Qualified retirement plans fall under one of two categories:
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Defined Benefit (DB) Plans
A Defined Benefit Pension Plan promises a specific benefit at retirement based on a formula which takes into consideration such factors as salary and years of service.
Since retirement benefits under a DB plan are determined by the plan's benefit formula - not by employer contributions and investment earnings as in a defined contribution plan - the employer, rather than the participant, bears the investment risk. This means that if investment return is lower than anticipated, larger employer contributions will be required to properly fund the plan; likewise, if investment performance is better than expected, smaller employer contributions will be required.
Employer contributions to a DB plan are determined each year by an actuarial valuation. If the actuarial valuation indicates that a contribution is required, that amount must be deposited within 8½ months following the close of the plan year. Failure to make the required contribution by the due date results in an excise tax payable to the IRS by the employer. Payment of the excise tax does not relieve the employer from the funding obligation.
Within limits, the Pension Benefit Guaranty Corporation (PBGC) guarantees benefits under private DB plans, other than plans sponsored by small professional organizations or plans which benefit only owners and their spouses.
DB plans tend to favor older, highly compensated employees creating higher tax deductions for the employer.
Defined Contribution (DC) Plans
In a Defined Contribution Plan, a participant's retirement benefits are based solely on the participant's account balance. The account balance depends on the level of employer and/or employee contributions and the earnings/losses on those contributions during an employee's years of participation in the plan.
The following are different types of Defined Contribution Plans:
Profit Sharing Plan:
A plan under which employer contributions are generally discretionary and not limited to current or accumulated net profits. The maximum annual contribution an employer may make to a profit sharing plan is 25% of participating compensation. Contributions to a profit sharing plan are allocated (divided up) among eligible participants based on a predetermined formula in the written plan document. The maximum allocation to a participant, per year, is 100% of compensation or $50,000 (as indexed by COLA), whichever is less.
Common allocation formulas are:
• pro rata, in which a participant receives an allocation based on the ratio of his compensation to the total compensation of all eligible participants;
• integrated, in which participants with compensation over the Social Security OASDI wage base receive an increased proportion of the total contribution;
• age-weighted, which considers both a participant's age and compensation in determining the participant's share of the total contribution, resulting in larger proportionate allocations to older workers;
• tiered or new comparability, in which participants are divided into groups, typically based on job title or description, and contributions are allocated on a pro rata basis within each group. In order for this type of formula to be used, the "tiered allocations" must be converted into equivalent benefits at retirement (as though they were benefits under a DB plan), and the resulting benefits must satisfy nondiscrimination tests. Tiered plans are ideal for employers with older owners and younger rank-in-file employees, allowing larger proportionate allocations to the owners.
Stock Bonus Plan:
A DC plan similar to a profit sharing plan except that benefit payments are generally made in shares of employer stock. A stock bonus plan may be designed to allow distributions of cash, instead of shares, with the participant's consent. If the plan permits cash distributions and the employer stock is not readily tradable on an established market, the employer must be required to repurchase the shares of stock it distributes to participants at fair market value.
Section 401(k) Plan:
A profit sharing plan to which employees may elect to make pre-tax contributions via payroll deduction in lieu of receiving those moneys as taxable income. This election is also known as a Cash or Deferred Arrangement or CODA. A 401(k) plan may be designed to allow discretionary employer matching and/or profit sharing contributions, or may be set up as a Safe Harbor 401(k).
Employee Stock Ownership Plan (ESOP):
A plan designed to invest primarily in employer securities. Unlike other types of qualified plans, an ESOP may borrow funds to acquire employer securities.
An employee stock ownership plan that takes out a loan to purchase employer stock.
A stock bonus plan in which 401(k) salary deferrals and/or employer contributions may be invested in employer stock. A KSOP must comply with all the stock bonus plan rules as well as the 401(k) rules.
Money Purchase Plan:
Similar to a profit sharing plan, contributions to a money purchase pension plan are allocated (divided up) among eligible participants based on a predetermined formula in the written plan document. The maximum allocation to a participant, per year, is 100% of compensation or $50,000 (as indexed by COLA), whichever is less.
Similar to a DB plan, employer contributions to a money purchase pension plan must be deposited within 8½ months following the close of the plan year. Failure to make the required contribution by the due date results in an excise tax payable to the IRS by the employer. Payment of the excise tax does not relieve the employer from the funding obligation.
Savings Incentive Match Plan for Employees (SIMPLE):
A plan involving simplified legal requirements for businesses with 100 or fewer employees. SIMPLEs cannot be used in conjunction with any other active qualified plan covering the same employees. SIMPLEs require 100% immediate vesting of participant account balances.
There are two types of SIMPLEs:
• SIMPLE 401(k):
A 401(k) plan for the small employer which is exempt from ADP and ACP testing and the top heavy rules in exchange for set employer contributions and a lower limit on employee salary deferrals.
• SIMPLE IRA:
Similar to a SIMPLE 401(k), except all contributions are made to IRAs. Participant loans are not allowed under a SIMPLE IRA.
Safe Harbor 401(k) Plan:
A 401(k) plan which is exempt from nondiscrimination testing of employee deferrals and/or matching contributions in exchange for providing (1) certain minimum levels of matching or nonelective employer contributions, and (2) advance notice to participants on an annual basis that Safe Harbor contributions will be provided.
Section 403(b) Plan:
A plan available to non-profit organizations exempt under Code Section 501(c)(3) - generally, churches, hospitals, and schools - under which employees may elect to make pre-tax contributions in lieu of receiving those moneys as taxable income.