What are the differences among the many kinds of qualified retirement plans available?

There are two major categories of qualified retirement plans for businesses (a sole proprietor is a business for this purpose).  The first is called DEFINED CONTRIBUTION, and the second is called DEFINED BENEFIT.  These two categories of plans are INVERSES OF EACH OTHER.

In a Defined Contribution Plan, the employer, and maybe employees as well, contribute to an account in the name of each individual in the plan.  The money is invested and accumulates to a lump sum that is available to take out, or rollover to an IRA, at retirement, or upon termination of employment.  For each person, the plan acts like a big investment account.  The CONTRIBUTIONS are DEFINED by a formula that is specified in the Plan Document.   Usually money CANNOT be withdrawn prior to termination, except in the case of financial hardship, or if the plan allows, loans.  Most of the retirement plans in America today are Defined Contribution Plans.  This category includes SEP's, SIMPLE's, Profit Sharing Plans, 401(k) Plans, Money Purchase Plans, and Employee Stock Ownership Plans.

The other category is the Defined Benefit Plan.  In this kind of plan, often called a Pension Plan, the Plan Document defines a benefit formula, such as 50% of Average Pay, payable for life at age 65.  Or, 500% of Final Average Pay, payable as a lump sum at age 65.  In a Defined Benefit Plan, the BENEFIT is DEFINED, and the CONTRIBUTIONS must be determined by the plan's Actuary.  Cash Balance plans and 412(e)(3) plans (formerly called 412(i) plans) are special kinds of defined benefit plans.

For anyone who has a long period to accumulate retirement savings, say 30 years or more, the Defined Contribution Plan is a good way to do so.  But for anyone over the age of 40 or so, a Defined Benefit Plan is a much faster and higher-powered tool to accumulate retirement funds.

More on each type of plan below.


Defined Benefit Pension Plan - Conventional

The Defined Benefit Pension Plan is a unique tool for quickly accumulating retirement funds.  Instead of determining contributions, and investing them to produce the greatest possible benefit, the DB Plan defines the Benefit Formula, and determines appropriate contributions to fund the benefit. 

Think of a DB Plan like a mortgage.  If you are 10 years away from retirement, contributions are made to fund a 10-year payoff of the mortgage.  If you are 30 years away, the mortgage is 30 years.  The older you are, the higher the allowable contribution, because you've got less time to pay off the mortgage.  This is why DB Plans are great for older professionals, business owners, and sole proprietors.  If you are over the age of 40, and have not saved much for retirement, the DB Plan is the ONLY way to accumulate enough money fast enough.   It also allows for fantastic tax deductions. 

Imagine this:  an attorney age 55 contributes, and deducts from his tax, $200,000 per year for 10 years to fund his pension, and retires at age 65 with a lump sum of $2.5 Million.   In a Defined Contribution Plan (401(k), profit sharing, or money purchase plan), the annual limit would be $60,000 (in 2017), and it would be impossible to accumulate enough to retire in 10 years.

Defined Benefit Pension Advantages

Defined Benefit Pension Disadvantages

No discrimination test required (usually)

MUST file Form 5500

Best and fastest way to accumulate retirement funds for older employees

MUST hire actuary to meet filing requirements (such as ALI Actuarial & Retirement Plan Services)

No effective limit on tax deductions because the limit is placed on benefits instead

Employer contributions are MANDATORY (your actuary can help if this becomes an issue)

Can exclude those under 21 or under 1 year

 

Employer contributions may use vesting schedule

 

If you are interested in adopting a defined benefit pension plan, or have questions about your current pension plan, please call us at 919-357-2267, or email us at bmarotta@aliactuary.com.


Defined Benefit Pension Plan - 412(e)(3) (formerly 412(i))

Section 412(e)(3) is a special section of the Internal Revenue Code.  It refers to defined benefit pension plans that are INSURED through insurance company products, such as whole life insurance, annuities, or both. The major advantage of this type of plan over a conventional Defined Benefit Plan is that sometimes higher deductions are allowed.  This is because insurance companies, which are regulated by state laws, must guarantee their interest rates at a low level, usually lower than the rates a pension actuary is allowed to use for an actuarial valuation for a conventional pension plan.  Lower interest rates translate into larger contributions, because more of the  ultimate benefits to be paid out must come from contributions than from the investment income.  

Another advantage of the 412(e)(3) plan is that you do not need to file Form 5500 Schedule SB.  (You need to file this form for a conventional DB plan.)

Disadvantages of the 412(e)(3) plan are that no plan loans are allowed, contributions must be made at the beginning of the year, and contributions are not very flexible.  Also, the plan usually becomes overfunded after 5 years or so, so little or no contributions may be possible after that period.  Also, under the Pension Protection Act of 2006, it is now possible to accelerate contributions to a conventional DB plan in such a way that the 412(e)(3) plan is no longer much of an advantage.  Still, the advantage of the slightly higher deductions may sometimes make a 412(e)(3) plan worthwhile.

412(e) Defined Benefit Plan Advantages

412(e) Defined Benefit Plan Disadvantages

Larger deductions allowed (initially)

No loans allowed

Life insurance provides death benefits

Must make contribution at BEGINNING of the year

 

Employer contributions are MANDATORY (your actuary can help if this becomes an issue)

 

Can become overfunded after 5 years or so

 

Must use insurance company investments (no investment trust exists)

 

Not much better than conventional plan after PPA

If you are interested in adopting a 412(e)(3) defined benefit pension plan, or have questions about your current pension plan, please call us at 919-357-2267, or email us at bmarotta@aliactuary.com.


Cash Balance Pension Plan

A cash balance plan is a hybrid plan.  It is a defined benefit plan that is made to look like a defined contribution plan.  An account balance is kept for each participant.  Each year, contributions are made to the account.  Upon retirement or termination, the participant gets the vested account balance - so the plan acts like a defined contribution plan in almost every way.  Except that participants DO NOT exercise control over their investments - instead the employer GUARANTEES a modest rate of investment return (usually tied to an interest rate index).  The employer must contribute to the plan and invest the plan assets in such a way to fully fund the vested account balances.  For this reason, the plan is tecnically a DB plan and contributions must be actuarially determined each year.  Unlike a profit sharing or 401(k) plan, a Cash Balance plan has a funding requirement, with a minimum required and a maximum deducitble contribution each year.

Participants enjoy the guaranteed nature of this type of plan - they get a statement each year showing their account balance, the employer contribution, and their guaranteed investment return.  So this type of plan has been popular with employees.  But it has been a nightmare for regulators, who recently passed sweeping regulations preventing employers from converting their connventional DB plans to cash balance plans - older employees could lose most of their promised pensions in this type of conversion.

Disadvantages of the cash balance plan are that they are not easy to administer, require services of an actuary, and can have volatile contribution patterns, depending on how the plan assets perform.

Cash Balance Plan Advantages

Cash Balance Plan Disadvantages

Easier for participants to understand

Not easy to administer

Guaranteed invesment return

Requires actuarial services

 

Employer contributions are MANDATORY (your actuary can help if this becomes an issue)

 

Conversion from conventional DB limited

If you are interested in adopting a cash balance pension plan, or have questions about your current cash balance plan, please call us at 919-357-2267, or email us at bmarotta@aliactuary.com.


Simplified Employee Pension (SEP)

A SEP allows small employers to set up an IRA account for all eligible employees.  The nice thing about SEP's is that they are simple.  The disadvantages are that the employer MUST cover all full-time and part-time employees (age 21 and older who have worked 3 of the last 5 years; if they have been paid at least $500 for the year); that all employees must be 100% Vested; and that the employer CANNOT skew the contribution toward the higher paid employees (except for Social Security permitted disparity).  The employee is responsible for all his own investment decisions.

SEP's are attractive for smaller businesses in that they are simple and they avoid the Form 5500 filing with IRS.  However, they also significantly limit what the employer can do.  SEP's can become very expensive if the employer's business grows.  This is the least flexible kind of retirement plan.

SEP Advantages

SEP Disadvantages

Easy to administer

Employer contributions MUST be 100% vested

No Form 5500 to file

Employer contributions MUST be allocated pro-rata

No discrimination tests

Cannot skew contributions toward older/higher-paid

Employees can make own investment decisions

MUST cover all employees making $500 and working 3 of last 5 years

Employer contribution is discretionary

Must contribute on behalf of all eligible employees

If you are interested in adopting a SEP, or have questions about your current SEP, please call us at 919-357-2267, or email us at bmarotta@aliactuary.com.


Savings Incentive Match Plan for Employees (SIMPLE)

SIMPLE's were great idea that fell flat.  The IRS idea was, "Let's give small employers a way to adopt a 401(k)-like plan, without the discrimination tests, and omit the Form 5500 reporting.  Oh, by the way, let's make it so restrictive that nobody will really want to do it."  The SIMPLE is a little 401(k) plan, with lower dollar limits, and simplified government reporting.  It is not a great tax-deferral vehicle.  The disadvantages are that employees can only defer $12,500 annually in 2017 (401(k) plans allow $18,000); the employer MUST either match the first 3% employees defer, or 2% of their entire pay; all contributions are 100% vested; and the employer MAY NOT MAINTAIN ANY OTHER PLAN.  There are much better ways to go than this.

SIMPLE Advantages

SIMPLE Disadvantages

Relatively easy to administer

Employer contributions MUST be 100% vested

Employee can defer up to $12,500 on pre-tax basis (2017 limit)

Employer MUST match at least 3% of employee deferrals, or else contribute 2% for all eligible employees

No discrimination tests

Employer CANNOT maintain another plan

 

Employer MUST have 100 or fewer employees

If you are interested in adopting a SIMPLE, or have questions about your current SIMPLE, please call us at 919-357-2267, or email us at bmarotta@aliactuary.com.


401(k) Plan

This has been the most popular type of plan for the last 30 years.  Employees can elect to Defer up to $18,000 (this is based on the law in the year 2017 and can increase later), and avoid current taxation on the money.  The employer may Match a portion of the employee deferral, and all money is invested, sometimes with employee direction.  401(k) deferrals may be withdrawn upon financial hardship, and some plans allow loans.

The advantages of the 401(k) are that they are very popular with employees, the employer may use a Vesting Schedule on the match, and the highest contribution limits allowed by law are permissible.  The disadvantage is that the plan must pass a complicated Discrimination Test of the 401(k) and matching contributions.  Of course, a competent plan administrator, such as ALI Actuarial & Retirement Plan Services, can help you with the testing each year.

An innovation added to the ADP Discrimination Test recently is the Safe Harbor option.  An employer electing to use this option can avoid the ADP completely, if several requirements are met:

1.    The plan provides a required notice to each participant.

2.    The plan provides to all non-highly compensated employees, either:

    a.     matching contributions of 100% of the first 3% contributed plus 50% of the next 2% deferred

    b.    non-elective contributions of 3% of pay, regardless of deferrals.

Either type of contribution must be fully vested.

Something else new for 401(k) plans is the Catch-up Contribution.  A participant age 50 or older can now make deferrals in excess of the $18,000 limit.  The extra amount is $6,000 in 2015 and later.

401(k) Advantages

401(k) Disadvantages

Employees can defer up to $18,000 in 2017 pre-tax

Not easy to administer

Employer match is not required, but it helps

MUST file Form 5500

Employer match need not be 100% vested, but it helps if it is

Discrimination test required (unless use Safe Harbor plan)

Can exclude those under 21 or under 1 year

 

Can allow employee loans

 

Catch-Up Contributions allowed (if age 50)

 

If you are interested in adopting a 401(k) plan, or have questions about your current 401(k) plan, please call us at 919-357-2267, or email us at bmarotta@aliactuary.com.


Profit Sharing Plan

Profit sharing plans have been around for many years.  A 401(k) plan is in fact a special kind of profit sharing plan.  The employer contributes a share of profits each year, up to 25% of the gross pay of all eligible employees.  The employer then Allocates this amount to eligible employees.  Not all employees have to be eligible.  The plan may exclude those under age 21 and those with less than 1 year of service (2 years if you want to use 100% vesting).  The employer may also skew the contribution toward the highly paid employees (and toward the owner himself).  The plan may also use a vesting schedule of up to 5 years (7 years with a graded schedule).   An individual may receive contributions of up to $54,000 (or $60,000 if age 50) in 2017. 

Profit sharing plans are still very popular and give the employer great flexibility.  The contribution is Discretionary, which means the employer may decide to fund  nothing for the year.

Profit Sharing Advantages

Profit Sharing Disadvantages

Relatively easy to administer

MUST file Form 5500

No discrimination tests required (usually)

Employer's contribution limited to 25% of payroll

Employer contribution is DISCRETIONARY

 

Employer contributions can be skewed for owners

 

Employee deferrals allowed if add 401(k) feature

 

Can exclude those under 21 or under 1 year

 

Employer contributions may use vesting schedule

 

Forfeitures can reduce employer contributions

 

If you are interested in adopting a profit sharing plan, or have questions about your current profit sharing plan, please call us at 919-357-2267, or email us at bmarotta@aliactuary.com.


Money Purchase Pension Plan

Just like a profit sharing plan with two important exceptions.  (1)  The contribution is determined by a formula, such as "5% of eligible pay."  (2)  The contribution is mandatory (not discretionary).  

Money Purchase Pension Plans are great for employers who want to take on a funding commitment.  Unlike the profit sharing plan, the contribution is mandatory.  Also, for plan years 2001 and prior, the maximum contribution limit to a Profit Sharing plan was 15% of pay, which gave the Money Purchase Plan an advantage at 25% of pay.  But starting in year 2002, both plans are limited to 25% of pay.  So this has made Money Purchase plans less attractive than Profit Sharing plans nowadays. 

An employer may have both a Profit Sharing Plan (with or without the 401(k) feature) and a Money Purchase Pension Plan.  In that case, the employer maximum to both plans combined is still 25% of pay, and the individual's maximum is still $54,000 ($60,000 if age 50) in 2017.

Money Purchase Advantages

Money Purchase Disadvantages

Relatively easy to administer

Must file Form 5500

No discrimination tests required (usually)

Employer contribution is MANDATORY

Can exclude those under 21 or under 1 year 

 

Employer contributions may use vesting schedule

 

Employer's total contribution can be 25% of payroll

 

Employer contribution can be skewed for owners

 

If you are interested in adopting a money purchase plan, or have questions about your current money purchase plan, please call us at 919-357-2267, or email us at bmarotta@aliactuary.com.


Employee Stock Ownership Plan (ESOP)

The ESOP was invented to allow a retiring business owner a neat way to sell his business, defer some tax on the sale, and have the company buy it back from him.  The ESOP is established as a tax-deferred vehicle for this purpose.  The plan may take out a loan, pay off the owner, and allocate the company stock to employees as the plan pays off the loan.  The selling owner may be eligible for deferral of the taxable gain on the sale of the business, if the ESOP owns at least 30% of the business.

Here is how it usually works:

  1. The ESOP takes out a loan from a bank, or other lender, and buys the stock from the owner.

  2. The company makes annual contributions to the ESOP to pay off the loan.

  3. As the loan gets paid off, stock is allocated to the accounts of employees.

  4. When employees terminate, the ESOP (or the company) buys back their shares and gives them cash.

The company may benefit from employee ownership, and the seller may get a big tax break.  Also, the company gets to pay off the loan (both principal and interest) with fully tax-deductible contributions.  And the employees benefit from the growth in value of the company stock.  Also, stock dividends may be used to help pay off the loan, or may be allocated to participants, or may be paid directly to participants.

Employee Stock Ownership Plan Advantages

Employee Stock Ownership Plan Disadvantages

Tax deferral if owner sells 30% of company

Not easy to administer

Employees gain control of company

Must make loan payments on schedule

Employer can deduct both loan principal and interest 

Must give employees voting power on their stock

Can exclude employees under 21 and under 1 year of employment

Designed for C-corporations (limited advantages for S-corporations)

Employer contributions may use vesting schedule

 

Employer's contribution can exceed 25% of payroll

 

If you are interested in adopting an ESOP, or have questions about your current ESOP, please call us at 919-357-2267, or email us at bmarotta@aliactuary.com.

If you have any more questions about any of these types of retirement plans, please contact us at ALI Actuarial & Retirement Plan Services.