Types of Retirement Plans
A qualified retirement plan (also referred to as a QRP) is an employer sponsored employee benefit arrangement established for the purpose of providing retirement income for eligible employees. The following are the most popular type of qualified retirement plans.
Defined Benefit Plans
A defined benefit plan is an employer-sponsored retirement plan that provides a predetermined benefit. Defined benefit plans require the employer to promise a designated retirement benefit and then fund the plan as necessary to meet that benefit obligation. The benefit objective is the controlling force under a defined benefit plan and the contribution amounts are simply a factor of that controlling force. If the investments in a defined benefit plan perform poorly, the employer must contribute increased amounts in subsequent years to counteract the poor investment performance and ensure that the plan will be able to satisfy the predetermined benefit objectives. Although defined benefit plans may allow for a larger dollar contribution than other employer plans, the costs of maintaining a defined benefit plan generally are quite high in comparison.
Defined Contribution Plans
A defined contribution plan is an employer-sponsored retirement plan that allows contributions to be made for employees based on a percentage of an employee’s compensation. Under a defined contribution plan, the maximum annual contribution on behalf of any plan participant may not exceed the lesser of 100 percent of compensation or $49,000 for 2009 and 2010. Defined contribution plans include a wide range of plan types, including profit sharing plans, money purchase pension plans, employee stock ownership plans, target benefit plans, and 401(k) plans.
Defined contribution plans do not guarantee a specified retirement benefit. Rather, the employer makes contributions to the individual accounts of each plan participant and whatever the employee’s account balance is worth at retirement is what the employee receives.
Profit Sharing Plans
Profit sharing plan contributions are discretionary and usually are made out of profits generated by the business. Consequently, the contribution that an employer makes to a profit sharing plan may vary from year to year, depending on a number of factors. Generally, if an employer elects to make a contribution, the same contribution percentage must be made for all eligible employees unless the employer has elected to use an allocation method referred to as permitted disparity.
The maximum deductible contribution that can be made to a profit sharing plan is 25 percent of eligible compensation. Eligible compensation is basically all of the compensation paid to the eligible plan participants during the employer’s tax year. The deduction is taken by the employer on the business tax return. Employer contributions are not considered taxable income to employees for the year in which the contribution is made.
A 401(k) plan is a type of profit sharing plan under which employees may be allowed to defer a portion of their compensation into the plan on a pretax basis. A 401(k) plan, sometimes called a cash or deferred arrangement (CODA), allows employees either to receive taxable compensation in a current year or to defer taxation by electing to have the employer contribute compensation into a qualified retirement plan (QRP). For 2006 and later plan years, if the plan provides, participants may make designated Roth (after-tax) contributions in amounts up to plan deferral limits. In addition to allowing employee deferrals, a 401(k) plan may allow for employer matching contributions, employee after-tax contributions, and employer profit sharing contributions. Earnings on employer contributions also are tax deferred.
As with other profit sharing plans, the overall deductible contribution limit under a 401(k) plan is 25 percent of the aggregate unreduced compensation paid to plan participants during the employer’s tax year.
Traditional 401(k) plans: A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested. Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.
Safe harbor 401(k) plans: A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401(k) plan is not subject to the complex annual non-discrimination tests that apply to traditional 401(k) plans. Safe harbor 401(k) plans that do not provide any additional contributions in a year are exempted from the top-heavy rules of section 416 of the Internal Revenue Code.
Savings incentive match plan for employees of small employers plans are similar to traditional 401(k) plans because they are funded by employee deferrals and an additional employer contribution. The SIMPLE IRA plan uses a SIMPLE IRA trust to receive contributions, and the SIMPLE 401(k) plan uses a single plan trust, as is typical of a 401(k) or other QRP.
Both plans are available to employers who have no more than 100 employees who each received at least $5,000 in compensation from the employer for the preceding calendar year. The plans have a lower deferral limit than regular 401(k) plans and require that the employer annually provide either a matching contribution to all who defer or a nonelective contribution to all employees eligible to participate in the plan and who are expected to earn $5,000 or more during that year.
Money Purchase Pension Plans
Unlike a profit sharing plan where the contribution level may vary from year to year, a money purchase pension plan represents a fixed commitment on the part of an employer to fund a plan according to the funding percentage specified by the employer in the plan documents. A 10 percent funding deficiency penalty is assessed in the event a contribution is not made when required. This funding deficiency penalty will apply even if the plan only has a single participant. Under a money purchase pension plan, the maximum per participant deductible contribution amount is 25 percent of eligible compensation up to $50,000 for 2012 and 2010.
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