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Appendix A: types of qualified plans.

INTRODUCTION

Qualified plans may be either profit sharing, stock bonus, or pension plans. In addition, the terms "defined benefi plan" and "defined contribution plan" are also used to classify retirement plans. This appendix highlights the major distinguishing features of each of these types of plans.

Profit Sharing Plans

The term "profit sharing plan" describes a method by which a company distributes all or some of its profits to its employees. The most typical kind of profit sharing plan consists of a relatively informal arrangement whereby the employer simply pays cash bonuses to its employees. However, qualified profit sharing plans defer the actual receipt of the funds by the employees under much more formal arrangements. They are a type of plan which is qualified under IRC Section 401 and, as such, are given certain tax benefits and are subject to a number of rules and regulations.

Profit sharing plans do not necessarily have to be "retirement" plans since they may provide for distributions while participants are still employed. A 401(k) plan (or cash or deferred arrangement), is a profit sharing plan that permits employees to contribute a portion of their current compensation on a tax-deferred basis.

Although most companies' contributions to qualified profit sharing plans come from current or accumulated profits, contributions may be made even if a company has no profits. For additional details on profit sharing plans, see "PROFIT SHARING PLANS," below.

Stock Bonus Plans

A qualified stock bonus plan is a type of qualified plan under which the benefits are generally in the form of the stock of the employer. The employer's contributions to the plan may be made in stock or cash and the amount contributed may vary from year to year. In operation the stock bonus plan works very much like a profit sharing plan. For additional information on stock bonus plans, see "STOCK BONUS PLANS," below.

Pension Plans

A pension plan represents a commitment by a company to provide retirement benefits to its employees, regardless of its profitability. Regulations under the Internal Revenue Code require that a pension plan provide that either definitely determinable contributions be made to the plan for each participant or definitely determinable benefits be paid from the plan to each participant.

While a qualified profit sharing or stock bonus plan may distribute benefits to participants who are still employed, a qualified pension plan may provide benefits only upon retirement or other earlier termination of employment. Money purchase pension plans are described at "MONEY PURCHASE PLANS," below.

Defined Benefit Plans

A defined benefit plan is a form of retirement plan in which the benefit is expressed as a certain amount which will be paid at the participant's retirement. For example, plan that provides $1,000 per month to every retiring participant is a defined benefit plan, as is a plan which provides that each retiring employee will be paid an amount equal to 4% of his average annual compensation multiplied by his years of service with the company. All defined benefit plans are thus pension plans which provide definitely determinable benefits.

Because a defined benefit plan promises a certain benefit to an employee at his retirement, the employer is responsible for contributing to the plan the amount of funds necessary to pay benefits when they are due. An actuary must be retained to determine what dollar level of contribution is necessary. The actuary must make several assumptions, the most important of which are the rate of return on the investments made with the plan contributions and the rate of future salary increases of the participants. If the investments perform better than the actuary has assumed or if salaries do not increase as expected, the actual amount of contributions necessary from the employer is reduced. Conversely, if the investments do not perform as well as the actuary has assumed or if salaries increase faster than assumed, the employer must make up the difference through higher contributions.

For additional information on defined benefit plans, see "DEFINED BENEFIT PLANS," below.

Defined Contribution Plans

Defined contribution plans do not promise specific benefits. The plan benefit provided is instead based upon the amount that is contributed on behalf of each participant. Defined contribution plans are those in which funds contributed on behalf of each participant are accounted for separately and paid to him at retirement.

"Defined contribution" plans actually may not have contributions that are defined at all. For example, a profit sharing plan is a type of defined contribution plan. So is a type of pension plan called a "money purchase" plan. A money purchase plan is one in which the employer promises to contribute a certain percentage of each participant's annual compensation to the plan each year (see "MONEY PURCHASE PLANS," below). A money purchase plan is a pension plan with definitely determinable contributions.

In a defined contribution plan, an account balance is established for each participant to record the accumulation of amounts contributed on his behalf and the account's share of earnings or losses made through the investment of the plan funds. The benefit that each employee ultimately receives is based upon his account balance.

PROFIT SHARING PLANS

Account Balances

When a profit sharing plan is adopted, an account is established for each participant to record the amounts held in the plan for his benefit. The total balance of all participants' accounts equal the total amount in the plan. Unless participants are given the right to direct the investment of their accounts, the actual funds of the plan are pooled together and invested by the trustees. Each participant's benefit is based upon all or a portion of his account balance. Special rules apply to 401(k) plans (see "SECTION 401(k) PLANS (CASH OR DEFERRED ARRANGEMENTS)," below), which are one type of profit sharing plan.

Employer Contributions

An employer's contributions to a profit sharing plan need not come from the employer's current or accumulated profits.

The maximum deductible contribution that the employer may make to a profit sharing plan in any one year is an amount equal to 25% of the compensation of all of the employees participating in the plan.

The employer's contribution may be fully discretionary or it may be based upon a stated percentage of profits. In the absence of a definite formula, there must be recurring and substantial contributions.

Oftentimes, a discretionary profit sharing plan is established by an employer whose profits are volatile or who cannot anticipate from year to year what its company's needs might be with respect to retaining profits for other important business needs. This is often the case with new companies. In almost all small closely held businesses, the profit sharing contribution is fully discretionary. In most large plans, however, the employer contribution is set forth in the plan as a percentage or formula of its annual profits on the presumption that employees will work harder to generate profits for the company if they know the employer has made a commitment to share part of those profits with them.

Allocation of Contributions

The employer contribution, once determined, is allocated among the participants' accounts. The plan must provide a definite, predetermined formula for allocating the contributions among the participants. The allocation formula is usually based upon the relative compensation of the participants for the year. In other words, the amount allocated to a participant whose compensation is $10,000 will equal half of the amount allocated to a participant whose compensation is $20,000.

In some plans, the allocation is based upon points, which represent a combination of years of service and compensation. For example, one point might be given for each $1,000 of annual compensation and one point for each year of service with the employer. Allocation based upon points is popular with older, larger companies which wish specially to reward longer-service employees. However, if weighting for service or other factors results in discrimination in favor of highly compensated employees, the plan will not be approved.

Employee Contributions

In addition to employer contributions, the plan may permit (or even require) contributions from participants. Participants' contributions are usually recorded in a separate account. There are special rules limiting the amount of employee contributions to a plan.

Maximum Allocations

For a defined contribution plan to be qualified, the "annual additions" allocated to any one participant's account cannot exceed a special limit (known as the "Section 415 limit," for the section of the Internal Revenue Code that governs the limits on qualified plan benefits and contributions).

The annual additions limit is the lesser of 100% of the participant's compensation, or $45,000 (as indexed for 2007). Annual additions include the employer's contributions, forfeitures, and the employee's contributions. Since a profit sharing plan is a defined contribution plan, it is covered by the foregoing rule.

Vesting

How much of a participant's account will be available to him if he terminates employment before retirement depends upon the terms of the plan. All plans must adopt a vesting schedule permitted under the Internal Revenue Code and ERISA, which give each participant a nonforfeitable right to a certain percentage of his account balance depending upon his years of service with the company.

Some companies use a graduated vesting schedule; others provide 100% vesting at five years of service and no vesting prior to that. "Top heavy" plans must utilize a vesting schedule which gives a participant at least 20% vesting after two years of service and an additional 20% each year thereafter until the participant is 100% vested when he has six years of service. In the alternative, the plan may provide 100% vesting at three years of service. Beginning after 2006, vesting for most employer contributions to defined contribution plans may not exceed this 6-year graded (or 3-year cliff) schedule.

No matter what vesting schedule is adopted, it must not discriminate in favor of the highly compensated employees. A participant is always 100% vested in the account balance for his own contributions.

Apart from the vesting schedule, most profit sharing plans provide that a participant's account balance will become 100% vested if he should become totally disabled or die while employed.

Forfeitures

Each year employees who have terminated their plan participation before becoming 100% vested forfeit the nonvested portion of their account balances. Usually the forfeitures are allocated to the remaining participants in exactly the same manner as the employer contribution (i.e., upon either compensation or points). Sometimes, however, forfeitures are allocated based on account balances. If this type of allocation disproportionately favors the highly compensated employees, it will not be permitted.

Some profit sharing plans which use formula contributions do not allocate forfeitures to the remaining participants, but instead offset the current contribution by amounts forfeited.

Benefits

A participant's benefit under a profit sharing plan is derived from his account balance for the employer's contributions plus forfeitures and his account balance for his own contributions. The earnings and losses of the trust are also allocated to his accounts at least annually as adjustments to the account balances. Upon becoming eligible for a benefit under the plan, the participant will receive his vested portion of the amount in his account or accounts.

Distributions

The distribution of account balances in profit sharing plans is generally made by payment in a single sum, installments, or the purchase of an annuity contract for the benefit of the participant.

The time at which the distribution of the account balance is actually made to a participant is dependent upon the terms of the plan. The IRC sets forth rules regarding the latest time benefits must commence; however, most profit sharing plans permit the distribution of benefits within a short time after an employee has terminated employment, becomes disabled, or dies. In cases in which the account balance is not immediately distributed, it must be credited with the trust's investment earnings or losses until it is actually paid.

Even though qualified profit sharing plans can be a form of retirement plan, since they defer the payment of amounts contributed on behalf of the participants to a later date, a profit sharing plan may distribute amounts contributed as long as such amounts have been in the plan for two years. The 2-year period begins to run when the contribution is actually made to the plan's trust. Most large plans permit withdrawals only for specified reasons (such as the need for funds to purchase a home, pay for a child's college expenses, or defray large catastrophic medical expenses) or hardship. However, a participant must often pay a ten percent early distribution penalty tax on any taxable distribution of funds if the distribution is made before age 59 1/2.

STOCK BONUS PLANS

Stock bonus plans are similar to profit sharing plans (see above). In a stock bonus plan, an account is established for each participant to record the contributions made for him.

Contributions are not fixed or required to be made every year. Contributions to a stock bonus plan may or may not come from the profits of the company. The rules governing the amount of deductible contributions that can be made by the company are the same for stock bonus plans and profit sharing plans. Contributions are made either in cash (which is then used to purchase the stock of the employer) or in the stock of the employer. If made in stock, the amount of deduction for the contribution is determined by the fair market value of the stock when it is contributed. Unless the stock is publicly traded, some or all of the voting rights must be passed through to participants.

MONEY PURCHASE PLANS

Account Balances

Money purchase plans also bear a resemblance to profit sharing plans (see above). Like a profit sharing plan, when a money purchase plan is adopted, an account is established for each participant to record the contributions made for him.

Employer Contributions

A money purchase plan is a pension plan and therefore contributions do not necessarily come from profits of the company, but rather represent a fixed commitment to be met, regardless of whether or not the company is profitable. It acquires its name from the fact that at retirement, the money accumulated for each participant is often used to purchase an annuity contract for him.

A money purchase plan states the employer's contribution, expressed as a percentage of each participant's compensation. For example, a plan may provide that each year the employer will contribute to the plan an amount equal to 10% of each participant's compensation. Although any amount the employer fixes as a contribution rate must be contributed, the maximum amount the employer may contribute and deduct for a money purchase plan is 25% of compensation.

Employee Contributions

As with a profit sharing plan (see above), a money purchase plan may permit or require employee contributions. Such contributions are subject to the same rules and regulations as employee contributions to profit sharing plans.

Maximum Allocations

The "annual additions" to a participant's account are subject to the same rules as apply to profit sharing plans (see above).

Vesting and Forfeitures

A money purchase plan contains a vesting schedule, subject to the same considerations and rules as the vesting schedule in a profit sharing plan (see above). Forfeitures from terminating participants who are not 100% vested are allocated to remaining participants, in the manner described above, or used to reduce the employer's future contributions to the plan.

Benefits

Like profit sharing plans, a participant's benefit is based upon his account balances, which represent employer and participant contributions, both adjusted for the earnings or losses of the trust fund.

Distributions

Because a money purchase plan is a pension plan, distributions prior to the participant's termination of employment are not permitted, unlike the case in a profit sharing plan. Further, employees terminating participation in a money purchase plan are often not given distributions of their account balances until they reach the plan's normal retirement age. However, like a profit sharing plan, a money purchase plan often provides for 100% vesting and immediate distribution if a participant becomes disabled or dies while employed.

DEFINED BENEFIT PLANS

The Benefit Provided

A defined benefit plan is a pension plan. It contains a promise to pay each participant a certain amount of money or percentage of pay at the participant's normal retirement age. The amount of money may be the same dollar amount for each participant, but is more often expressed as a formula, for example "40% of the participant's final average compensation." The normal retirement age is established by the plan but can be no later than the later of normal retirement age under Social Security or the fifth anniversary of the beginning of the employee's participation in the plan. Very often a defined benefit plan contains an early retirement provision which states that upon completion completion of a certain number of years of service, or within a certain number of years of normal retirement age, the employee will become 100% vested in his accrued benefit (if he is not already) and may require the plan to pay his benefit immediately, either with or without actuarial reduction to take into account the longer years of payments.

Defined benefit plans usually express the benefit to be paid to the participant as an annuity. Most defined benefit plans express the "normal" form of retirement benefit as an annuity for the participant that ends on his death (a "life annuity") and offer different types of annuities as alternatives. There are many types of alternative annuities. One type is a "joint and survivor" annuity with the spouse or another person. A pension plan must pay benefits to married participants in the form of a joint and survivor annuity unless the participant and spouse elect otherwise.

A joint and survivor annuity provides for payments over the life of both the participant and his joint annuitant. Another type of annuity, a "life and term certain" annuity, provides for payments over the life of the participant with a guarantee that a minimum number of payments will be made. Each type of annuity has a different value because of the expected number of payments to be made. If a different type of annuity is selected, the payment amount will be adjusted so that the value is equal to the type of annuity that is the normal form. For example, a life annuity of $1,000 per month may be equal in value to a joint and survivor annuity of $800 per month payable to the participant and his spouse. The $200 reduction in the participant's monthly benefit reflects longer expected payments since the annuity must be paid over two lifetimes.

Typically, defined benefit plans express the benefit to be paid as a percentage of average compensation. Oftentimes, however, defined benefit plan formulas take into consideration the employee's length of service. An example of this type of formula is "1% of average compensation for each year of service with the employer." Alternatively, sometimes the formula is expressed as a percentage of compensation, so long as the employee has a certain number of years of service with the employer. Service of less than the full number of years will result in a prorated cutback. For example, a benefit may be expressed as "40% of compensation reduced by 1/30th for each year of service less than 30 at normal retirement age."

Funding

There are no separate account balances in defined benefit plans. Rather, the entire trust fund is held for the benefit of all participants. An actuarial cost method is adopted to ascertain plan contributions. In calculating the amount that needs to be contributed to the fund each year, the actuary may take into consideration the benefits expected to be paid based upon projected levels of compensation, the employee turnover anticipated, the vesting schedule, and the rate at which amounts contributed will grow by reason of the investment return on the plan funds.

Each year the assumptions are measured against the actual experience of the plan. Both gains, which result from assumptions which prove too conservative, and losses, which result from assumptions which prove too aggressive, affect future contributions. However, gains and losses are amortized, that is, they are spread over a number of years rather than all being immediately applied to the next year's contribution.

Deductions for contributions to a defined benefit plan are permitted in the amount that the plan's actuary has certified is necessary to properly fund the plan. Each actuarial assumption must be reasonable or, when aggregated, result in a total contribution equivalent to that which would be determined if each were reasonable.

Benefit Accrual

Very few participants actually retire on their normal retirement dates. Therefore, it is important to understand the concept of how the defined benefit plan benefit is earned or accrues throughout plan participation. It is the accrued benefit upon which an employee's benefit is based if he terminates employment prior to the plan's normal retirement age.

In a defined contribution plan, the participant's account balance is his accrued benefit. In a defined benefit plan, the concept is more complex. ERISA permits several methods by which a plan may calculate an employee's accrued benefit.

Pension Benefit Guaranty Corporation The Pension Benefit Guaranty Corporation (PBGC), a corporation within the Department of Labor and established established under ERISA, has as its purpose the insurance of most defined benefit pension plan benefits. If the plan must be terminated when there are not enough plan assets to cover the vested accrued benefits of the participants, the PBGC will make up any shortage, within certain limits. The PBGC then has the right to require reimbursement from the employer.

Maximum Benefit

A defined benefit plan can provide an annual benefit at retirement as high as 100% of the participant's compensation averaged over his three highest years, but the benefit cannot exceed $180,000 per year (as indexed for 2007.

For benefits commencing before age 62, this amount is actuarially reduced to reflect a lower dollar benefit of equal value payable at an earlier date. Similarly, if benefits commence after age 65, the limit is actuarially increased to reflect a higher dollar benefit of equal value payable at a later date. Generally, the indexed amount may be paid as a life annuity or a joint and survivor annuity with the participant's spouse. If it is paid in any other manner, it must be actuarially reduced to reflect the other form of payment.

Fully Insured (412(i)) Plans

A defined benefit plan can be funded entirely by life insurance and annuities, if special requirements are met. Such a plan is called a fully insured plan, or a 412(i) plan, so named for the Internal Revenue Code section in which the basic requirements were previously set forth. The Pension Protection Act of 2006 redesignated Section 412(i) as Section 412(e)(3). Fully insured plans are exempt from the minimum funding requirements set forth in IRC Section 412.

If properly structured, a fully insured (412(i)) plan provides a useful retirement planning tool by providing for level funding of defined benefit plans, based on scheduled premium payments. Since larger contributions are necessary to fully fund a plan with life insurance and/or annuities, a larger amount is deductible (within limits), as compared with other defined benefit plans.

The IRS has issued guidance designed to target certain abusive 412(i) arrangements on three issues: (1) the valuation of life contracts distributed out of 412(i) plans, (2) the issue of discrimination in the types of contracts provided to highly compensated employees, versus the rank and file, and (3) the ability of employers to purchase and deduct premiums paid for amounts of life insurance the Service views as excessive.

TARGET BENEFIT PLANS

A target benefit plan is a type of money purchase plan (see above). However, it begins with a defined benefit concept, by providing a theoretical or "targeted" benefit expressed as a defined benefit formula. For example, the plan may provide that the targeted benefit is 40% of average compensation. Having defined the targeted benefit, separate accounts are established for each participant and an amount is contributed to each participant's account which, based on the level premium funding method , will fund the benefit that is targeted. Because the target benefit plan is a defined contribution plan, it is subject to the annual additions limit of IRC Section 415(c), which is the lesser of 100% of compensation, or $45,000 (as indexed for 2007).

The actuarial assumptions of the level premium funding method, of course, assume that a particular investment rate of return will be earned on the funds contributed. In the case of a target benefit plan, regardless of the actual fund earnings, the level contribution to the account does not change. Therefore, if the fund's earnings are greater than the actuary has assumed, the participant's actual benefit will be higher than his targeted benefit. Conversely, if the earnings are lower than the actuarial assumption, the actual benefit will be lower than the targeted benefit.

If the compensation of the employee increases in any one year, giving rise to a higher targeted benefit, the additional amount of benefit because of the new compensation level is treated as if it were a separate benefit for the participant and an additional amount is then contributed each year to fund the increment in the benefit.

The PBGC does not guarantee the benefit under a target benefit plan, since it is a defined contribution plan under which no set benefits are promised to the participant at normal retirement age.

As with other defined contribution plans, when a participant terminates employment, he is entitled to the amount of his account, multiplied by his vested percentage, if applicable.

SECTION 401(k) PLANS (CASH OR DEFERRED ARRANGEMENTS)

The most popular variation on the profit sharing or stock bonus plan concept is a 401(k) plan, referred to in IRC Section 401(k) as a cash or deferred arrangement. Under a 401(k) plan, a participant may elect to defer current taxes on the portion of his compensation that he contributes to the plan. The election may apply to compensation currently payable (for example, a bonus) or to future salary payments.

Amounts that are deferred under this election are excluded from a participant's gross income for the year of the deferral (i.e., the contributions are made with before-tax dollars) and treated as employer contributions to the plan. Certain pre-ERISA money purchase pension plans may also include a cash or deferred arrangement.

Although state and local government employers are generally prohibited from maintaining 401(k) plans, certain exceptions apply. Tax-exempt employers and partnerships are eligible to maintain a 401(k) plan.

CASH BALANCE PLANS

A cash balance plan is a defined benefit plan that calculates benefits in a manner similar to defined contribution plans. It resembles a defined contribution plan in that each employee has a hypothetical account or "cash balance" to which contributions and interest payments are credited; however, since the actual funds are pooled, directed investing is not available. As with other defined benefit plans, the employer bears both the risk and the benefits of investment performance.

In a typical cash balance plan, the employee's benefit accrues evenly over his years of service, with annual service or pay credits to a hypothetical account (usually a fixed percentage of pay, such as 4% to 5%). The amount is determined actuarially to insure that the plan has sufficient funds to provide the promised benefits, and interest is credited at a rate specified in the plan document, and compounded at least annually.

In plan years beginning after 2007, benefits in cash balance plans must be 100% vested after three years of service (this includes service before the effective date).

ESOPs AND THRIFT PLANS

ESOPs

An "employee stock ownership plan" or ESOP is a stock bonus plan (see above), or a stock bonus plan combined with a money purchase plan, which is designed to invest primarily in the common stock of the employer.

Unless there are corporate restrictions on stock holding by non-employees, an ESOP maintained by a C corporation must give a participant the right to require that his distribution upon termination of employment be entirely in the form of employer stock. An ESOP must give the participant the right to require the employer to purchase any distribution of employer stock made to him if the stock is not readily tradable on an established market.

Normally, loans or extensions of credit between an employer and its plan are "prohibited transactions." However, ERISA and the IRC make an exception in the case of ESOPs. Sometimes an ESOP borrows large amounts of money from a financial institution based on the credit (and guarantee) of the employer, and then uses the money to purchase the stock of the employer directly from the employer. The employer typically uses the funds to finance major capital purchases. Each year the employer then makes contributions to the ESOP equal to the amount necessary to repay the debt. As the debt is repaid, the stock is allocated to the accounts of the employees. This is known as a leveraged ESOP.

The complexity of establishing a leveraged ESOP is usually not necessary. The same tax benefit can be accomplished if the employer borrows funds directly from a financial institution and contributes an amount of its stock to a stock bonus plan each year equal in value to the amount of its loan repayment.

Thrift/Saving Plans

Thrift/savings plans were in widespread use in large companies, prior to the enactment of IRC Section 401(k) (see above). Typically, a thrift/savings plan merely permits employees to make contributions to the plan with after-tax dollars. Because the earnings of a qualified plan grow tax-free and because contributions to thrift/saving plans are usually made through payroll deductions, employees find thrift/savings plans a convenient and attractive way to save money.

Employee contributions must be 100% vested at all times. Such contributions have to meet the nondiscrimination rules of IRC Section 401(m).

Sometimes, to encourage savings, the employer matches a portion or all of the employees' contributions. In this case, the percentage of compensation that all participants are permitted to contribute must be set at a level that does not result in discrimination in favor of the highly compensated employees. Further, the highly compensated employees are limited by another test, which resembles the limitations imposed on them under 401(k) plans. Usually, employees are not immediately fully vested in employer contributions but become vested in them according to a vesting schedule. In plan years beginning after 2006, a faster graded vesting schedule (i.e., the 2-6 year top heavy vesting schedule) applies to most employer contributions to defined contribution plans.

In legal form, thrift/savings plans are either profit sharing or money purchase plans. The plan provisions permitting withdrawal of the employees' contributions are usually fairly liberal. However, to discourage frequent withdrawals, some thrift/savings plans do not allow an employee to make contributions for a stated period following a withdrawal. If the plan is part of a profit sharing plan, the employer's contributions may also be distributed after an established period of time. Distributions are generally included as taxable income.
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Title Annotation:APPENDICES
Publication:Tools & Techniques of Retirement Income Planning
Date:Jan 1, 2007
Words:5198
Previous Article:Chapter 20: future trends in retirement income planning.
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