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Retirement Plans

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Defined Benefit Plans

A defined benefit pension plan is a qualified retirement plan to provide pension income to retired employees on the basis of a formula that accounts for a worker’s years of service at a firm and earnings. Distributions are typically made for the remainder of the employee’s life, making the plan similar to an annuity. Contributions are generally made by the employer only, who is responsible for determining what level of contributions is necessary to provide the promised benefits to all current and future employees. Contributions to defined benefits plans are tax-deferred, meaning that neither the employer nor the employee pays tax on the initial contributions or accumulated earnings.

  • Compared with other types of retirement accounts, the risk in a defined benefit plan is borne mostly by the employer. If employees live longer in retirement than anticipated, or if the investments financing the employees’ pensions fail to meet expectations, it is the employer’s responsibility to increase contributions so as to make good on the promised benefits.
  • Defined benefit plans are more likely to be offered by large employers who are better suited to bear the risk involved, but can be very advantageous for smaller employers as an asset accumulation vehicle.
  • Defined benefit plans are insured by the Pension Benefit Guarantee Corporation, a federal entity whose responsibility is to ensure that employees receive a minimum pension benefit in the event that their employer is unable to pay the promised benefits in full.

Cash Balance Plans

A cash balance plan is considered an employer sponsored hybrid defined benefit pension plan. While a traditional defined benefit pension plan provides a monthly benefit at retirement, the cash balance plan expresses the benefit in terms of an “account balance” –very similar to a 401(k) in appearance.  As such, it is much better understood & appreciated by employees.

How do cash balance plans work?

A cash balance plan provides each participant a “pay credit” each year, which is added to their “hypothetical account” and also credited a guaranteed rate of interest each year “interest credit”. The Pay Credit is usually some percent of pay or dollar amount and can vary by participant or group (i.e, 25% of pay to owners & 3% of pay to others). The Interest Credit will normally be a fixed rate such as 5% or tied to an index like US Treasuries. Both the Pay Credit and Interest Credit are defined in the Plan Document.

401(k)

A 401(k) is a qualified retirement plan that allows employees to contribute a portion of their wages to individual accounts.

  • Elective salary deferrals are excluded from the employee’s taxable income (except for designated Roth deferrals).
  • Employers can contribute to employees’ accounts.
  • Distributions, including earnings, are includible in taxable income at retirement (except for qualified distributions of designated Roth accounts).

Profit Sharing Plans

A Profit Sharing Plan is a qualified retirement plan that allows employers to receive an immediate tax deduction for contributions to employee accounts while they receive tax-deferral on such contributions until retirement or distribution.

  • A profit is not required in order to make contributions to a profit-sharing plan.
  • Contributions to a profit-sharing plan are discretionary and can vary from year to year.
  • A set formula for determining how the contributions are divided is required. This money goes into a separate account for each employee.
  • One common method for determining each participant’s allocation in a profit-sharing plan is the “comp-to comp” method which allocates contributions based on their percentage of total compensation.
  • Contributions are limited to the lesser of 25% of compensation or $51,000 (indexed).

New Comparability Plans

A New Comparability Plan is a particular type of Profit Sharing Plan that allows employers to receive an immediate tax deduction for contributions to employee accounts while they receive tax-deferral on such contributions until retirement or distribution.

  • A profit is not required in order to make contributions to a profit sharing plan.
  • Contributions to a profit sharing plan are discretionary and can vary from year to year.
  • A set formula for determining how the contributions are divided is required. This money goes into a separate account for each employee.
  • This approach allows us to vary contribution rates by employee or employee group subject to nondiscrimination testing.
  • Contributions are limited to the lesser of 25% of compensation or $51,000 (indexed).
  • Works best for smaller employers where the owners are older than their employees.

Employee Stock Ownership Plans

An employee stock ownership plan (ESOP) is a qualified defined contribution plan. An ESOP must be designed to invest primarily in qualifying employer securities as defined by IRC section 4975(e)(8) and meet certain requirements of the Code and regulations.

Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual.

When employees leave the company, they receive their stock which the company must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares. In private companies, employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the board of directors) on other issues. In public companies, employees must be able to vote all issues.

Why create an ESOP?

  • To buy share of a departing owner
  • To borrow funds at a lower after-tax cost
  • To create an additional employee benefit

What are the tax benefits?

  • Contributions of stock are tax-deductible
  • Cash contributions are tax-deductible
  • Contributions used to repay loans used to buy company shares are tax-deductible
  • Sellers in a “C” Corporation get tax deferral
  • Dividends are tax-deductible
  • Employees may get favorable tax treatment on distributions at retirement

403(b) Plans

A 403(b) tax-sheltered annuity (TSA) plan is a retirement plan, similar to a 401(k) plan, offered by public schools and certain 501(c)(3) tax-exempt organizations. An individual may only obtain a 403(b) annuity under an employer’s TSA plan.

SIMPLE IRA Plans

SIMPLE IRA plans can provide a significant source of income at retirement by allowing employers and employees to set aside money in retirement accounts. SIMPLE IRA plans do not have the start-up and operating costs of a conventional retirement plan.

  • Available to any small business – generally with 100 or fewer employees
  • Easily established
  • Employer cannot have any other retirement plan
  • No filing requirement for the employer
  • Contributions:
    • Employer is required to contribute each year either a:
      • Matching contribution up to 3% of compensation, or
      • 2% nonelective contribution for each eligible employee
        • Under the “nonelective” contribution formula, even if an eligible employee doesn’t contribute to his or her SIMPLE IRA, that employee must still receive an employer contribution to his or her SIMPLE IRA equal to 2% of his or her compensation
      • Employees may elect to contribute
      • Employee is always 100% vested in (or, has ownership of) all SIMPLE IRA money

SEP Plans

Simplified Employee Pension (SEP) plans can provide a significant source of income at retirement by allowing employers to set aside money in retirement accounts for themselves and their employees. A SEP does not have the start-up and operating costs of a conventional retirement plan and allows for a contribution of up to 25 percent of each employee’s pay.

  • Available to any size business
  • Easily established
  • Cannot have any other retirement plan (except another SEP)
  • No filing requirement for the employer
  • Only the employer contributes
    • Traditional IRAs (SEP-IRAs) set up for each eligible employee
    • Employee is always 100% vested in (or, has ownership of) all SEP-IRA money

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