QUALIFIED RETIREMENT
PLAN? A retirement plan is
established by an employer for the purpose of providing retirement benefits for
its employees. A plan becomes "Qualified" for tax advantages if it
meets the many conditions established under the Internal Revenue Code. Among
those conditions is the establishment of a trust to which contributions are
made. Those contributions are limited based on the type of plan and neither the
benefits paid nor the contributions allocated can discriminate in favor of Highly Compensated Employees. Tax advantages include the
deferral of taxes on all contributions and investment earnings until amounts
are distributed to participants and the availability of continuing tax deferral
by rolling over distributions to an IRA.
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STANDARD 401(K) PLAN?401(k) plans permit employees to make pre-tax
contributions directly out of their salary. The maximum amount that employees
can contribute to this plan is the lesser of $14,000 or 100% of total
compensation. The plan sponsor may elect to match up to a certain percentage of
the employees’ contributions. The amount which "Highly
Compensated Employees" can contribute may be limited if
"Non-Highly Compensated Employees" do not contribute enough. Any employee born before 1956 has the right
to contribute an additional $4,000 bringing their maximum up to $18,000.
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SAFE HARBOR 401(K)
PLAN?Under a Safe Harbor 401(k)
Plan, the amount which the Highly Compensated Employees
contribute is not limited by the amount contributed by the Non Highly
Compensated Employees. In exchange, the employer agrees to either contribute
3% of pay for all employees, or to match up to a total of 4% of pay for all
employees. These employer contributions are 100% vested.
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PROFIT SHARING PLAN? Also known as a Discretionary Defined Contribution
Plan, a profit sharing plan allows employers to set their own level of
contributions and to change that level from year to year without amending the
plan. The maximum amount which can be contributed is 25% of total eligible
payroll. The maximum amount which can be allocated to any individual is the
lesser of $42,000 or 100% of pay (for 2005). Accounts are maintained for each participant
and updated at least once a year to include the participant’s share of the
company contribution, forfeitures from participants who terminated employment,
and earnings from the plan’s investments.
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MONEY PURCHASE PLAN?Employers maintaining Money Purchase Plans make a
commitment to contribute a certain percentage of compensation each year. The
percentage being contributed can only be changed by amending the plan. The
maximum percentage which can be contributed is 25% of total eligible payroll.
As with Profit Sharing Plans, accounts are maintained for
all participants and the maximum which a participant can receive is the lesser
of $42,000 or 100% of pay.
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TARGET BENEFIT PLAN?Under a Target Benefit Plan, employer contributions
for each participant are determined using a complex formula involving age,
salary, and years of service for each participant. The formula tends to favor
older employees. Except for the allocation formula, this plan works the same as
a Money Purchase Plan.
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EMPLOYEE STOCK
OWNERSHIP PLAN? A qualified Employee
Stock Ownership Plan operates similarly to a Profit Sharing
Plan except that the majority of funds in the plan must be invested in
company stock. Accounts consisting primarily of that company stock are
maintained for each participant. For non-publicly traded companies, an annual
appraisal of the value of the employer must be performed so that the stock can
be properly valued. Unless the plan provides otherwise, participants who leave
the employer will be given a choice of either receiving cash equal to the value
of their account, or the stock itself.
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TRADITIONAL DEFINED
BENEFIT PLAN? Benefits under a
Defined Benefit Plan are based on a specified formula which utilizes
compensation, salary, and service. Unlike the other plans described, no account
is maintained for participants. When participants reach their retirement age,
they receive a monthly pension determined under the plan’s formula. The maximum
benefit which a participant can receive at age 62 is $170,000 per
year. Some plans allow participants to convert that monthly pension into a lump
sum. Participants who terminate employment prior to retirement receive a
reduced benefit or lump sum based on their compensation, age, and service as of
their termination date.
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NEW COMPARABILITY
PLAN? New comparability is a term
used to describe the method of allocating contributions to a Profit
Sharing or a Money Purchase Plan. This approach can
also be uses in conjunction with both standard and Safe Harbor 401(k) plans. New Comparability Plans establish
separate groups of employees based on job description, salary, service, or even
by name. The employer then determines how much to contribute for each group.
The amount which can be contributed for the highly
compensated employees is limited by the non-discrimination
rules established by the IRS. Except for the New Comparability Money Purchase
Plan, the employer can change the amount to be contributed for each group
without amending the plan.
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CASH BALANCE PLAN?The Cash Balance Plan is a combination plan which
provides benefits based on "Theoretical Account Balances".
Contributions to the accounts are based on a predetermined formula which takes
into account any or all of compensation, service, age, or job classification.
As with New Comparability Plans, the formula must not
discriminate in favor of Highly Compensated Employees.
Where this plan differs from defined contribution plans is that a) each participant’s
account grows at a set rate of interest rather than using actual plan earnings,
and b) the maximum amount which a participant can receive is limited by the
defined benefit rules, thus allowing "theoretical contributions"
significantly in excess of $30,000 per year.
Definitions
NON DISCRIMINATION TEST? The Internal
Revenue Code requires that contributions and benefits under a Qualified
Retirement Plan cannot discriminate in favor of Highly
Compensated Employees. This includes contributions made by employees under
a 401(k) Plan. There are separate tests for 401(k) contributions, matching
contributions, employer contributions, and pension benefits. Some of these
tests are extremely complex and offer several options for passing.
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HIGHLY COMPENSATED
EMPLOYEE?Since all plans must pass
at least one of the Non-Discrimination Tests, the determination of who is a
Highly Compensated Employee (HCE) is critical. All employees who were 5% owners
either this year or last year are automatically considered to be HCE’s. So are
their lineal ascendants and descendants. Employees who earned over $90,000 last
year may or may not be HCE’s depending upon which definition is selected.
Choosing the right definition of HCE can make a big difference in whether or
not the plan passes the Non-Discrimination Tests.
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TOP-HEAVY PLAN? If 60% or more of the plan’s assets or 60% or more
of the value of plan benefits belongs to Key Employees,
the plan is considered to be Top-Heavy. This complex test takes into account
all plans maintained by the company as well as distributions made over the past year. If a retirement program is determined to be Top Heavy then it must
provide either a minimum benefit or a minimum contribution to all eligible
Non-Key Employees. This rule is frequently overlooked by companies maintaining
401(k) plans who erroneously believe that these plans are exempt from the Top
Heavy requirements. In fact, if a 401(k) plan is Top-Heavy and at least one Key
Employee contributes to the plan, a 3% of pay contribution must be made for all
eligible Non-Key Employees.
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KEY EMPLOYEE? All 5% owners and their ascendants and descendants
are Key Employees. Individuals who own less than 5% may or may not be Key
Employees depending upon their annual compensation and on how many individuals
own more stock than them.
THIRD PARTY ADMINISTRATOR (OR TPA)? In order to maintain a qualified retirement program,
each aspect of the administration must be properly assigned. The plan sponsor,
or "First Party" is responsible for collecting basic data, funding
the plan, and delegating the various jobs. The financial institution where assets
are to be invested is the "Second Party". The company which makes
sure that the plan meets all the requirements of the internal revenue code is
then known as the "Third Party Administrator." Many financial
institutions combine the work of the second and third parties in order to
provide a "Bundled" or "Turnkey" service. Read The Battle of the Century to see why it is a good idea
for plan sponsors to retain an outside consultant, or TPA.
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What happens to
pension money when an owner...
TERMINATES THE PLAN?:A plan sponsor retains the right to terminate a plan
at any time. Typical reasons for plan termination are adverse business
conditions, changes in laws, sale or dissolution of the business, and
termination of employment for any reason by the owner. Upon plan termination,
all participants become fully vested in either their accrued benefit or account
balance. Some defined benefit plans only offer the participants the right to
receive a pension, but the great majority of small business retirement plans
give all participants the right to receive a lump sum benefit. This benefit can
then in turn be rolled over to an IRA to continue the deferral of taxes. It is
important to note that any option offered to the owner must also be offered to
all other participants.
RETIRES?: Generally when the sole owner of a business retires,
the plan is terminated. (link to above description) . If there
are multiple owners and one of them retires, the retiring owner will usually
have the right to roll over his funds to an IRA. Owners who are over 70 1/2
must begin receiving minimum distributions from the plan whether or not they
actually retire. The fact that minimum distributions have begun, however, does
not prevent the owner from rolling over his or her remaining funds to the IRA.
Individuals who qualify may also wish to look into converting their IRA’s to
Roth IRA’s from which minimum distributions need not be made until after death.
BECOMES DISABLED OR
TERMINATES EMPLOYMENT?: Disability
and termination of employment are generally treated the same as retirement.
Owners who terminate employment, however, need to be careful about vesting. If
they are not 100% vested upon termination, they are treated the same as
employees who terminate before achieving full vesting and will forfeit the
portion of their account which is not vested. This issue needs to be addressed
during any termination negotiations. In most plans, individuals who become
disabled are automatically 100% vested.
SELLS THE COMPANY?: An owner who is negotiating to sell his company (or
to buy another company) should keep his retirement plan consultant in the loop.
When the stock in a company is sold, the former owner loses control of his
retirement plan. The new owners can invest the assets of the plan as they see
fit and, depending upon the plan’s terms, they can delay the payment of the
former owner’s benefits. In addition, if the former owner is not fully vested,
he or she will forfeit the non-vested portion. Special attention must be paid
to defined benefit plans which can be overfunded or underfunded. Overfunding
can provide a windfall for the acquiring company while underfunding can create
an additional liability which, depending upon the conditions of the sale, can
sometimes become the responsibility of the seller. Asset sales do not generally
have the same set of issues because the retirement plan remains under the
control of the former owner.
GOES BANKRUPT?: Under federal law, funds accumulated in qualified
retirement plans remain safe from creditors. This is true whether the owner or
the business declares bankruptcy. If a company sponsoring a defined benefit
plan enters bankruptcy, the plan may be taken over by the Pension Benefit
Guaranty Corporation, a federal agency which makes sure that defined benefit
plans meet their obligations to plan participants.
GETS DIVORCED?: Divorce law varies from state to state but pension
assets are considered to be part of the marital estate. Measuring the value of
these benefits can sometimes be difficult, and the valuation must frequently be
determined by the court. The divorce settlement can also call for the issuance of
a Qualified Domestic Relations Order (QDRO) under which the retirement plan
will pay a portion of the participant’s benefit to the spouse. The pension
consultant can play a vital role in making sure that the retirement plan is
handled equitably in a divorce settlement.
DIES?: Several issues come up upon the death of an owner
including the practical questions of who will run the business and administer
the plan. Assuming these matters are in order, the designation of the
individual’s beneficiary is critical. If the owner is married and the
beneficiary is someone other than the spouse, it is essential that the
paperwork be executed properly. If not, the spouse retains a claim to the
assets and a bitter dispute could result. There are also complex minimum distribution
rules which must be followed after death in order to avoid large federal excise
taxes.
