By Stephen Abramson
What are the best qualified retirement plans to recommend to your clients? To answer that question, you first must understand the differences between the various types of retirement plans available to your client’s business. This article will provide an overview of plan types to be considered and later follow-up articles will go into much more detail for each plan type.
Generally, qualified retirement plans fall into two broad categories: defined contribution and defined benefit. As the name implies in a defined contribution plan, the deposit made by the plan sponsor, the employer, is identified. In a defined benefit plan, the retirement benefit, in the form of a monthly benefit at retirement age, is defined.
Defined contribution plans include money purchase, target benefit (a hybrid between defined contribution and defined benefit), profit sharing and 401(k) plans -- which are really not a plan type but an add-on provision to a profit-sharing plan.
Before we go further, I must differentiate between two different limits for defined contribution plans -- annual additions which apply to the participating employee, and deduction limits which apply to the plan sponsor, the employer.
Each employee must satisfy the annual additions limit which is the lesser of 100% of compensation or $58,000 for 2021. This limit includes employer contributions, employee contributions and reallocated forfeitures (the non-vested account balances of terminated employees that are re-allocated to active participants). The only exception to the dollar limit is the catch-up contribution in 401(k) plans for those participants age 50 or above, currently $6,500, bringing the limit for those employees to $64,500. The basic salary deferral in a 401(k) plan is limited to the lesser of 100% of compensation or $19,500 for 2021 which is part of the annual additions limit.
The deduction limit, applied to the employer, is 25% of total plan compensation limited to $290,000 for any one participant. The 25% does not include the employee’s salary deferral. Confusing but true of most rules for retirement plans. The non-discrimination rules for 401(k) plans are specific to those plans as discussed below.
Money Purchase Plans
If I had to place money purchase plans in a sub-category, I would call them a true employee benefit plan as each employee participant receives a contribution as a percent of their compensation -- a true measure of value to the sponsoring business. That percentage is defined in the plan document and creates a mandatory contribution on behalf of the company sponsoring the plan. A money purchase plan is considered a pension plan so if the contribution is not made by 8½ months after the end of the plan year that would create a funding deficiency subject to a 10% excise tax and if not corrected within 90 days a 100% excise tax. This type of plan should only be considered if the employer’s cash flow is such that it can meet the funding requirement every year. Notwithstanding the funding issue, it is true that the plan can be amended to reduce the mandatory contributions. However, there are specific IRS timing rules that must be followed to make that amendment. The statutory maximum deduction is 25% of the employee’s compensation as limited by IRS guidelines above. For 2021, the maximum compensation that can be considered is $290,000 and the maximum contribution for 2021 is $58,000, the annual additions limit as described above. A money purchase plan is not a good fit for a small business that wants to benefit owners/key employees at a higher level than rank and file employees.
Target Benefit Plan
A target benefit plan is a money purchase plan that takes the employee’s age into consideration. Two employees of different ages but the same compensation and service will receive different contributions, i.e., the older employee will receive a higher contribution. The limits for a target benefit plan are the same as money purchase plans indicated above. A target benefit plan can work in a small company where the owners/key employees are older than the rank-and-file employees as long as the mandatory funding is not an issue.
A profit-sharing plan has the same deduction limits as a money purchase and target benefit plan, i.e., 25% with the attendant compensation and annual additions dollar limits. The primary difference is the flexibility of the contribution which is totally discretionary in a profit-sharing plan. The plan document does not define the amount of the contribution but defines how that contribution will be allocated to eligible employees once the amount is determined. Since there is no mandatory contribution, there is no excise tax to be concerned about if a contribution is not made. Allocation of the contribution can be in proportion to each employee’s compensation, can consider benefits provided through Social Security (referred to as permitted disparity), can be allocated differently to classes of employees or can be based on compensation and age referred to as age-weighted.
The basic allocation is in proportion to compensation. If an employee’s compensation for the year represents 10% of the compensation of all eligible employees, subject to IRS limits, they will receive 10% of the contribution. This is consistent with a true employee benefit plan as mentioned under the money purchase plan, wherein each employee receives a contribution based on compensation only.
Using permitted disparity takes the Social Security wage base into consideration and allocates the contribution on two levels at different statutory rates, compensation in excess of the wage base and compensation less than the wage base. This approach recognizes that the employer is already funding a retirement benefit through Social Security. This results in a slightly higher total percentage contribution going to higher wage earners, i.e. owners and key employees.
A class allocation approach treats each employee class, as defined in the plan document, differently. Classes may be based on the employee’s job, physical location if the company has more than one location, or each employee may be placed in a separate class. Age cannot be used in defining classes. The result must pass IRS non-discrimination rules each year. This approach is more focused on leveraging the plan for owners and key employees.
The age-weighted approach is similar to a target benefit plan in that employees with the same compensation, but different ages would receive a different contribution, but the contribution is not mandatory.
As mentioned above there is no 401(k) “plan.” Also, there is no “solo 401(k) plan”, only a traditional 401(k) plan for one participant. Instead, the 401(k) deferral provisions which are the same for a one-person plan, are included in a traditional profit-sharing plan using any of the allocation approaches described above. Limitations for 401(k) plans are the same as profit sharing plans with some minor differences.
The traditional 401(k) plan must satisfy the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test. The ADP test compares the average deferral percentage of the Highly Compensated Employees (HCEs)” to the “Non-Highly Compensated Employees (NHCEs).” The ACP test does the same for matching contributions that are not subject to immediate vesting. The description of those two groups is beyond this article but will be explained in a later article. The result can severely restrict the deferrals of the HCEs if there is not sufficient participation from the NHCEs. As an alternative the plan can be established as a Safe Harbor 401(k) plan which eliminates the testing requirement. To qualify as a Safe Harbor plan the employer must make a contribution to participants of either 3% of compensation to all eligible employees whether or not they make salary deferrals or a matching contribution of 100% of the first 3% an employee defers plus 50% of the next 2% an employee defers. That translates to a 4% match to an employee that makes a salary deferral of 5% or more of compensation. Over the past several years as defined benefit plans (see below) became more costly to operate due to low interest rates and higher administrative costs, 401(k) plans have become the plan of choice for small and large employers alike.
Defined benefit plans include traditional defined benefit plans and cash balance plans (a hybrid between defined contribution and defined benefit). Although a third option, fully insured plans, are available, I do not recommend them as their complexities and restrictions are not worth the benefits of the plan design.
Traditional Defined Benefit Plan
The best comparison would be to Social Security, i.e., a plan that will pay a monthly benefit at retirement age. As in defined contribution plans, there are limits. The compensation limit is the same capped at $290,000. The maximum benefit that can be provided is the lesser of 100% of high three-year consecutive average compensation or $230,000 annually. A defined benefit plan, unlike a defined contribution plan, has a limit on what comes out rather than what goes in. There is no dollar limit on the contribution only what is required to fund promised benefits.
If the funding requirement is not satisfied by 8½ months after the end of the plan year, there is a 10% excise tax on the deficiency and a 100% excise tax if not satisfied in 90 days. In smaller companies a defined benefit plan is used to reduce taxes as the contribution and therefore the deduction is very high and not limited by the 25% as in defined contribution plans. In a large company, it is a true employee benefit plan although many companies are terminating their defined benefit plans because of the high cost, and offering 401(k)/profit sharing plans instead.
Cash Balance Plan
A cash balance plan is a hybrid, i.e., it has elements of a defined contribution plan and elements of a defined benefit plan. The plan document defines a “pay credit” and an “interest credit.” The pay credit can be a percentage of the participant’s compensation or a fixed dollar amount. The pay credit is projected to retirement with interest at the rate of the interest credit and converted to a monthly benefit. The monthly benefit is subject to traditional defined benefit limits, i.e., $230,000 annually. Each employee’s theoretical account balance is tracked annually similar to a defined contribution plan, i.e., opening balance plus pay credit plus interest credit, and reported to the employee as an account balance. When an employee terminates, they are paid the vested portion of their theoretical account balance. This plan design allows a different pay credit to be applied to different participants/groups but must pass non-discrimination testing as in a class allocation profit-sharing allocation. The nature of a cash balance plan allows different pay credits to be applied to owners in a multiple owner company. In many cases older owners want maximum funding but younger owners who have other financial obligations, e.g., education funding for their children, may want lower funding amounts. This cannot be accomplished in a traditional defined benefit plan. A cash balance plan is not appropriate for a one-person company as the same funding level can be developed in a traditional defined benefit plan at a much lower cost of administration.
About the author: Stephen Abramson is the president and founding partner of APS Pension & Financial Services established in 1977, a midsize consulting and actuarial firm employing 22 professional and support staff specializing in pension and pension-related services.