What type of plan works best?
There is no one type plan that addresses all employer and employee needs. There are a number of plan types and each has their own design features that respond to needs and process of achieving a plan sponsor’s goal. But before we look at plans, let’s first review a few of the design variables.
Retirement law requires that all eligible employees be considered in a retirement plan design, but that does not mean that every employee must participate in each plan. Employees who have worked less than one year may be excluded. In some instances employees who have worked less than two years may also be excluded if their benefits are fully vested as soon as they enter the plan, except in the case of a 401(k) plan. Part-time employees (those who work less than 1,000 hours a year) do not need to be covered by the plan, and no one under age 21 needs to be covered.
Employers may also elect to exclude particular employees or classes of employees from plan participation regardless of their age or how long they have worked, based on passing required tests.
There are any number of possible times when an employee may enter a plan, ranging from every day of the year to quarterly to semi-annually or annually.
Vesting is an ownership concept. If a plan participant has an account balance and terminates employment, the portion of the account balance they take with them depends on their ownership or “vested” percentage.
Plans usually have vesting schedules that detail how long a participant needs to work before they “vest in their benefits”. Participants who terminate before becoming fully vested forfeit all of the benefit which is not vested. Any forfeited amount is divided among the remaining participants, used to pay fees or used to reduce future employer contributions.
Each of the various plan types have different options which may be utilized when designing contribution formulas or allocation styles. Some of these options create the opportunity to select contributions on an annual basis ranging from as low as zero to as high as multiple thousands of dollars. Others produce high, required annual contributions.
Our design team will analyze these and other variables along with the plan sponsors group of employees and their goals to determine which of the following plans and what exact design works best to advance the employers desired outcome.
The 401(k) Plan is an employer sponsored plan that permits employees to defer part of their current income on a pre-income tax basis. Contributions are almost always made by payroll deductions.
The maximum amount that an employee can contribute to a 401(k) Plan in 2017 is $18,000. The limit may be adjusted each year to reflect cost-of-living changes.
Participants age 50 and older may also make “catch up” contributions to a 401(k) plan. The maximum “catch up” contribution for 2017 is $6,000.
Highly Compensated Employees (HCEs) are limited in what they may contribute by the amounts contributed by the non-highly compensated employees.
Determination of the amount HCEs may contribute is determined by regulations that require the use of nondiscrimination tests. These tests are designed to ensure that the plan benefits all employees in a nondiscriminatory manner and can sometimes result in making it difficult for some employers to maintain 401(k) plans.
- Participation by employees is optional.
- Employee participants may reduce their taxable income.
- Deferrals accumulate in a tax-deferred environment.
- The employer may make discretionary matching and/or profit sharing contributions.
- Administration and testing may be more complicated than for other kinds of plans.
- Plans must pass nondiscrimination testing – otherwise some corrective action must be taken.
Profit Sharing Plans
Profit Sharing Plans are the most flexible of the qualified plans. An employer may contribute up to 25% of the total covered compensation of eligible employees. The maximum amount which can be allocated to any one participant is 100% of the participant’s compensation or $54,000, whichever is less. The $54,000 limit applies for years ending in 2017 and may be adjusted annually to reflect changes in the cost-of-living index.
Contributions to a profit sharing plan are not required and the employer may choose to make or not make contributions each year.
The tax code allows larger contributions to be made on behalf of older employees. In many businesses, the key executives are older than most of the other employees. The tax code allows a greater contribution to be made for these older, key executives.
- Contributions are discretionary. The employer may vary their contribution from year to year.
- Terminating non-vested employees leave unvested dollars in the plan.
- Possible tiered allocations favoring certain employees.
- The individual defined contribution limitation of $54,000 can be limiting. A defined benefit plan may produce higher contributions.
Defined Benefit Plans
Defined benefit plans operate in a completely different manner from 401(k) or profit sharing plans. A defined benefit plan commits to providing plan participants a monthly income when they retire. The amount of monthly benefits is often the result of the participant’s pay and years of service.
With a defined benefit plan it is the plan sponsor’s responsibility to make certain that there is enough money in the plan to pay the promised benefits. Annual contributions are determined by an actuary based on actuarial assumptions about future pay increases, investment performance, years until retirement and life expectancy after retirement.
Contributions to a Defined Benefit Plan are mandatory and must satisfy minimum standards. Larger contributions must be made on behalf of older participants to fund a specified benefit level. This is because an older participant has fewer years remaining until retirement. This can be advantageous to key executives, who are often older than the other participants.
- Contribution for older executives may be substantially higher in a defined benefit plan than in other types of retirement plans.
- Defined Benefit plans tend to favor older, higher-paid employees.
- Defined benefit plans need greater administrative attention.
- Poor investment performance results in increased contribution requirements – employer bears the investment risk.
Selecting the Right Plan
The right plan is a plan that advances the aspirations of the plan sponsor and the goals of the sponsoring business. The first step is to determine what those goals are, and then build the plan that facilitates reaching those goals.