There is no better way for a company to accumulate
a substantial nest egg for its loyal employees --and
the working owner --than to establish a tax-favored
What are the basic tax advantages of a qualified
A qualified plan must meet a certain set of requirements
in the Internal Revenue Code such as minimum participation,
vesting and funding requirements. In return, the IRS
provides significant tax advantages to encourage businesses
to establish retirement plans including:
- Employer contributions to the plan are tax deductible.
- Earnings on investments accumulate tax-deferred
which allows contributions and earnings to compound
at a faster rate. (IRC 401, 501)
- Employees are not taxed on the contributions
and earnings until they receive the funds. (IRC
- Employees may make pretax contributions to certain
types of plans.
- Income taxes on certain types of distributions
may be deferred by rolling over the distribution
to an IRA or to another retirement plan. (IRC 401(a)(31),
- Ongoing plan expenses are tax deductible.
In addition, sponsoring a qualified retirement plan
has the following advantages:
- Attract experienced employees in a very competitive
job market--retirement plans are fast becoming
a key part of the total compensation package.
- Retain and motivate good employees--you don't
want to lose them to your competitors because of
the qualified plans they are offering.
- Help employees save for their future since Social
Security retirement benefits alone will be inadequate
to support a reasonable lifestyle for most retirees.
- Plan assets are protected from creditors.
Types and Choices of Plans
The range of retirement plan alternatives is extensive;
our consultants can help you choose the right plan
for your company.
Qualified retirement plans generally fit into one
of two broad categories: Defined Contribution plans
and Defined Benefit plans.
What is a Defined Contribution plan?
A defined contribution plan defines the contribution
the company will make to the plan and how the contribution
will be allocated among the eligible employees. A defined
contribution plan provides for an individual account
for each participant and for benefits based solely
upon the amount contributed to the participant's account,
and any income, expenses, gains and losses, and any
forfeitures of accounts of other participants which
may be allocated to such participant's account. 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 ultimate retirement
benefit cannot be predicted. The employee's retirement,
death or disability benefit is based upon the amount
in his account at the time the distribution is payable.
Employer account balances may be subject to a vesting
schedule. Non-vested account balances forfeited by
terminating employees can be used to reduce employer
contributions, plan expenses, or be reallocated to active participants.
Defined contribution plans include the following:
- Money Purchase Pension plans
- 401(k) plans
- Target Benefit
- Profit Sharing plans
- Age Based Profit Sharing
- Comparability Plans
- Thrift or Savings plans
- 403(b) plans
- Stock bonus plans
- Employee Stock Ownership Plans
- Simplified Employee Pensions (SEPs)
- Savings Incentive
Match Plans for Employees (SIMPLE plans)
Three major characteristics of a retirement plan
being classified as a defined contribution plan:
- plan contributions are determined by formula
and not by actuarial requirements (except for target
- plan earnings and losses are
allocated to each participant's account and do not
affect the company's retirement plan costs; and
- plan benefits are not insured by the Pension Benefit
Guaranty Corporation (PBGC).
What is a Money Purchase Pension plan?
A money purchase pension plan operates like a profit
sharing plan. The major difference is that, unlike
profit sharing plans where employers are permitted
to make discretionary contributions each year, the
employer has a set contribution rate which is stated
in the plan document. Contributions are generally based
on a fixed percentage of each employee's compensation.
For tax deduction purposes, the company contribution
cannot exceed 25% of total compensation to a maximum
of $49,000 per employee in 2010. The contribution may
be integrated with Social Security which results in
larger contributions for higher paid employees.
Forfeitures that occur because of employee turnover
may reduce future contributions of the company or may
be used to increase the benefits of remaining participants.
Retirement benefits are based on the amount in the
participant's account at the time of retirement.
The obligation to fund the plan makes a money purchase
pension plan different. In most profit sharing plans,
there are generally no unfavorable consequences for
the company if it fails to make a contribution. However,
if the company maintains a money purchase pension plan,
its failure to make a contribution can result in the
imposition of a penalty tax. Contributions must
be made to a money purchase pension plan even if the
company has no profits. With the increase in the primary
limitation on tax-deductible contributions to a profit
sharing plan to 25 % of total compensation, there is
little reason for an employer to adopt or continue
to maintain a money purchase pension plan.
What is a Target Benefit plan?
A target benefit plan is a hybrid or cross between
a defined benefit plan and a money purchase pension
plan. It is like a defined benefit plan in that the
annual contribution is determined by the amount needed
each year to accumulate (at an assumed rate of interest)
a fund sufficient to pay a projected retirement benefit
(the target benefit) to each participant on reaching
retirement age. Thus, if a target benefit plan contains
a target formula, such as 40 percent of compensation,
that is identical to the benefit formula in a defined
benefit plan and is based on identical actuarial assumptions
(e.g., interest rates, mortality, employee turnover),
the employer's initial contribution for the same group
of employees will be the same.
However, this is where the similarity ends. In a
defined benefit plan, if the actual experience of the
plan differs from the actuarial assumptions used (for
example, if the interest earned is higher or lower
than the assumptions), then the employer either increases
or decreases its future contributions to the extent
necessary to provide the promised benefits. In a target
benefit plan, however, the contribution, once made,
is allocated to separate accounts maintained for each
participant. Thus, if the earnings of the fund differ
from those assumed, this does not result in any increase
or decrease in employer contributions; instead, it
increases or decreases the benefits payable to the
In this regard, the target benefit plan operates
like a money purchase pension plan. In fact, the only
difference between a money purchase pension plan and
a target benefit plan is that in a money purchase pension
plan contributions are generally determined and allocated
as a percentage of current compensation; in a target
benefit plan, contributions are determined as if the
plan were to provide a fixed benefit. In a money purchase
pension plan, contributions for identically compensated
employees are the same even though their ages differ;
in a target benefit plan, age is one of the factors
that determine the size of the contributions. Because
older employees have less time in which to have their
benefits funded, employer contributions on their behalf
are greater, as a percentage of compensation, than
for younger employees. Consequently, target benefit
plans appeal to employers that desire to benefit older
What is a Profit Sharing plan?
A profit sharing plan is a defined contribution plan
to which the company agrees to make "substantial
and recurring," although generally discretionary,
contributions. Amounts contributed to the plan are
invested and accumulate (tax-free) for eventual distribution
to participants or their beneficiaries either at retirement,
after a fixed number of years, or upon the occurrence
of some specified event (e.g., disability, death, or
termination of employment). The profit sharing plan
is one of the most flexible qualified plans available.
Unlike contributions to a pension plan, contributions
to a profit sharing plan are usually keyed to the existence
of profits. However, neither current nor accumulated
profits are required for a company to contribute to
a profit sharing plan. Even if the company has profits,
it can generally forgo or limit its contribution for
a particular year if the plan contains a discretionary
formula. Although most profit sharing plans adopt a
discretionary contribution formula, others adopt a
fixed contribution formula.
A profit sharing plan must provide a definite predetermined
formula for allocating the contributions made to the
plan among the participants. A formula for allocating
the contributions among the participants is definite
if, for example, it provides for an allocation in proportion
to the compensation of each participant.
The maximum annual amount that may be credited to
an employee's profit sharing account is limited to
the lesser of 100% of compensation or $49,000 for 2010
Although the percentage limit has substantially increased
from 25% to 100%, there are still tax deduction limits
that must be taken into consideration. For example,
the maximum company profit sharing deduction is limited
to 25% of total compensation.
As with other defined contribution plans, retirement
benefits in profit sharing plans are based on the amount
in the participant's account at retirement. Unlike
defined benefit plans, forfeitures in profit sharing
plans arising from employee turnover may be reallocated
among the remaining participants.
What is an Age-based Profit Sharing plan?
An age-based profit sharing plan is a profit sharing
plan that uses both age and compensation as a basis
for allocating employer contributions among plan participants.
This concept is similar to a target benefit plan, where
age and compensation are factors used to determine
the amount of the employer contribution.
All of the basic requirements that apply to regular
profit sharing plans also apply to an age-based profit
sharing plan. An age-based profit sharing plan can
have a discretionary contribution formula and provide
the employer with flexibility over the amount of the
contribution to be made each year.
Because age is a factor, this type of plan favors
older employees who have fewer years than younger employees
to accumulate sufficient funds for retirement. For
purposes of satisfying the nondiscrimination requirements,
an age-based profit sharing plan is tested under the
What is a Comparability plan?
These plans, sometimes referred to as "cross-tested
plans," are profit sharing or money purchase pension
plans (defined contribution 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 defined
contribution nondiscrimination testing. New comparability
plans are generally utilized by small businesses who
want to maximize contributions to owners and higher
paid employees while minimizing those for all other
Employees are separated into two or more identifiable
groups such as owners and non-owners. Each group may
receive a different contribution percentage. For example,
a higher contribution may be given to the owner group
than the non-owner group, as long as the plan satisfies
the nondiscrimination requirements.
As with an age-based profit sharing plan, to satisfy
the nondiscrimination requirements, a comparability
plan is tested under the cross-testing rules. A
comparability plan must contain a definite predetermined
formula for allocating contributions made to the plan
among the participants.
What is a Thrift or Savings plan?
A thrift or savings plan is a defined contribution
plan in which employees are directly involved in contributing
toward the ultimate benefits that will be provided.
The plan can be in the form of a money purchase pension
plan or a profit sharing plan.
These plans are contributory in the sense that employer
contributions on behalf of a particular employee are
geared to mandatory contributions by the employee.
Employees can participate in the plan only if they
contribute a part of their compensation to the plan.
Employer contributions are made on a matching basis
--for example, 50 percent of the contribution made
by the employee. The plan may permit the employer,
at its discretion, to make additional contributions
and may also permit employees to make voluntary contributions.
A contributory plan must satisfy a nondiscrimination
test that compares the relative contribution percentages
of HCEs with those of NHCEs. 401(K) Plans have
for the most part replaced these types of plans.
What is a 401(k) plan?
A 401(k) plan is a qualified profit sharing or stock
bonus plan that offers participants an election to
receive company contributions in cash or to have these
amounts contributed to the plan. An eligible
employee may make a cash-or-deferred election (CODA)
to have the employer make a contribution to the plan
on the employee's behalf or pay an equivalent amount
to the employee in cash. The amount contributed to
the plan under the CODA on behalf of the employee is
called an elective contribution. Subject to certain
limitations, elective contributions are excluded from
the employee's gross income for the year in which they
are made and are not subject to taxation until distributed.
More and more employees perceive 401(k) plans as
a valuable benefit, which has made them the most popular
retirement plans today. Employees can benefit from
a 401(k) plan even if the employer makes no contribution.
Employees voluntarily elect to make pre-tax contributions
through payroll deductions up to an annual maximum
limit of $16,500 in 2010.
Beginning in 2002, employees age 50 and older were
able to defer an additional amount (referred to as "catch-up
contributions"). The catch-up contribution amounts
increase after 2002 by $1,000 each year until reaching
$5,500 in 2010.
Often the employer will match some portion of the
amount deferred by the employee to encourage greater
employee participation, i.e., 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 borrow from the plan.
Employee and employer matching contributions are
subject to a special nondiscrimination test which limits
how much the group of employees referred to as a "Highly
Compensated Employees" can defer based on the
amount deferred by the "Non-Highly Compensated
Employees." The plan may be designed to satisfy "401(k)
Safe Harbor" requirements (certain minimum employer
contributions and 100% vesting of employer contributions)
which can eliminate this nondiscrimination test.
Benefits attributable to employer contributions to
a 401(k) plan generally may not be distributed without
penalty until the employee retires, becomes disabled,
dies, or reaches age 59 1/2. Contributions made by
the employer to the plan at the employee's election
are non-forfeitable (i.e., 100 percent vesting is required
at all times).
For years beginning before 1997, state and local
governments and tax-exempt organizations were prohibited
from maintaining 401(k) plans, unless the plan was
established prior to May 6, 1986, in the case of a
plan sponsored by a state or local government, or prior
to July 2, 1986, in the case of a plan sponsored by
a tax-exempt organization. This prohibition did not
apply to a rural cooperative plan. For years beginning
after 1996, 401(k) plans are available to tax-exempt
organizations, but remain unavailable to state and
local governments other than a rural cooperative plan.
Employees who participate in 401(k) plans assume
responsibility for their retirement income by contributing
part of their salary and, in many instances, by directing
their own investments. Each 401(k) plan participant
will need to consider the investment objectives, the
risk and return characteristics, and the performance
over time of each investment option offered by the
plan in order to make sound investment decisions. Fees
and expenses are one of the factors that will affect
the investment returns and will impact the participant's
What is a Stock Bonus plan?
A stock bonus plan is similar to a profit sharing
plan, except that benefit payments must be made in
shares of stock of the company. However, a stock bonus
plan may distribute cash to a participant, subject
to the participant's right to demand a distribution
of employer securities. Further, if the plan permits
cash distributions and the employer securities are
not readily tradable on an established market, participants
must be given the right to require the company to
repurchase the shares of stock it distributes to
them under a fair valuation formula.
What is an Employee Stock Ownership Plan (ESOP)?
An ESOP is a type of profit sharing plan that is
required to invest primarily in the employer's stock.
Although the rules surrounding an ESOP are somewhat
unique and differ from those which apply to a regular
profit sharing plan, the general principals are the
As the name implies, employees have some ownership
in the employer. As owners, employees may be more motivated
to improve corporate performance because they can benefit
directly from company profitability.
What is a Simplified Employee Pension (SEP)?
A SEP is a defined contribution plan that takes the
form of an individual retirement account (IRA) but
is subject to special rules. A SEP may be adopted by
both incorporated and unincorporated businesses.
What is a Savings Incentive Match Plan for Employees
A SIMPLE plan may be adopted by small employers who
do not maintain another employer-sponsored retirement
plan covering the same employees. A SIMPLE plan may
be either in the form of an IRA for each employee (in
this case, the employer cannot maintain any other qualified
retirement plan whether or not covering the same employees)
or part of a 401(k) plan.
If established in an IRA form, a SIMPLE plan will
not be subject to the nondiscrimination rules generally
applicable to qualified retirement plans (including
top-heavy rules), and simplified reporting requirements
will apply. A SIMPLE plan may be adopted by both incorporated
and unincorporated businesses.
What is a Defined Benefit plan?
A defined benefit plan is a retirement plan "other
than an individual account plan." In other words,
a plan that is not a defined contribution plan is classified
as a defined benefit plan. Under a defined benefit
plan, retirement benefits must be definitely determinable.
For example, a plan that entitles a participant to
a monthly pension for life equal to 30 percent of monthly
compensation is a defined benefit plan. The most common
types of defined benefit plans are flat benefit plans
and unit benefit plans.
If a plan is categorized as a defined benefit plan:
(1) plan formulas are geared to retirement benefits
and not to contributions (except for cash balance plans);
(2) the annual contribution is usually actuarially
determined; (3) certain benefits may be insured by
PBGC; (4) early termination of the plan is subject
to special rules; and (5) forfeitures reduce the company's
cost of providing retirement benefits.
Participants begin to earn (accrue) retirement benefits
as soon as they become a participant in a defined benefit
plan. However, they do not obtain a permanent right
to the benefits (become vested) until they have worked
a minimum period of time, as specified in the plan.
The participants will then have a legal right to receive
a portion, or all, of the benefits at retirement age,
even if they change jobs and go to work for another
employer before reaching retirement age. Participants
may lose their accrued benefits if they leave employment
before becoming vested, even if they return to the
same employer in later years. For example, a worker
who leaves a company after four years of service and
returns after a five-year break can lose credit for
the first four years. Being vested means that a participant
covered by a defined benefit plan has completed sufficient
years of service and is entitled to receive benefits
accrued under the plan, whether or not the participant
continues with the company until retirement.
amount earned in a defined benefit plan is determined
by a formula that is spelled out in the plan. Usually,
it involves compensation and years of service. The
longer someone works under the same defined benefit
plan, the larger the retirement benefit. Some plans
are integrated with Social Security benefits. This
means that, in these plans, retirement benefits can
be reduced because of Social Security coverage.
benefit plans usually are funded entirely by the employer.
Employers generally contribute enough annually to cover
the normal cost of the plan --an amount that is at
least the value of the benefits that participants in
the plan have earned that year. In addition, employers
may have to make additional contributions for various
reasons, such as to make up for any investment losses
by the plan. If an employer fails to make the legally
required contributions, the employer can be assessed
taxes for each year the deficiency exists. The IRS
may permit the employer to pay the contribution in
future years under a funding waiver arrangement.
Who To Call
To learn more about the services FBA has to offer
or to obtain a customized proposal request form, please
call, fax or E-mail:
Richard (Dick) Watson
Direct Line: (504) 849-1030
Fax: (504) 835-9296
He will be happy to assist you or schedule an appointment
to discuss how FBA can be your Retirement Plan Resource.