Bryant - Course 5. Retirement Planning & Employee Benefits. 2. Qualified Retirement Plans Flashcards
Module Introduction
In many businesses these days, human resources are the single most valuable asset. With keen competition for the best people, a comprehensive benefits package, including a retirement plan, may give a company a recruiting edge and facilitate employees retention. Apart from attracting and retaining valuable employees, a competitive retirement plan may aid in improving employee morale. Establishing a retirement plan shows the employees that their employer cares about their future and their families. A retirement plan gives them even more reason to remain committed to the business and its success.
Employees without this coverage rely heavily on Social Security benefits, on their personal wealth, and on post-retirement employment for retirement income. The most essential step in the retirement planning process is recognition of the need to plan. Surveys confirm that by and large employees fail to estimate their retirement needs because of the intimidating complexity of the process.
Financial planners play an important role in understanding the technical features of retirement plans. Financial planners should use this knowledge when developing financial plans, whether their clients are employers or employees.
The Qualified Retirement Plans module will explain the characteristics of qualified retirement plans.
Upon completion of this module, you should be able to:
* State the rules and tests defining qualified plans,
* Specify regulations that govern vesting, funding, contributions, and loans,
* List the various defined contribution plans,
* Describe the features of each defined contribution plan,
* Enumerate the various defined benefit plans, and
* Explain the features of each defined benefit plan.
Module Overview
Retirement plans are either qualified or nonqualified. In contrast to nonqualified plans, qualified retirement plans receive more favorable tax benefits. On the other hand, they are also subject to very stringent government regulations.
Qualified retirement plans are either defined contribution or defined benefit plans. As the names imply, this depends on whether the plan specifies an employer contribution rate on the one hand, or guarantees a specified benefit level on the other.
To ensure that you have an understanding of qualified retirement plans, the following lessons will be covered in this module:
* Qualified Plan Characteristics
* Defined Contribution Plan
* Defined Benefit Plans
Section 1 - Qualified Plan Characteristics
The most favorable characteristic of a qualified plan is the tax benefit that it offers. The tax advantages of qualified plans mean that an employer’s dollar spent on qualified plan benefits is bigger than a dollar spent on cash compensation. This is because while the employer gets a current deduction for the cost of the plan, benefits are not taxable to employees until they are paid. The taxes that are not paid currently can be thought of as an interest-free loan from the U.S. Treasury. The time value of money leverages the value of each employer dollar. The income earned on deferred taxes directly benefits the employee but costs the employer nothing extra.
The Internal Revenue Code (IRC) defines complex rules and regulations governing qualified plans. These include age, service, coverage, funding, vesting, and loan requirements that subject the qualified plans through stringent tests. Special rules apply to key employees and those belonging to a higher income bracket. The qualified plan may also be integrated with Social Security.
To ensure that you have an understanding of qualified plan characteristics, the following topics will be covered in this lesson:
* Qualified Plan Rules
* Vesting
* Funding Requirements
* Limitations on Benefits and Contributions
* Top Heavy Requirements
* Loans
Upon completion of this lesson, you should be able to:
* Define the age and service tests for qualified plans,
* Vesting,
* State the vesting regulations,
* Explain the requirements that govern funding,
* Detail the limits on benefits and contributions,
* Specify the laws that apply to highly compensated and key employees, and
* Describe the loan requirements for qualified plans.
Describe Qualified Plans and Tax-Advantaged Plans
Many individuals in the retirement planning field often refer to any type of arrangement that allows an employer to make pre-tax contributions to tax-sheltered savings accounts as a qualified plan. Technically, this is not accurate.
Qualified Plans share unique characteristics and are made up of five types of plans:
* Profit-Sharing Plan
* Money Purchase Plan
* Target Benefit Plan
* Cash Balance Plan
* Defined Benefit Plan
Profit-Sharing, Money Purchase, and Target Benefit plans are Defined Contribution plans. Federal regulations control how much money from the employer (and sometimes from the employee) can be added to the plan each year.
* Generally, employers are limited to a maximum contribution of no more than 25% of the business’ covered compensation.
* Furthermore, each employee is limited to receiving annual additions (employer contributions, employee contributions, and forfeitures) no greater than 100% of their employee compensation or $66,000(2023).
Defined Benefit plans provide for a specific benefit to be paid at retirement.
* This may be determined by a formula based on years of service, average compensation, or other factors or due to a required annual contribution from the employer and a guaranteed rate of return in the plan.
Of these five plans, four are subject to the Minimum Funding Standard which requires the employer to either make a contribution (i.e., Money Purchase or Target Benefit) or provide a guaranteed benefit (i.e., Cash Balance or Defined Benefit). For that reason, these four plans are called Pension Plans.
The Profit-Sharing Plan is not a pension plan and has variations that are often used.
* If it is funded solely with employer stock it is referred to as a Stock Bonus.
* Another version of a profit-sharing plan which uses company stock is an Employee Stock Ownership Plan or ESOP.
* All of these fall under the category of Profit-Sharing Plans and are not considered pension plans.
Other tax-advantaged plans available to employers exist but are not considered Qualified Plans.
* These include the SEP-IRA, SIMPLE-IRA, 403(b) plan, and 457 plans. These plans have their own unique characteristics and will be discussed separately in another chapter.
Describe Qualified Plan Rules
The design of qualified pension and profit-sharing plans is a very complex subject. These plans are of great importance in an employer’s benefits program and for personal financial and retirement planning. Therefore, every planner should have a basic understanding of how these plans are structured, what they can do, and the rules for qualifying these plans.
In order to obtain the tax advantages of qualified plans, complex IRC and regulatory requirements must be met. Though these rules have many exceptions and qualifications specified in the IRC, this lesson gives the general details of these requirements.
A qualified plan must cover a broad group of employees, not just key employees, and business owners. Two types of rules must be satisfied:
* The age and service or waiting period requirements, and
* The overall coverage and participation requirements.
What are the Age and Service Requirements?
Plans often use a minimum waiting period and age requirement. This is done to avoid burdening the plan with employees who terminate after short periods of service. However, the following rules apply to such plans:
* The plan cannot require more than one year of service for eligibility.
* Any employee who has attained the age of 21 must be allowed to enter the plan upon meeting the plan’s waiting period requirement.
* As an alternative, the plan’s waiting period can be up to two years if the plan provides immediate 100% vesting upon entry.
* (This option is not available to 401(k) plans)
* No plan can impose a maximum age for entry.
* For eligibility purposes, a year of service means a 12-month period during which the employee has at least 1,000 hours of service.
Jack, age 25, has been working for Boat Company for two years and is now eligible to participate in Boat Company’ qualified plan. Boat Company must 100% vest Jack in his plan.
* False
* True
True
* The plan’s waiting period can be up to two years if the plan provides immediate (100%) vesting upon entry.
Who are considered Highly Compensated Employees?
An employee is a highly compensated employee with respect to a plan year if he or she:
* Was a greater than five percent owner as defined for top-heavy purposes at any time during either the current year or the preceding year, or
* Is a spouse, child, grandchild, or parent of a greater than 5% owner, (family attribution rules)
* Received compensation for the preceding year in excess of $150,000 (2023) (indexed) from the employer. Alternately, the employer may elect to simply identify the “top paid” of eligible employees as highly compensated.
The top-paid group of employees for a year is the group of employees in the top 20%, ranked on the basis of compensation paid for the year.
For the purpose of determining the top-paid group, the following employees may be excluded:
* Employees with less than six months of service,
* Employees who normally work less than 17½ hours per week,
* Employees who normally work for not more than six months in any year,
* Employees under the age of 21,
* Except as provided by regulations, employees covered by a collective bargaining agreement, and
* Nonresident aliens with no U.S.-earned income.
An alternative to using the $150,000 (2023) rule is to define highly compensated employees as members of the top 20% of eligible employees, ranked on the basis of compensation.
An employer would elect the top-paid group when a large number of the employees make more than the highly compensated threshold, therefore making it more difficult to satisfy the coverage rules without this election. At the employer’s election, a shorter period of service, a smaller number of hours or months, or lower age than those specified above may be used.
Former employees are treated as highly compensated employees if:
* They were highly compensated employees when they separated from service, or
* They were highly compensated employees at any time after attaining age 55.
The controlled group, common control, affiliated service group, and employee leasing provisions of IRC Section 414 must be applied before applying the highly compensated employee rules.
Describe the Coverage Requirements
In addition to the rules restricting age and service-related eligibility provisions, qualified plan coverage is further regulated through several alternative overall coverage tests. These tests are useful if an employer has legitimate business reasons for wanting a plan to cover some but not all employees. For example, a company may want the qualified plan to cover salaried employees but not commissioned salespeople.
For a plan to pass muster, it must pass any one of the following three tests:
* The Safe Harbor Test: If the plan covers at least 70% of all eligible non-highly compensated employees, it passes.
* The Ratio Percentage Test: If the percentage of non-highly compensated employees covered by the plan is at least 70% of the percentage of the highly compensated employees covered by the plan, it passes.
* The Average Benefits Test: If the average benefit enjoyed by the non-highly compensated employees covered by the plan is at least 70% of the average benefit enjoyed by the highly compensated employees covered by the plan, it passes.
What is the Safe Harbor Test?
The Safe Harbor Test is the first test of a plan that will not cover all employees.
* A plan passes the safe harbor test if at least 70% of eligible non-highly compensated employees are covered under the qualified plan.
* If a plan fails to meet the safe harbor test, the plan must pass either the ratio percentage test or the average benefit test to be qualified.
Additionally, all defined benefit plans must pass the 50/40 test.
The 50/40 test requires the defined benefit plan to cover the lesser of
* 50 employees or
* 40% or more of all eligible employees.
Angio Corporation produces and sells equipment to hospitals and doctors for use during heart surgeries. Angio employs 12 salespeople and 26 office staff. All these individuals have been with the company for more than one year and are over age 21.
Angio does not want the qualified plan to cover the sales staff. Eleven of the twelve salespeople are highly compensated and six of the office staff are highly compensated.
Will the plan pass the Safe Harbor Test?
* Yes
* No
Yes
- If a total of 17 of the employees are highly compensated, then 21 are non-highly compensated.
- Therefore, the plan would need to cover at least 15 non-highly compensated employees to pass (21 x 0.70 = 14.7).
- It will cover 20 non-highly compensated employees who work in the office and, therefore, passes the Safe Harbor Test.
What is the Ratio Percentage Test?
The ratio percentage test requires that the plan must cover a percentage of non-highly compensated employees that is at least 70% of the percentage of highly compensated employees covered.
Using the same Angio Corporation from the previous page but changing the fact pattern, if there are 12 salespeople (10 highly compensated) and 10 office people (8 highly compensated) the plan would not pass the Safe Harbor Test.
4 non-highly compensated employees x 0.70 = 2.8 therefore the plan must cover at least 3 non-highly compensated employees. With only two non-highly compensated employees in the office covered by the plan, it fails the Safe Harbor Test.
However, it passes the ratio percentage test.
* The non-highly compensated employee coverage ratio is 2 of 4, 50%.
* The highly compensated employee coverage is 8 of 18, 44.44%.
* Divide 0.50 by 0.44.
* The ratio percentage test is 112.5% which is higher than the minimum 70%, and the plan passes the test.
Although this version of the plan did not satisfy the General Safe Harbor test, it did satisfy the Ratio Percentage Test and therefore will be allowed.
What is the Average Benefit Test?
The Average Benefit Test requires that the plan must benefit a nondiscriminatory classification of employees. The average benefit is calculated as a percentage of compensation. The total average benefit for all non-highly compensated employees must be at least 70% of the average benefit for highly compensated employees.
In applying these coverage tests, certain employees are not counted, which means that they can be excluded from the plan. Employees included in a collective bargaining unit can be excluded if there was good faith bargaining on retirement benefits.
All related employers must be treated as a single employer. Thus, an employer cannot break up its business into a number of corporations or other separate units to avoid covering rank-and-file employees. However, if the employer actually has bona fide separate lines of business, the coverage and 50/40 tests can be applied as necessary, separately to employees in each line of business. This allows plans to be provided only to one line of business, or several different plans tailored to different lines of business. In determining whether a plan satisfies the 50/40 test on this basis, however, it is not required that a separate line of business have at least 50 employees.
Describe Nondiscrimination in Benefits and Contributions
Qualified plans must be nondiscriminatory with respect to highly compensated employees either in terms of benefits or employer contributions to the plan. Some nondiscriminatory formulas will, however, provide a higher benefit for highly compensated employees. For instance, contributions or benefits can be based on compensation or years of service.
Detailed regulations govern the application of the nondiscrimination requirements for contributions and benefits under IRC Section 401(a)(4). A defined contribution plan will generally be tested under the contributions test, although the plan accounts can be converted to benefits and tested under the benefits test.
* However, Employee Stock Ownership Plans (ESOPs), Section 401(k) plans, and plans with after-tax employee contributions and/or employer matching contributions may not be tested on a benefits basis.
* Section 401(k) plans and plans with after-tax employee contributions and/or employer matching contributions must continue to meet the special nondiscrimination tests for those plans.
Under the final regulations, a defined benefit plan will be nondiscriminatory if it meets a general test or a uniformity requirement and one of three safe harbors. These nondiscrimination rules for defined benefit plans compare the rate at which benefits accrue for highly compensated employees to the rate at which benefits accrue for other employees.
Describe the Integration with Social Security
Qualified plan benefit or contribution formulas can be integrated with Social Security. In an integrated plan, greater contributions or benefits generally are provided for higher-paid employees whose compensation is greater than an amount based on the Social Security taxable wage base. The difference in contributions or benefits permitted under these rules is referred to as permitted disparity.
As most employees will receive Social Security benefits when they retire, a calculation of an employee’s retirement needs must take these into account. As Social Security benefits are effectively paid out of employer compensation costs, an employer is permitted by law to take Social Security benefits into account by integrating a qualified plan’s benefit formula with Social Security benefits. Though the rules for doing so are quite complex, the financial planner should be familiar with at least the basic integration rules.
Social Security integration benefits employers from a cost point of view as it effectively reduces the cost of the qualified plan. Also, as Social Security provides a higher retirement income, relatively speaking, for lower-paid employees, Social Security integration of qualified plans permits such plans to provide relatively greater benefits for highly compensated employees, which is often an employer objective.
There are two methods for integrating qualified plans benefit formulas with Social Security:
* The excess method, and
* The offset method.
Defined benefit plans may choose to use either integration method.
Defined contribution plans may use only the excess method of integration.
What are Defined Benefit Plans?
There are two methods for integrating defined benefit formulas with Social Security:
The excess method, and
The offset method.
Under the excess method of integration with Social Security, the plan defines a level of compensation called the integration level.
* The plan then provides a higher rate of benefits for compensation above the integration level.
* A plan’s integration level is an amount of compensation specified under the plan by a dollar amount or formula.
* Benefits under the plan expressed as a percentage of compensation are lower for compensation below the integration level than they are for compensation above the integration level.
What are Maximum Integration Level Rules?
The Code and regulations provide various rules specifying what maximum integration level a plan can use, and how large the percentage spread above and below the integration level can be.
* As a general rule, a plan’s integration level cannot exceed an amount known as covered compensation.
* Qualified plans using permitted disparity generally use the Social Security wage base as the integration level.
What is the Excess Method?
Under the excess method, the benefit percentage cannot exceed the lesser of:
* 2 times the base percentage or,
* the base percentage plus 5.7%.
The difference between the base and excess benefit percentages, that is, the maximum excess allowance, can be no greater than the base percentage.
* Thus if a plan provides 10% of the final average compensation below the integration level, it can provide no more than 20% of compensation above the integration level.
What is the Offset Method?
Under the offset method of integration, the plan formula is reduced by a fixed amount or a formula amount that is designed to represent the existence of Social Security benefits.
* There is no integration level in an offset plan. The Code and regulations provide limits on the extent of an offset for Social Security.
* In particular, the rules provide that no more than half of the benefit provided under the formula without the offset may be taken away by an offset.
For example, if a plan formula provides 50% of the final average compensation with an offset, even the lowest-paid employee must receive at least 25% of the final average compensation from the plan.
A plan formula provides 40% of final average compensation with an offset. The lowest paid employee must receive at least what percentage of the final average compensation from the plan?
* 20%
* 40%
* 10%
* 60%
20%
- Code and regulations provide limits on the extent of an offset for Social Security. In particular, the rules provide that no more than half of the benefit provided under the formula without the offset may be taken away by an offset.
- In this case, the lowest paid employee must receive at least 20% of the final average compensation from the plan (0.40 x 0.50 = 0.20).
Describe Defined Contribution Plans
Defined contribution plans can be integrated only under the excess method. Generally, if the integration level is equal to the Social Security taxable wage base in effect at the beginning of the plan year, which is $160,200 (2023), the difference in the allocation percentages above and below the integration level can be no more than the lesser of:
* The percentage contribution below the integration level, or
* The greater of:
* 5.7%, or
* The old-age portion of the Social Security tax rate. The IRS will publish the percentage rate of the portion attributable to old-age insurance when it exceeds 5.7%.
Another way to state the rule is that the amount of permitted disparity is the lesser of twice the percentage contribution below the integration level or 5.7%.
For example, an integrated plan, for a plan year beginning in 2023, might have an integration level of $160,200. The plan allocates employer contributions plus forfeitures at the rate of 15.7% of compensation above the integration level. Then it would have to provide at least a 10% allocation for compensation below the integration level, making the difference 5.7%.
Percentage contribution below the integration level Maximum allowable percentage contribution above the integration level
1% 2%
2% 4%
3% 6%
4% 8%
5% 10%
6% 11.7%
7% 12.7%
8% 13.7%
9% 14.7%
10% 15.7%
11% 16.7%
12% 17.7%
Practitioner Advice:
* The integration level may be set to any salary level at or below the current social security wage base, as long as this does not create a discriminatory plan.
Describe Employee Vesting
If a qualified plan provides for employee contributions, the portion of the benefit or account balance attributable to employee contributions must at all times be 100% vested, or nonforfeitable.
Brenda works for ABC Inc. and contributes $1,500 to her qualified plan during her first year of participation. The ABC Inc. plan has a 3-year cliff vesting schedule. How much of her contributions can she take with her if she leaves ABC Inc.?
* $750
* $1,500
* $1,000
* $0
$1,500
- Brenda can take 100% of her contributions from the plan because employee contributions are always 100% vested. Employer contributions, on the other hand, follow the vesting schedule.
Describe Regular Employer Contributions
The portion attributable to employer contributions must be vested under a specified vesting schedule that is at least as favorable as one of two alternative minimum standards depending on whether the plan is a Defined Contribution Plan or a Defined Benefit Plan.
FOR DEFINED CONTRIBUTION PLANS:
* Three-Year Cliff Vesting: A plan’s vesting schedule satisfies this minimum requirement if an employee with at least three years of service is 100% vested. No vesting at all is required before three years of service.
* Two- to Six Year Graded Vesting: The plan must provide vesting that is at least as fast as the following schedule:
Years of Service Vested Percentage
2 20
3 40
4 60
5 80
6 or more 100
FOR DEFINED BENEFIT PLANS, A LONGER SCHEDULE MAY APPLY.
The portion attributable to employer contributions must be vested under a specified vesting schedule that is at least as favorable as one of two alternative minimum standards:
* Five-Year Cliff Vesting: A plan’s vesting schedule satisfies this minimum requirement if an employee with at least five years of service is 100% vested. No vesting at all is required before five years of service.
* Three- to Seven-Year Graded Vesting: The plan must provide vesting that is at least as fast as the following schedule:
Years of Service Vested Percentage
3 20
4 40
5 60
6 80
7 or more 100
Prior to 2006, employer contributions to Defined Contribution plans and Defined Benefit Plans could use either the 3-7 Year Graded or 5 Year Cliff vesting schedules. Beginning in 2007, only Defined Benefit plans can use those longer schedules. Defined Contribution plans must use the shorter “top heavy” schedules.
Describe Employer Matching Contributions
Employer matching contributions are contributions made by an employer on account of:
* An employee contribution or elective deferral, or
* Forfeiture allocated on the basis of employee contributions, matching contributions or elective deferrals.
Employer matching contributions must vest under the faster vesting schedule that is at least as favorable as one of the following two standards:
* Three-Year Cliff Vesting: A plan’s vesting schedule satisfies this minimum requirement if an employee with at least three years of service is 100% vested. No vesting at all is required before three years of service.
* Two- to Six-Year Graded Vesting: The plan must provide vesting that is at least as fast as the following schedule:
Years of Service Vested Percentage
2 20%
3 40%
4 60%
5 80%
6 or more 100%
This faster vesting schedule is also applicable to all employer contributions in Defined Contribution plans.
Please keep in mind that employers can always provide a more generous vesting schedule, which means that the employee will be vested sooner.
Using the table above, after Jamel has 4 years of service his vesting will be __ ____??____ __ of employer matching contributions.
* 0%
* 100%
* 60%
* 80%
60%
- After Jamel has attained 4 years of service his vesting will be 60% of employer matching contributions.
Describe Funding Requirements
Employer and employee contributions to a qualified plan must be deposited into an irrevocable trust fund or insurance contract that is for the exclusive benefit of plan participants and their beneficiaries.
* Pension Plans are subject to certain funding requirements that will compel the employer to provide either a contribution or the accrual of a benefit each year.
* Profit Sharing plans are subject to the less restrictive “substantial and recurring” benchmark.
Pension plans, both defined benefit and defined contribution, must meet their annual funding requirements or be subject to a penalty and/or plan disqualification.
* Profit sharing plans are not subject to the same standards. Profit Sharing plan contributions must be recurring and substantial or the IRS can deem the plan to be terminated.
* Substantial and recurring is not clearly defined in the law so that there is always some risk in repeatedly omitting contributions.
The funding requirements for defined contribution pension plans is based on the contribution amount outlined in the plan documents.
For defined benefit pension plans, the minimum funding is more complicated. The Pension Protection Act of 2006, changed the methodology for determining minimum funding in defined benefits plans. The details will be discussed later.
Define Benefit Plan Funding Requirements
An actuarial cost method determines the employer’s annual cost for a defined benefit plan.
* Actuaries use a number of different actuarial cost methods that are relatively complex mathematically. However, these methods are based on simple principles that should be understood by financial planners even though the computational complexities are left to the actuary.
* An actuarial cost method develops a series of annual deposits to the plan fund that will grow to the point where as each employee retires the fund is sufficient to fully fund the employee’s retirement benefit.
If a defined benefit plan provides past service benefits, the cost of these can be made part of the annual cost. Alternatively, the past service benefit can be funded separately by developing what is known as an unfunded past service liability or a supplemental liability.
* The supplemental liability is paid off through deposits to the plan fund over a fixed period of years, up to 30, regardless of actual retirement dates for employees. The use of a supplemental liability can provide additional funding flexibility in many cases.
The Pension Protection Act of 2006 has completely changed the funding rules for Defined Benefit Plans.
* PPA-06 requires plans to establish a “funding target” which can be thought of as 100% of the present value of the accrued benefit’s of the plan at the beginning of a year.
* Next, the plan’s “Target Normal Cost”, benefits accrued during the plan year by participants, is factored in.
If the value of the plan’s actual assets are less than the funding target, the required contribution to the plan must bring the plan assets up to the sum of the funding target and the target normal cost. In other words, the plan assets must equal the accrued benefits that the plan must pay.
Any plan shortfalls must be made up and can be amortized over seven years.
What are the Actuarial Assumptions?
Actuarial cost methods depend on making assumptions about various cost factors, as actual results cannot be known in advance. The annual cost developed under an actuarial cost method depends significantly on these assumptions, and there is some flexibility in choosing assumptions. Under the Code, each assumption must be reasonable, within guidelines in the Code and regulations. Actuarial assumptions include:
* Investment return on the plan fund,
* Salary scale, which is an assumption about increases in future salaries and is particularly significant if the plan uses a final average type of formula,
* Mortality, or the extent to which some benefits will not be paid because of the death of employees before retirement,
* Annuity purchase rate, which determines the funds needed at retirement to provide annuities in the amount designated by the plan formula,
* Assumptions about future investment return and postretirement mortality that the annuity purchase rate depends on, and
* Turnover, or the extent to which employees will terminate employment before retirement and thereby receive limited or no benefit.
Exam Tip:
* The CFP Exam will test your knowledge as to the impact of these assumptions on the funding level of the plan for each year.
* For example, if the assumption of investment return is too low, the funding may have to be increased next year.
What are the Deduction Limits?
An employer’s maximum annual deduction for contributions to a defined benefit plan is limited to the amount determined actuarially under standards set forth in Section 404(a) of the Code, or the amount required to meet the minimum funding standards, if greater. There is a full funding limitation within the minimum funding standards that limits this deduction.
The maximum amount an employer can contribute and deduct to a defined contribution plan is 25% of aggregate covered compensation.
The definition of covered compensation includes employee elective deferrals. This has the effect of creating a higher total payroll amount which allows for greater employer contribution levels.
However, employee elective deferrals are not counted as part of the 25% contribution limit placed on employers. This also allows a greater contribution by the employer as employee contributions are not part of the 25% number.
For example, Lauren owns a small security firm, Eyeballs, Inc. Payroll is $100,000 and employees have made total elective contributions to the 401(k) plan of $10,000. Because elective deferrals of $10,000 do not count toward the $25,000 limit ($100,000 x 25%), the largest contribution that Eyeballs Inc. can make to the company’s profit-sharing plan will be $25,000.
For a combination of defined benefit and defined contribution plans, the deduction limit is the greater of:
* 25% of the compensation of all participants, or
* The amount required to meet the minimum standard for the defined-benefit plan.
There is a penalty of 10% on nondeductible contributions by the employer, that is, contributions in excess of these limits.
Describe Timing of Contributions
Under the minimum funding rules:
* Defined benefit plan contributions must be paid within 8½ months after the end of the plan year, and
* Defined contribution pension plan contributions must be paid within 2½ months after the end of the plan year. This is subject to a six-month extension.
Penalties apply if the minimum funding requirements are not met.
* Profit sharing plans are not subject to the minimum funding rules.
If a defined benefit plan fails to meet certain funding requirements for a plan year, a quarterly payment requirement must be met in the following plan year. For a calendar year taxpayer, contributions are due April 15, July 15, October 15 and January 15 of the following year and corresponding dates apply to fiscal year taxpayers. A failure to make timely payments subjects the taxpayer to interest on the missed installment.
Each quarterly payment must be 25% of the lesser of:
90% of the annual minimum funding amount, or
100% of the preceding year’s minimum funding amount.
What are the Fiduciary Rules?
There are strict limits on the extent to which an employer can exercise control over the plan fund. The plan trustee can be a corporation or an individual, even a company president or shareholder.
In any case, plan trustees are subject to stringent federal fiduciary rules requiring them to manage the fund solely in the interest of plan participants and beneficiaries.
What are the Limitations on Benefits and Contributions?
To prevent a qualified plan from being used primarily as a tax shelter for highly compensated employees, there is a limitation on plan benefits or employer contributions.
What are the Defined Benefit Limits?
Under a defined benefit plan, the highest annual benefit payable under the plan must not exceed the lesser of:
100% of the participant’s compensation averaged over the three highest consecutive years of highest compensation, or
$265,000 (2023).
The $265,000 limit is adjusted in $5,000 increments under a cost-of-living indexing formula.
The $265,000 limit is also adjusted actuarially for retirement ages earlier or later than age 65.
What are the Defined Contribution Limits?
The annual additions to each participant’s account are limited for a defined contribution plan. The annual additions include:
* Employer contributions
* Employee elective deferrals
* Forfeitures reallocated from other participants’ accounts.
Please note that rollovers, participant account earnings, or age 50+ catch-up contributions are not considered in applying the annual addition limits in defined contribution plans.
The annual additions limit cannot exceed the lesser of:
100% of the participant’s annual compensation, or
$66,000(2023).
The annual additions limit is subject to indexing in increments of $1,000.
What are the Compensation Limits?
A further limitation on plan benefits or contributions is that only the first $330,000 (2023) of each employee’s annual compensation can be taken into account in the plan’s benefit or contribution formula. This is referred to as covered compensation.
* Thus, if an employee earns $400,000 annually in 2023, and the employer maintains a 10% money purchase plan, the maximum contribution for that employee would be $33,000 (10% of $330,000).
The covered compensation limit is indexed for inflation in increments of $5,000.
Exam Tip:
The covered compensation limit of $330,000 (2023) for benefit formulas applies to all qualified plans.
Be mindful of the various rules in play for a given type of plan, but remember knowing whether a plan is a defined contribution plan or a defined benefit plan is critical in solving the application-based questions you can expect on your exam.
What are the Top Heavy Requirements?
A top-heavy plan is one that provides more than 60% of its aggregate accrued benefits or account balances to key employees.
These plans must meet certain additional qualification rules.
* SIMPLE Individual Retirement Account (IRA) plans, as well as SIMPLE 401(k) plans that allow contributions only under Section 401(k)(11), are exempt from the top-heavy requirements.
* Safe harbor 401(k) plans are also exempt from the top-heavy requirements.
* This rule applies to a plan that consists solely of contributions meeting the requirements of Section 401(k)(12) and safe harbor matching contributions meeting the requirements of Section 401(m)(11).
If a plan is top-heavy for a given year, it must provide more rapid vesting than generally required. The plan can either provide 100% vesting after three years of service or 6-year graded vesting as follows:
Years of Service Vested Percentage
2 20
3 40
4 60
5 80
6 or more 100
In addition, a top-heavy plan must provide minimum benefits or contributions for non-key employees.
For defined benefit plans the benefit for each non-key employee during a top-heavy year must be at least two percent of compensation multiplied by the employee’s years of service, up to 20%. The average compensation used for this formula is based on the highest five years of compensation. Additionally, a defined benefit plan deemed top-heavy must use an accelerated vesting schedule, such as 2-to-6-year graded or 3-year cliff vesting.
For a defined contribution plan, employer contributions during a top-heavy year must be at least 3% of compensation.
Define Key Employee
A key employee, for purposes of the top-heavy rules, is an employee who, at any time during the plan year, is:
* An officer of the employer who has annual compensation greater than $215,000 (2023). The $215,000 limit is subject to future indexing
* A more-than-five-percent owner of the employer, or
* A more-than-one-percent owner of the employer who has annual compensation from the employer of more than $150,000 (not indexed).
For these purposes, no more than 50 employees will be treated as officers. If lesser in number, the greater of three or 10% of the employees will be treated as officers.
Exam Tip:
* Distinguishing between Highly Compensated Employees (HCEs) and Key Employees is essential for navigating the retirement plan selection process and understanding certain employer-provided benefits.
* Highly Compensated: More than a 5% owner or received compensation in excess of $150,000 (2023) (indexed).
* Key Employee: Greater than a 5% owner or an officer of the employer having annual compensation greater than $215,000 or a greater than 1% owner whose salary exceeds $150,000.
Here, Mike serves up a breakdown of the two categories and points out the need-to-know elements of each category.
Exam Tip: AUDIO: Highly Compensated Employees (HCEs) & Key Employees
Exam Tip:
* Distinguishing between Highly Compensated Employees (HCEs) and Key Employees is essential for navigating the retirement plan selection process and understanding certain employer-provided benefits.
* Highly Compensated: More than a 5% owner or received compensation in excess of $150,000 (2023) (indexed).
* Key Employee: Greater than a 5% owner or an officer of the employer having annual compensation greater than $215,000 or a greater than 1% owner whose salary exceeds $150,000.
Here, Mike serves up a breakdown of the two categories and points out the need-to-know elements of each category.
Need to keep these straight:
Highly Compensated Employees (HCEs) - Someone that is more than a 5% owner will ALWAYS be a Highly Compensated Employee.
* ADP
* ACP testing
* 401k
* Coverage Test, Safe Harbor Test
* Ratio Test
* Average Benefit Test
Key Employees
* Top Heavy Testing
* Qualified plans
* Group life insurance
Using the table below, identify the Highly Compensated Employees (HCEs) at BIF-Brews, Co.
Employee % Ownership Annual Compensation (2021)
Adam 3% $225,000
Brendan 6% $75,000
Jerry 3% $115,000
Mike 5% $135,000
* Adam
* Brendan
* Jerry
* Mike
Adam
Brendan
Mike
* A Highly Compensated Employee (HCE) is:
* More than a 5% owner or
* Compensated in excess of $130,000 (2021) (indexed)
As a result, Brendan (6%) and Mike (5%) meet the 5% ownership standard. Adam is considered a HCE due to his compensation in excess of $130,000 in 2021 (i.e., $225,000).
Describe Loans
Due to the 10% penalty tax on early distributions from qualified plans, a plan provision allowing loans to employees may be attractive. This allows employees access to plan funds without extra tax cost. However, a loan provision increases administrative costs for the plan and may deplete plan funds available for pooled investments.
For participants to borrow from a plan, the plan must specifically permit such loans.
* Any type of qualified plan or Section 403(b) tax deferred annuity plan may permit loans.
* Loan provisions are most common in defined contribution plans, particularly profit sharing plans.
* There are considerable administrative difficulties connected with loans from defined benefit plans because of the actuarial approach to plan funding.
* Loans from IRAs and Simplified Employee Pensions (SEPs) are not permitted.
One of the reasons that employers permit loans in 401(k) plans is to encourage non-highly compensated employees to participate. Highly-compensated employees are only allowed to defer an amount that is based on the percentage of compensation that the non-highly compensated employees defer. This is referred to as Actual Deferral Percentage and we will discuss this further.
When taking a loan from a 401(k), the interest is paid back to the participant’s account. There is a drawback to taking a loan since you are using post-tax dollars to pay this interest that will later be taxed at ordinary income rates once you take distributions from the 401(k). However, in some cases, borrowing from a 401(k) is better than other financing arrangements based on the specific facts and circumstances of a person’s situation.
The graph below shows that when a participant takes out a loan from a 401(k), there are additional record-keeping costs and increased administrative costs for the plan that are born by the plan administrator. These costs are not paid by the participant from the interest they pay themselves back on the loan.
Requirements
Loans to participants are generally prohibited transactions, subject to penalties unless such loans:
* Are exempted from the prohibited transaction rules by an administrative exemption, or
* Meet the requirements set out in Code Section 4975(d)(1).
The requirements of that section are met if:
* Loans made by the plan are available to all participants and beneficiaries on a reasonably equivalent basis
* Loans are not made available to highly compensated employees in an amount greater than the amounts made available to other employees
* Loans are made in accordance with specific provisions regarding such loans set forth in the plan
* The loans bear reasonable rates of interest, and
* The loans are adequately secured
Loans may be made from a qualified plan to:
* A sole proprietor,
* A more-than-10% partner in an unincorporated business, and
* An S corporation employee who is a more-than-5% shareholder in the corporation.
A loan from a qualified plan or a Section 403(b) tax deferred annuity will be treated as a taxable distribution if it does not meet the requirements of Code Section 72(p).
* Section 72(p) provides that aggregate loans from qualified plans to any individual plan participant cannot exceed the lesser of:
* $50,000, reduced by the excess of the highest outstanding loan balance during the preceding one-year period over the outstanding balance on the date when the loan is made, or
* One-half the present value of the participant’s vested account balance, or accrued benefit in the case of a defined benefit plan.
* A loan of up to $10,000 can be made, even if this is more than one-half of the participant’s vested benefit. For example, a participant having a vested account balance of $17,000 could borrow up to $10,000.
Loans must be repayable, by their terms, within five years, except for loans used to acquire a principal residence of the participant.
Interest on a plan loan, in most cases, will be consumer interest, which is generally not deductible by the employee, unless the loan is secured by a home mortgage. Interest deductions are specifically prohibited in two situations:
* If the loan is to a key employee, as defined in the Code’s rules for top-heavy plans, or
* If the loan is secured by a Section 401(k) or Section 403(b) tax deferred annuity plan account based on salary reductions.
Practitioner Advice:
* Many planners discourage loans from qualified plans for two reasons.
* First, the outstanding balance loses the opportunity for growth.
* Second, many plans “call the note” when an employee terminates from service. If the employee cannot pay back the outstanding loan balance within the prescribed time period (usually 60-90 days), then the outstanding loan balance is deemed a distribution subject to taxes and possibly early withdrawal penalties.
Practitioner Advice:
Practitioner Advice:
* Many planners discourage loans from qualified plans for two reasons.
* First, the outstanding balance loses the opportunity for growth.
* Second, many plans “call the note” when an employee terminates from service. If the employee cannot pay back the outstanding loan balance within the prescribed time period (usually 60-90 days), then the outstanding loan balance is deemed a distribution subject to taxes and possibly early withdrawal penalties.
Section 1 - Qualified Plan Characteristics
Qualified retirement plans must satisfy specific requirements set forth in the Internal Revenue Code. If they meet these requirements, qualified retirement plans offer employers and their employees special tax advantages. Both the employer and the employees save on taxes because the amounts they contribute are tax deductible. The employees benefit from pretax contribution because they don’t pay taxes on those earnings until they make a withdrawal.
In this lesson, we have covered the following:
* Qualified plan rules include age and service requirements and coverage requirements. To meet coverage requirements, a qualified plan must satisfy either the ratio percentage test or the average benefit test. These tests ensure that the plan benefits a nondiscriminatory classification of employees. Qualified plans can also integrate with Social Security. A qualified plan must use the excess method or the offset method for integrating its benefit formulas with Social Security.
* Vesting standards qualified plans may include a vesting schedule for all employer contributions. Defined Contribution plans must use a graded schedule that is at least as generous as two to six years graded or three-year cliff vesting. Defined Benefit plans may use a schedule that is at least as generous as three to seven years graded or five-year cliff vesting.
- Funding requirements specify that an irrevocable trust fund or insurance contract must be set up for the exclusive benefit of plan participants. Both employer and employee contributions to a qualified plan must be deposited into this fund. Pension plans must meet minimum funding standards, and profit-sharing plan contributions must be recurring and substantial. An actuarial cost method determines the annual cost for a plan, upon which the minimum funding standard depends. Funding requirements also regulate the deduction limits and timing of contributions and specify strict fiduciary rules regarding the trust fund.
- Limitations on benefits and contributions prevent a qualified plan from being used primarily as a tax shelter for highly compensated employees. The highest annual benefit payable for a defined benefit plan must not exceed the lesser of 100% of the participant’s three-year average of highest compensation or $265,000(2023). Annual additions for each participant for defined contributions plans must not exceed the lesser of 100% of the participant’s annual compensation or $66,000(2023).
- Top-heavy requirements are applicable to a plan that provides more than 60% of its aggregate accrued benefits or account balances to key employees. Such top-heavy plans must meet additional qualification rules such as rapid vesting and benefit levels or contributions for non-key employees.
- Loan provisions allow employees to borrow from the plan funds without extra tax costs. Such loans must be exempted from the prohibited transaction rules and meet the Code requirements.
A qualified retirement plan must meet stringent Code requirements. Which of the following would be most likely to result in plan disqualification?
* Attempting to integrate the plan with Social Security.
* Allowing only employees age 21 and over to be eligible for the plan.
* A requirement that employees must complete five years of service before participating in the plan.
* A provision that results in the plan covering only 70% of non highly compensated employees.
A requirement that employees must complete five years of service before participating in the plan.
* The plan would be disqualified if a five-year waiting period is imposed for plan participation. It cannot require more than one year of service for eligibility. The only exception is that it can require a waiting period of two years, if the plan provides 100% vesting upon entry.
A loan from a qualified plan to a participant must meet all of the following requirements to be exempt from treatment as a prohibited transaction except?
* It must bear a reasonable rate of interest.
* It must be made available to all participants on a reasonably equivalent basis.
* The amount of a loan must not exceed $10,000
* It must be adequately secured.
The amount of a loan must not exceed $10,000
* A reasonable rate of interest, availability to all participants on a reasonably equivalent basis and adequate securing of loans are three of the requirements for loans to be exempted from the prohibited transaction rules. However, loans may exceed $10,000, but cannot exceed $50,000.
Which of the following provisions would violate the Code’s vesting requirements for qualified retirement plans?
* In a non-top heavy Defined Benefit Plan, employees are 40% vested after five years of service, and vesting increases by 20% each year until reaching 100% after seven years.
* In a Defined Contribution plan, employees are 100% vested after three years of service, with zero vesting prior to that date.
* In a Defined Benefit plan, employees are 100% vested for a non-top-heavy plan after five years of service, with zero vesting prior to that date.
* For a non-top-heavy Defined Contribution plan, employees are 20% vested after two years of service, and vesting increases by 20% each year until fully vested in six years.
In a non-top heavy Defined Benefit Plan, employees are 40% vested after five years of service, and vesting increases by 20% each year until reaching 100% after seven years.
* In a Defined Contribution plan, the vesting schedule must not exceed the Top Heavy vesting schedules: 2-6 year graded or 3 year cliff. A Defined Benefit plan may use 3-7 year graded and 5 year cliff. Therefore, in a Defined Benefit plan, the employee must be at least 60% vested after five years of service which increases by 20% per year until full vesting in seven years.
For eligibility purposes, a year of service is defined as which of the following?
* 12-month period during which the employee has at least 1,000 hours of service.
* 12-month period during which the employee has at least 1,500 hours of service.
* 6-month period during which the employee has at least 1,000 hours of service.
* 6-month period during which the employee has at least 1,500 hours of service.
12-month period during which the employee has at least 1,000 hours of service.
- For eligibility purposes, a year of service means a 12-month period during which the employee has at least 1,000 hours of service.
Match the following:
Highly Compensated
Top-Paid Group
Key Employee
* A greater than 5% owner; an officer with income in excess of $215,000 or a greater than one percent owner with income greater than $150,000
* The group of employees in the top 20%, ranked on the basis of compensation paid for the year.
* A greater than 5% percent owner or received compensation in excess of $130,000 in the prior year
- Highly Compensated - A greater than 5% percent owner or received compensation in excess of $130,000 in the prior year
- Top-Paid Group - The group of employees in the top 20%, ranked on the basis of compensation paid for the year.
- Key Employee - A greater than 5% owner; an officer with income in excess of $215,000 or a greater than one percent owner with income greater than $150,000
Section 2 - Defined Contribution Plan
In a defined contribution plan, the employer establishes and maintains an individual account for each plan participant. When the participant becomes eligible to receive benefit payments, which is usually at retirement or termination of employment, the benefit is based on the total amount in the participant’s account. The account balance includes employer contributions, employee contributions in some cases and earnings on the account over all the years of deferral.
The employer does not guarantee the amount of the benefit a participant will ultimately receive in a defined contribution plan. Instead, the employer must make contributions under a formula specified in the plan. The principal types of defined contribution plan formulas will be discussed in this lesson.
To ensure that you have a solid understanding of defined contribution plans, the following topics will be covered in this lesson:
* Money Purchase Pension Plan
* Profit Sharing Plan
* Savings Plan
* Section 401(k) Plan
* Target/Age Weighted Plan
Upon completion of this lesson, you should be able to:
* State the principal features of money purchase pension plans,
* Describe the design of a profit sharing plan,
* Explain the working of a savings plan,
* Define structure of a Section 401(k) plan,
* State the characteristics of target age/weighted plans,
* Identify the circumstances in which each plan may be offered,
* List the advantages and disadvantages of each defined contribution plan, and
* Analyze the tax implications of each plan.
Describe Money Purchase Pension Plan
A money purchase pension plan is a qualified employer retirement plan that is, in many ways, the simplest of all qualified plans. The following are the highlights of a money purchase plan:
* Each employee has an individual account in the plan. The employer makes annual contributions to each employee’s account under a nondiscriminatory contribution formula. Usually the formula requires a contribution of a specified percentage, which may total up to 25% of the employer’s covered compensation.
* Plan benefits consist of the amount accumulated in each participant’s account at retirement or termination of employment. This is the total of employer contributions, interest or other investment return on plan assets and capital gains realized by the plan on sales of assets in the employee’s account.
* The plan may provide that the employee’s account balance is payable in one or more forms of annuities equivalent in value to the account balance.
When are Money Purchase Pension Plans Used?
A business of any size may find the money purchase pension plan suitable. The most common situations wherein a money purchase pension plan may be used are as follows:
* When an employer wants to install a qualified retirement plan that is simple to administer and explain to employees.
* When employees are relatively young and have substantial time to accumulate retirement savings.
* When employees are willing to accept a degree of investment risk in their plan accounts, in return for the potential benefits of good investment results.
* When some degree of retirement income security in the plan is desired. While accounts are not guaranteed, annual employer contributions are required. This provides a degree of retirement security that is intermediate between a defined benefit plan and a profit sharing plan.
* When an employer seeks to reward long-term employee relationships.
What are the Advantages of Money Purchase Pension Plans?
The major advantage of the money purchase pension plan is that it is not complex and expensive to design. It also guarantees that employees receive an annual contribution.
The advantages of the money purchase pension plan are as follows:
* As with all qualified plans, a money purchase pension plan provides employees a tax-deferred retirement savings medium.
* The plan is relatively simple and inexpensive to design, administer and explain to employees.
* The plan formula can provide a deductible annual employer contribution of up to 25% of aggregate covered compensation. Additionally, employees are restricted to individuals receiving total annual additions no greater than:
* $66,000(2023), or
* 100% of compensation.
Individual participant accounts allow participants to choose the investment allocation in their account from the choices offered in the plan.
What are the Disadvantages of Money Purchase Plans?
- There are some disadvantages of the money purchase plan that involve employees entering the plan at older ages, highly compensated employees and general investment risks:
-
Retirement benefits may be inadequate for employees who enter the plan at older ages. For example, an employer contributes 10% of compensation annually to each employee’s account. Assume that the plan fund earns 9% interest on average. The accumulation at age 65 for employees with varying entry ages will be as follows:
Age at plan entry Annual compensation Account balance at age 65
25 $35,000 $1,289,022
30 $35,000 $822,937
40 $35,000 $323,134
50 $35,000 $112,012
55 $35,000 $57,961
60 $35,000 $22,832
This table shows that the time factor works rapidly to increase account balances.
If a closely held corporation that has been in business for many years adopts a money purchase plan, key employees often will be among the older plan entrants. The money purchase pension plan’s failure to provide adequately for such employees, even with their high compensation levels, can be a serious disadvantage.
However, there’s another factor in realistic situations that reduces the apparent disparity between long-service and short-service employees. As salaries increase over time, the long-service/short-service disparity in the annual pension from a money purchase plan, as a percentage of final average compensation, is much less than if salaries do not increase. Click here to view a chart that shows that
* if all salaries increase at 7% annually, a 15-year employee receives a pension of 19% of final average salary while the 35-year employee gets 48% of final average salary.
* This is much less than the disparity resulting if salaries increase at only 3% annually, or do not increase at all. In short, in actual practice a money purchase plan may not be as disadvantageous to shorter service employees as it might appear.
-
In 2023, total annual additions for each employee by all plans of a single employer is limited to the lesser of:
$66,000, or
100% of compensation.
The 415 threshold limits the relative amount of funding available for highly compensated employees. - For example, if an employee earns $400,000 in 2023, no more than $66,000 annually can be contributed for that employee.
- This $66,000 represents only 20% of the $330,000(2023) of the employee’s covered compensation that can be taken into account.
- Overall, it is 15.25% of the employee’s actual income.
- Employees bear investment risk under the plan. The ultimate amount that can be accumulated under a money purchase plan is very sensitive to investment return, even for an employee who entered the plan at an early age. Click here to view a graph that shows this by comparing the ultimate account balance resulting from
- $1,000 of annual contribution at two different return rates. While bearing investment risk is a potential disadvantage to employees, it does tend to reduce employer costs as compared with a defined benefit plan.
- The plan is subject to the Code’s minimum funding requirements. Employers are obligated to make the plan contribution each year or be subject to minimum funding penalties.
What are the Design Features of Money Purchase Pension Plans?
Most money purchase pension plans use a benefit formula requiring an employer contribution that is a flat percentage of each employee’s compensation.
* Percentages up to 25% may be used.
* Only the first $330,000 in 2023 of each employee’s compensation can be taken into account in the plan formula.
Some money purchase pension formulas also use a factor related to the employee’s service.
* Service-related factors generally favor owners and key employees.
* In small, closely-held businesses or professional corporations, the use of a service-related factor might result in prohibited discrimination in favor of highly compensated employees. Plan designers generally avoid service-related contribution formulas in these situations.
Nondiscrimination regulations under Code Section 401(a)(4) provide safe harbors for money purchase pension plans with uniform allocation formulas. Alternative methods for satisfying nondiscrimination requirements include satisfying a general nondiscrimination test, restructuring or cross-testing, that is, testing defined contribution plans on the basis of benefits.
A plan benefit formula can be integrated with Social Security, also referred to as permitted disparity.
* This avoids duplicating Social Security benefits already provided to the employee and reduces employer costs for the plan.
* An integrated formula defines a level of compensation known as the integration level.
* The plan then provides a higher rate of employer contributions for compensation above that integration level than the rate for compensation below that integration level.
For example, the money purchase plan specifies an integration level of $20,000. It provides for employer contributions of 14% of compensation above the $20,000 integration level and 10% below the $20,000 integration level. Following are the details of employee Art Rambo:
Art’s earnings for this year: $30,000
Employer contribution to Art’s account this year:
14% of $10,000, which is Art’s compensation in excess of the $20,000 integration level $1,400
10% of the first $20,000 of Art’s compensation $2,000 $3,400
The Internal Revenue Code and regulations specify the degree of integration permitted in a plan.
Any of the Code’s permitted vesting provisions can be used in a money purchase plan. As money purchase plans tend to be oriented toward longer service employees, the 2-6 year graded vesting schedule is often used.
This means employees will be at least vested in 20% of the employer contributions after two years with at least an additional 20% vesting for each year following until fully vested after six years.
If an employee leaves before becoming fully vested in his or her account balance, an unvested amount referred to as a forfeiture is left behind in the plan.
* Forfeitures can be used either to reduce future employer contributions under the plan, or they can be added to the remaining participants’ account balances.
* Adding forfeitures to participants’ account balances tends to be favorable to key employees, as they are likely to participate in the plan over a long time period.
* For this reason, the IRS requires forfeitures to be allocated in a non-discriminatory manner. This usually requires forfeiture allocation in proportion to participants’ compensation, rather than in proportion to their existing account balances.
Benefits in a money purchase pension plan are usually payable at the termination of employment or at the plan’s stated normal retirement age.
* Money purchase pension plans traditionally provide that the participant’s account balance is converted to an equivalent annuity at retirement, based on annuity rates provided in the plan.
* This is the origin of the term money purchase.
* It has become more common to provide for a lump sum or installment payment from the plan as an alternative to an annuity.
* However, a money purchase pension plan, as a condition of qualification, must provide a joint and survivor annuity as the automatic form of benefit.
* The participant, with the consent of the spouse, may elect a different benefit option.
The IRS generally does not allow money purchase plans to provide for in-service distributions, that is, benefits payable before termination of employment. Distributions of employer contributions or earnings from pension plans are not permitted prior to death, retirement, disability, severance of employment, or termination of the plan.
However, plan loan provisions are allowable, although relatively uncommon. If money purchase plan assets are spun-off to a profit-sharing plan, the accounts in the new plan must retain the money purchase restrictions on in-service distributions. However, if the money purchase pension accounts are rolled over to a profit-sharing plan, the money purchase plan in-service restrictions no longer apply.
Money purchase pension plan funds are generally invested in a pooled account managed by the employer or a fund manager designated by the employer, through a trustee or insurance company. Either a trust fund or group or individual insurance contracts can be used.
What are the Tax Implications of Money Purchase Plans?
As with all qualified plans, contributions to the money purchase plan are tax-deferred. The details of the tax implications of money purchase plans are as follows:
* Employer contributions to the plan are deductible by the employer when made, so long as the plan remains qualified. A plan is qualified if it meets eligibility, vesting, funding, and other requirements of the Code. In addition, the plan must designate that it is a money purchase pension plan.
* Assuming the plan remains qualified, taxation of the employee on plan contributions is deferred. Both employer contributions and earnings on plan assets are nontaxable to plan participants until withdrawn.
* Under Code Section 415, for the year 2023, annual additions to each participant’s account are limited to the lesser of:
* 100% of the participant’s compensation, or
* $66,000.
* Annual additions include:
* Employer contributions to the participant’s account,
* Forfeitures from other participants’ accounts, and
* Employee contributions to the account.
* Distributions from the plan must follow the rules for qualified plan distributions. Certain premature distributions are subject to penalties.
* The plan is subject to the minimum funding rules of Section 412 of the Code. This requires minimum annual contributions, which are subject to a penalty imposed on the employer if less than the minimum amount is contributed. For a money purchase plan, the minimum contribution is generally the amount required under the plan’s contribution formula. For example, if the plan formula requires a contribution of 20% of each participant’s compensation, this is generally the amount required to meet the minimum funding rules.
* A plan may permit employees to make voluntary contributions to a deemed IRA established under the plan. Amounts so contributed reduce the limit for other traditional or Roth IRA contributions and are subject to the phase-out rules applicable to traditional or Roth IRAs for participants covered under a qualified retirement plan.
* The plan is subject to the Employee Retirement Income Security Act of 1974 (ERISA) reporting and disclosure rules.
What are the Alternatives to Money Purchase Pension Plans?
There are several alternatives to the money purchase pension plan. A comparison of these alternatives with the money purchase plan is listed below:
* Target benefit pension plans are much like money purchase plans, but the employer contribution percentage can be based on age at plan entry, which would be higher for older entrants. Such a plan may be more favorable where the employer wants to provide adequate benefits for older employees.
* Profit-sharing plans provide more employer flexibility in contributions but less security for participants. The limit on employer deductible contributions to a profit-sharing plan is 25% of covered compensation.
* Defined benefit pension plans provide more security of retirement benefits and proportionately greater contributions for older plan entrants, but are much more complex to design and administer.
* Nonqualified deferred compensation plans can be provided exclusively for selected executives, but the employer’s tax deduction is generally deferred until benefit payments are made. This can be as much as 20 or 30 years after the employer’s contribution is made.
* Individual retirement saving is available as an alternative or supplement to an employer plan, but except for certain IRAs, there is no tax deductibility to the employee.
Alternatives to Money Purchase Pension Plans Example
Prior to EGTTRA ‘01, many smaller employers utilized a strategy often termed Tandem Plans or Paired Plans, which used the combination of a profit-sharing plan and a money purchase plan. Employers set up these two plans if they wanted to contribute the maximum 25% of covered compensation but still wanted the flexibility to avoid contributions in certain years. In those days, the profit-sharing plan would only allow 15% contributions. In any given year, the owner may or may not decide to make a profit-sharing contribution (subject to the “substantial and recurring” requirement). The only required contribution would be 10% to a Money Purchase plan.
After EGTTRA ‘01 increased the contribution limit for Profit Sharing Plans to 25%, there no longer was any reason to keep the Money Purchase plan as the profit-sharing plan would now allow the entire contribution limit of 25% and would also provide flexibility.
Most employers who had both plans have subsequently terminated the Money Purchase plan and just use a Profit Sharing plan.
For this reason, the Money Purchase has limited value in the real world and is rarely used anymore.
One place where it is still actively used is when the employees are unionized and subject to collective bargaining.
Unions often want the employer to use a Money Purchase plan because unlike a Profit Sharing plan, it is subject to the Minimum Funding Standard and therefore, must be funded by the employer each year.
Describe a Profit Sharing Plan
A profit sharing plan is a qualified, defined contribution plan featuring a flexible employer contribution provision. The outstanding characteristics are:
* The employer’s contribution to the plan each year can be either a purely discretionary amount or, if the employer wishes, nothing at all. Otherwise it can be based on some type of formula, usually relating to the employer’s annual profits.
* Each participant has an individual account in the plan. The employer’s contribution is allocated to the individual participant accounts on the basis of a nondiscriminatory formula. The formula usually allocates employer contributions in proportion to each employee’s compensation for the year. Age-weighted formulas can be used as well.
Plan benefits consist of the amount accumulated in each participant’s account at retirement or termination of employment. This is the total of:
* Employer contributions,
* Forfeitures from other employees’ accounts, and
* The interest, capital gains and other investment return realized over the years on plan assets.
The plan usually distributes the employee’s account balance in a lump sum at termination of employment, although other forms of payout may be available or, in the case of certain plans, may be required.
When are Profit Sharing Plans Used?
A business where profits vary considerably from year to year would usually find a profit sharing plan appropriate. A profit sharing plan is structured to suit the following situations:
* When an employer’s profits or financial ability to contribute to the plan varies from year to year. A profit sharing plan is particularly useful as an alternative to a qualified pension plan where the employer anticipates that there may be years in which no contribution can be made.
* When the employer wants to adopt a qualified plan with an incentive feature by which contributions to employee accounts increase with the employer’s profits.
* When the employee group has the following characteristics:
* Many employees are relatively young and have substantial time to accumulate retirement savings.
* Employees can, and are willing to, accept a degree of investment risk in their accounts in return for the potential benefits of good investment results.
* When the employer wants to supplement an existing defined benefit plan. The advantages of a profit sharing plan tend to provide exactly what is missing in a defined benefit plan - and vice versa - so that the two together provide an ideal balanced tax-deferred savings and retirement program.
What are the Advantages of Profit-Sharing Plans?
The profit-sharing plan provides employers with the flexibility to vary the annual contributions. It is appropriate for businesses with unpredictable cash flows. It is inexpensive and simple to design and implement. Its advantages are:
* The maximum employer contribution is 25% of covered compensation.
* The maximum compensation base for each employee is $330,000(2023).
* Employees may receive annual additions up to the lesser of 100% of compensation or $66,000(2023).
* A profit-sharing plan provides maximum contribution flexibility from the employer’s viewpoint.
* Contributions can be made even if there are no current or accumulated profits. Even a nonprofit organization can have a qualified profit-sharing plan.
* As with all qualified plans, a profit-sharing plan provides employees with a tax-deferred retirement savings medium.
* The plan is relatively simple and inexpensive to design, administer and explain to employees.
* Profit-sharing plan benefits are among the most portable as they can be rolled to other plans and IRAs
* Individual participant accounts allow participants to benefit from good investment results in the plan fund.
Contributions cannot be made even if there are no current or accumulated profits in a Profit Sharing Plan.
* False
* True
False.
* Contributions can be made even if there are no current or accumulated profits. Even a nonprofit organization can have a qualified Profit Sharing Plan.
What are the Disadvantages of Profit Sharing Plans?
The disadvantages of a profit sharing plan are listed as follows:
* Like money purchase plans, retirement benefits may be inadequate for employees who enter the plan at older ages. The problem of adequate benefits is even worse in a profit sharing plan than in a money purchase plan because a profit sharing plan does not involve any required minimum annual contribution by the employer. Thus, ultimate retirement benefits in a profit sharing plan are quite speculative. Therefore, some planners consider a profit sharing plan primarily as a supplemental form of incentive-based deferred compensation and not as a retirement plan. However, this disadvantage can be reduced by using an age-weighted formula which will allow a greater percentage of contributions for older participants.
* Despite the increase in the annual additions limit, the relative amount of plan funding available for highly compensated employees represents a smaller percentage of their compensation than can be contributed for lower-paid employees.
* Employees bear investment risk under the plan. While bearing investment risk is a potential disadvantage to employees, from the employer’s viewpoint it is an advantage compared with a defined benefit plan. The employer’s risk and costs tend to be lower for a profit sharing plan.
* From the employee’s standpoint, profit sharing plans are disadvantageous compared to pension plans because there is no predictable level of employer funding under the plan. However, employees have a right to expect that employer contributions will be substantial and recurring.
Describe Employer Contribution Arrangements in Profit Sharing Accounts
Employer contributions to a profit sharing plan can be based on either:
* A discretionary provision, or
* A formula provision.
Under a discretionary provision, the employer can determine each year the amount to be contributed. A contribution can be made to a profit sharing plan even if there are no current or accumulated profits. If the employer desires to make a contribution, any amount up to the maximum deductible limit can be contributed.
An employer can omit a contribution under a discretionary provision, but IRS regulations require recurring and substantial contributions. There are no clear guidelines from the IRS as to how often contributions can be omitted. If too many years go by without contributions, the IRS will likely claim that the plan has been terminated.
* When a qualified plan is terminated, all non-vested amounts in participants’ accounts become 100% vested. This is usually an undesirable result from the employer’s viewpoint.
Under a formula provision, a specified amount must be contributed to the plan whenever the employer has profits. For example, a formula might provide that the employer will contribute 10% of all company profits in excess of $100,000. This, however, must not exceed the deduction limit that we have already discussed. The IRS does not dictate how to define profits for this purpose, so the employer can specify any appropriate formula. The most common approach is to define profits as determined on a before-tax basis under generally accepted accounting principles. As mentioned earlier, even a nonprofit corporation can adopt a profit sharing plan with contributions based on some appropriately defined surplus account.
Once a formula approach has been adopted, the employer is legally obligated to contribute the amount determined under the formula. However, formulas can be drafted that allow an omitted contribution if certain adverse financial contingencies occur. A suitable fail-safe provision of this type will avoid the necessity of amending the plan in the future if financial difficulties arise.
Describe Allocation to Participant Accounts in Profit Sharing Accounts
All profit-sharing plans, regardless of how the total amount of employer contributions is determined, must have a formula under which the employer’s contribution is allocated to employee accounts. This allocation formula must not discriminate in favor of highly compensated employees.
Most formulas make an allocation to participants on the basis of their compensation as compared with the compensation of all participants.
For example, participant Fred earns $50,000 this year. The total payroll for all plan participants this year is $500,000. For this year, the employer contributes $100,000 to the plan and the amount allocated to Fred’s account is determined as follows:
* Total employer contribution x (Fred’s Compensation/Compensation of All Participants)
* $100,000 x ($50,000 / $500,000) =$10,000
* The allocation to Fred’s account equals 1/10 of $100,000, or $10,000.
The plan must define the term compensation in a nondiscriminatory way. For instance, if compensation is defined to include bonuses and exclude overtime pay, and only highly compensated employees receive bonuses and only lower-paid employees receive overtime pay, the formula would likely be found discriminatory.
It is important to remember the $330,000 (2023) limit on the amount of each employee’s compensation that can be taken into account in the allocation formula, as well as for the 25% deduction limit discussed later.
Some profit-sharing allocation formulas also take into account the years of service of each employee. Such a formula can satisfy the nondiscrimination requirements by meeting the requirements for one of the safe harbors provided in the regulations or by utilizing cross-testing. Alternative methods for satisfying nondiscrimination requirements include satisfying a general nondiscrimination test, restructuring or cross-testing, that is, testing defined contribution plans on the basis of benefits. Plans that use these concepts are often called “cross-tested plans,” “new comparability plans,” or “comparability plans.”
The allocation formula can be integrated with Social Security. This helps the employer avoid duplicating Social Security benefits that are already provided to the employee. It also reduces the employer’s cost of the plan.
An integrated formula defines a level of compensation known as the integration level. The integration level is typically the taxable Social Security wage base ($160,200 in 2023). The plan then provides a higher rate of allocation of the employer contribution for compensation above that integration level than the rate for compensation below that integration level.
