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401(k) And Qualified Plans: Introduction
During retirement years, income for retirees usually comes from three primary sources:
- social security benefits
- the regular savings account of the retiree
- retirement-plan savings, such as IRAs and employer-sponsored retirement plans
A qualified plan is established by an employer to provide retirement benefits for employees and their beneficiaries. Unlike SEP and SIMPLE IRAs, a qualified plan is not IRA based nor subject to the same rules concerning contributions and distributions. The same types of business may chose either a qualified or IRA-based plan, but the decision usually depends on the contribution limits (and how much the business wants to or can afford to contribute) and the employer's desire or ability to handle the administration of the plan. Qualified plans require more complex administration than SEP and SIMPLE IRAs.
A qualified plan may be a defined-benefit plan or a defined-contribution plan. Qualified plans allow the employer a tax deduction for contributing to the plan, and employees typically do not pay taxes on plan assets until these assets are distributed; furthermore, earnings on qualified plans are tax deferred.
In order for a plan to maintain its qualified status, it must operate in accordance with requirements as provided by the Internal Revenue Code (IRC), the Department of Labor (DOL) and the Employee Retirement Income Security Act (ERISA) of 1974.
Defined-Benefit Plans
Under a defined-benefit plan, employees' retirement benefits are predetermined by their compensation, years of service and age. For example, the plan may determine that upon retirement an employee will receive 1% of his or her average salary for the last five years of employment for every year of service with the employer. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement.
Let's use an example to demonstrate:
John was employed by ABC Company for 10 years, and during the last five years of employment, John's compensation was as follows:
2004 - $55,000
2005 - $60,000
2006 - $70,000
2007 - $80,000
2008 - $90,000
John's average compensation for these last five years of employment is $71,000, and 1% of John's average salary for these five years is $710.
Under the provisions of the plan, John will receive $710 for 10 years, that is, 1% of his average salary for his last five years of employment for the number of years he was employed by the company.
The employer will make contributions that, based on actuarial assumptions including projected growth of investments, are required to reach the predetermined retirement benefit. Should the performance of plan investments fall below the projected amount, the employer is required to make additional contributions to make up for the shortfall.
The contribution limits for defined-benefit plans are significantly higher than the limits of defined-contribution plans.
The operation of a defined-benefit plan, which is beyond the scope of this tutorial, may require the assistance of an actuary as contributions are based on actuarial assumptions and formulas.
Defined-Contribution Plans
A defined-contribution plan does not promise a specific amount of benefit at retirement. Employees or employers (or both) contribute to these plans. Typically, the contribution will be a percentage of compensation up to a certain dollar amount. Depending on the plan type, the contributions made by the employer may be mandatory or discretionary. The contributions are invested on the employee's behalf, and the benefits paid to employees are based on contributions and any earnings or loss. For defined-contribution plans, employers are not required to make up for any loss on investments. A defined-contribution plan can be a profit-sharing plan, an employee stock ownership plan (ESOP), a 401(k) plan or a money-purchase pension plan.
Plan Definitions
Profit-Sharing or Stock-Bonus Plans
A profit-sharing plan is used for sharing profits from the business with employees, but an employer may make profit-sharing contributions regardless of whether the business had profits for the year. Contributions to the plan are usually discretionary, which means that the employer may choose not to contribute to the plan every year. Despite this flexibility, however, the employer must take care not to allow too many consecutive years to pass before contributions are made. The IRS does not specify how many consecutive years are unacceptable but does indicate that contributions to the plan must be substantial and recurring.
A stock-bonus plan is a type of profit sharing by which a corporation uses its own stock to make contributions and distributions. These plans, however, are not available to sole proprietorships and partnerships.
A profit-sharing and stock-bonus plan may include a 401(k) plan feature.
Profit-sharing and stock-bonus plans are suited for employers who are newly established and are unable to determine profit patterns or who want to have flexibility with making plan contributions.
Money-Purchase Pension Plan
In general, an employer has more flexibility in contributing to a profit-sharing plan than to a money-purchase pension plan or a defined-benefit plan.
Contributions to a money-purchase pension plan are fixed and are not based on business profits. For example, if according to the plan each participant will receive 10% of eligible compensation, each eligible employee must receive the contribution without regard to the employer's profits for the year.
A money-purchase pension plan is suited for employers who are able to determine profit trends and do not mind being mandated to make contributions to the plan each year.
401(k) Profit-Sharing Plan
A 401(k) plan is a qualified plan that allows employees to defer receiving compensation in order to have the amount contributed to the plan. This arrangement is commonly referred to as a cash or deferred arrangement (CODA). Contributions deferred by employees are referred to as elective deferrals, which are typically made to the 401(k) plan on a pre-tax basis. An employer may chose to have a stand-alone 401(k) plan or a profit-sharing plan with a 401(k) feature. The employer may also choose to make matching, nonelective or profit-sharing contributions to the plan. A 401(k) plan is suited for an employer who wants employees to assist with funding the plan.
Age-Weighted Plans
An employer may add an age-weighted feature, which allocates a higher percentage of plan contributions to older employees. The assumption is that older employees have less time before they retire and therefore less time to accumulate retirement savings. Age-weighted plans are suitable for business owners who are considerably older than their employees and who may not have had the opportunity to accumulate retirement savings in their earlier years.
Employee Stock Ownership Plans (ESOPs)
Employee stock ownership plans (ESOPs) are a form of defined-contribution plan by which the investments are primarily in the employer's stock. Congress authorized the creation of ESOPs as one method of encouraging employee participation in corporate ownership.
Why Establish a Qualified Plan?
For a business, choosing the right retirement plan is one of its most important financial decisions because the plan must suit not only the employer's immediate needs but also its financial and business profile.
A qualified plan offers benefits to both employer and employees:
Benefits for Employers
- Employers may receive a tax deduction for plan contributions.
- Employers are able to attract and retain high-quality employees. A qualified plan may be the tiebreaker that wins over a skilled person who is offered relatively similar compensation packages from different potential employers.
- Employers may be able to claim a tax credit for part of the ordinary and necessary costs of starting up the plan, if these expenses are incurred in tax years beginning after Dec 31, 2001. With a maximum of $500 per year for each of the first three years of the plan, the credit equals 50% of the cost to set up the plan, administer it and educate employees about it.
Benefits for Employees
- Employees are provided with some guarantee that their retirement years will be financially secure.
- For plans that provide salary-deferral features, employees are able to defer paying taxes on a portion of their compensation until their retirement years, when their tax bracket may be lower.
- Some plans allow employees to borrow from the plan. The interest paid on the loan amount is credited to the employee's account, unlike interest on loans obtained from financial institutions, which is paid to the financial institution.
Next: 401(k) And Qualified Plans: Eligibility Requirements
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