement income in a tax-efficient manner. The best way
to achieve this is through a qualified retirement plan.
The benefits of establishing and maintaining a qualified plan are vast. While
not all plans are designed in the same manner, they all share the following
attributes:
- Contributions made to the plan by the employer are immediately tax deductible.
- Earnings accumulate within the plan on a tax-deferred basis.
- Plan participants do not recognize taxable income until benefits are distributed
from the plan.
- Taxable income can be further delayed by rolling over the proceeds to an
individual retirement account.
- With very few exceptions, plan assets are protected from creditors of the
employer as well as those of the individual plan participants.
This article briefly discusses the different types of qualified retirement
plans—and their available features—available for closely held businesses.
Types of Qualified Retirement Plans
There are two main types of qualified retirement plans: defined benefit plans
and defined contribution plans. While the features of these plans differ, they
both share some basic characteristics as described below.
A. Defined Contribution Plans
1. In general
Defined contribution plans are designed to provide employees with a fixed contribution
rate or amount each year. These plans are written with a specific formula to
determine exactly how each employee qualifies for a share in the contribution—and
how that contribution is then allocated among each of the employees who qualify.
An employee’s interest in the plan is expressed as an account balance.
Each year, an employee’s defined contribution account is credited with
their annual contribution and then either credited or debited with their portion
of the investment earnings within the plan. An employee’s retirement benefit
in a defined contribution plan is always based on the actual earnings of the
investments within the plan.
The different types of defined contribution plans are summarized below.
2. Profit-Sharing Plans
A profit-sharing plan is the most common form of defined contribution plan
and, in many cases, the most flexible. It is employer funded, based on one of
the following allocation formulas:
a. Non-Integrated. With a non-integrated formula (also called “pro-rata”),
each employee is allocated the same percentage of compensation.
Example: Corporation A sponsors a defined contribution plan with a non-integrated
formula of 10% of compensation. Employee 1, with compensation of $200,000,
will receive a profit sharing allocation of $20,000.
b. Integrated. With an integrated formula, each employee is given a uniform
percentage of compensation, similar to the non-integrated formula. Further,
each employee whose compensation is in excess of the Social Security Taxable
Wage Base (“Taxable Wage Base”) is given an additional percentage
of compensation in excess of the Taxable Wage Base.
Example: Corporation B sponsors a defined contribution plan with an integrated
formula of 10% of compensation, plus 5% of compensation in excess of the
Taxable Wage Base ($127,200 for 2017). Employee 1, with compensation of
$200,000, will receive the same base allocation of 10% of compensation as
other employees, or $20,000. Because, however, the compensation of Employee
1 exceeds the 2017 Taxable Wage Base by $72,800, he will also receive an
additional allocation of $3,640, for a total of $23,640.
c. New Comparability. A New Comparability plan affords the employer the maximum
flexibility in allocating contributions. Most new comparability formulas provide
that each employee is in his or her own allocation group, giving the employer
far more control over how much each employee is receiving. Because this formula
allows employers to increase or decrease contributions for select employees,
New Comparability plans must pass an annual nondiscrimination test.
The test divides the plan into two classes of employees: Highly Compensated
Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). HCEs are any
employees who either:
- earned more than the compensation threshold in the prior year ($120,000
for 2017), or
- owned directly or by attribution more than 5% of the ownership interest
in the employer.
The test essentially weighs the contributions by age, providing larger allocations
for employees who are closer to retirement and smaller allocations for employees
who are further from retirement. New Comparability is a perfect fit for closely
held businesses whose owners want to maximize their deductible contributions.
An older business owner may be able to make substantial contributions to a New
Comparability plan without having to make the same level of contribution to
the staff.
3. 401(k) Plans
A 401(k) component, technically known as a Cash or Deferred Arrangement (CODA),
is a feature where an employer allows its eligible employees to defer a portion
of their salary into the company’s defined contribution plan. These 401(k)
deferrals may either be made on a pre-tax basis, where the employee is taxed
when the funds are withdrawn at retirement or termination of service, or on
an after-tax basis, where the employee pays tax when the deferral goes into
the plan and then is not taxed on the deferrals, plus earnings, when the funds
are withdrawn (known as a Roth 401(k)).
An employee may choose to make traditional (pre-tax) 401(k) contributions,
Roth (after-tax) 401(k) contributions, or both—provided the total 401(k)
deferral does not exceed the annual IRS limit ($18,000 for 2017). Employees
who are age 50 or older may make “catch-up” 401(k) deferrals, increasing
their annual limit from $18,000 to $24,000 in 2017. Both the $18,000 deferral
limit and the additional $6,000 “catch-up” limit are subject to
annual cost of living increases.
The 401(k) contributions are also subject to an annual nondiscrimination test,
called the Annual Deferral Percentage Test (or ADP Test), which limits the permissible
contribution levels of HCEs if there is not enough participation by NHCEs. Plans
that fail this test either need to allocate an employer contribution, called
a Qualified Nonelective Contribution (QNEC) to the NHCEs, or issue taxable refunds
of elective deferrals to the HCEs.
a. Safe Harbor 401(k) Plans
Some employers have difficulty passing the ADP test due to the low level
or lack of participation by NHCEs. These employers may bypass the numerical
ADP test entirely by adding a “Safe Harbor” component to their
plan. Plans with this component must issue an annual notice to all eligible
participants prior to the start of the plan year informing them that the employer
will be making a Safe Harbor contribution for the upcoming plan year.
There are two types of Safe Harbor plans:
i. Safe Harbor Match. The employer pledges to make a matching contribution,
generally equal to (a) 100% of the employee’s first 3% of compensation
contributed as a 401(k) deferral, plus (b) 50% of the employee’s next
2% of compensation contributed as a 401(k) deferral. This contribution caps
out at 4% of the employee’s salary when they contribute at least 5%
of compensation as a 401(k) deferral.
ii. Safe Harbor Non-elective. The employer pledges to make a 3% employer
contribution to all eligible employees, regardless of whether or not they
make a 401(k) deferral for the plan year.
4. Single Defined Contribution Plan May Have Various Components
Many employers choose to design their plans with a combination of these components.
For example, an employer might want to set up a 401(k) plan for its employees
and may have a safe harbor component to ensure there are no ADP testing failures.
A New Comparability component can be added to allow the owners of the business
to maximize their retirement savings.
B. Defined Benefit Plans
In contrast to defined contribution plans, defined benefit plans provide employees
with a guaranteed benefit to be paid out of the plan at retirement. Rather than
expressing the employee’s interest in the plan as an account balance,
the employee’s interest in a defined benefit plan is generally expressed
as a monthly annuity beginning on their retirement age and payable for life.
While an employee’s account balance in a defined contribution plan fluctuates
with actual investment earnings, the investment risk of a defined benefit plan
falls solely on the employer. If the plan experiences large investment gains,
the employer’s funding requirement will be reduced. If, however, the plan
experiences large investment losses, the employer might be required to contribute
additional funds to the plan to make up for those losses.
In order to determine the employer’s annual contribution to a defined
benefit plan, the employer must enlist an enrolled actuary. The plan’s
actuary will calculate a range of permissible contribution options to satisfy
the plan’s obligation to pay retirement benefits.
Many closely held businesses establish defined benefit plans because of the
potential for much larger tax-deductible contributions. Under a defined contribution
plan, in 2017, each individual is limited to $54,000 per year in annual contributions
(increased to $60,000 if the individual makes use of the 401(k) catch-up component
described earlier). In a defined benefit plan, individuals are limited in what
they can withdraw, rather than what the employer may contribute on their behalf.
For example, an individual age 62 who has participated in a defined benefit
plan for 10 years may withdraw close to $2.7 million. Funding to that number
amounts to an average contribution of over $200,000 per year.
1. Defined Benefit Plan Formulas
a. Flat Benefit. A flat benefit formula provides a benefit percentage or
amount projected to retirement and earned over the employee’s working
lifetime. An employee may earn the full benefit upon attaining a certain age
or by completing a certain number of years of service.
Example: Corporation C sponsors a defined benefit plan that provides each
employee with a benefit equal to $800 per month payable at age 65. Employee
1 enters the plan at age 40. Employee 1 will earn or “accrue”
1/25 of the projected $800 benefit for each year he or she works for Corporation
C because he or she entered the plan 25 years prior to retirement age.
b. Unit Benefit . Unit benefit plans are more common than flat benefit plans.
Unit benefit plans provide employees with a percentage of pay or fixed dollar
amount for each year of service. Unit formulas could cap the number of years
an employee earns a benefit (e.g., 4% of compensation for each year of service,
limited to 10 years) or provide a formula for employees without a service
limit (e.g., 3% of compensation for each of the first 10 years of service
and 2% of compensation for each year of service thereafter).
2. Cash Balance Plans
A defined benefit plan with a cash balance formula is similar to a unit benefit
defined benefit plan. Cash balance plans are subject to the same funding requirements,
operations, and benefit limitations of traditional defined benefit plans, while
looking similar to a defined contribution plan.
Cash balance plans still provide employees with a fixed benefit at retirement.
Instead of expressing this benefit as a monthly annuity payable for life, a
cash balance benefit is expressed as a “hypothetical account balance.”
This hypothetical account balance is comprised of contribution credits and interest
credits. The contribution credits may be a fixed dollar amount or a percentage
of compensation and look similar to the contribution allocation of a defined
contribution plan. Interest credits, however, are not based on actual investment
gains or losses in the plan, but on a formula specified in the plan document.
Interest credits are generally either a fixed percentage earned per year or
indexed on a specific yield (such as the 30-year Treasury).
Many employers choose to establish both a cash balance plan and a defined contribution
plan for their businesses. This allows them to benefit from the higher deduction
limits provided by the cash balance plan while also retaining the added flexibility
of their defined contribution plan.
Conclusion
Regardless of the type, qualified retirement plans in any form can be a valuable
tool to save for retirement in a tax-efficient manner. These plans can be custom
designed to fit the needs of the employer and its owners. Employers should have
their current retirement plans reviewed by pension experts to ensure their plan
has adapted and grown to fit their ever-changing business needs. Whether an
employer takes advantage of the flexibility of a defined contribution plan,
the large tax-deductible contributions of a defined benefit plan, or even a
combination of the two, a qualified plan is a “must-have” for closely
held businesses.
The author wishes to thank Alex Nahoum, EA, MAAA, for his contributions to this
article.
Andrew E. Roth, Esq., JD, LLM (taxation), is a partner of Danziger & Markhoff LLP with over 30 years of experience as an ERISA attorney. Andy is a frequent lecturer in the areas of pension, profit-sharing, and employee benefits law. He has substantial experience in designing and implementing qualified plans for business owners that maximize deductible contributions on their behalf. His services include designing, drafting and obtaining IRS qualification for a broad range of defined contribution and defined benefit plans, as well as ensuring their continued compliance with applicable law. He is admitted to practice before the U.S. Tax Court, the Federal District Courts for the Southern and Eastern Districts of New York, and is a member of the New York State Bar Association. He can be reached at (914) 948-1556 or ARoth@dmlawyers.com.