Attention FAE Customers:
Please be aware that NASBA credits are awarded based on whether the events are webcast or in-person, as well as on the number of CPE credits.
Please check the event registration page to see if NASBA credits are being awarded for the programs you select.

Qualified Retirement Plan Design for Closely Held Businesses

Andrew E. Roth, Esq., JD, LLM
Published Date:
May 1, 2017


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.


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.

andrewAndrew 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  

Views expressed in articles published in Tax Stringer are the authors' only and are not to be attributed to the publication, its editors, the NYSSCPA or FAE, or their directors, officers, or employees, unless expressly so stated. Articles contain information believed by the authors to be accurate, but the publisher, editors and authors are not engaged in redering legal, accounting or other professional services. If specific professional advice or assistance is required, the services of a competent professional should be sought.