Profit Sharing Plans
Profit Sharing Plans offer both design flexibility and discretion as to contribution levels. These plans provide maximum flexibility, as a specified contribution is not required each year and the employer may vary the contribution annually. The maximum contribution is 25% of total eligible compensation of the practice and the maximum allocation to an individual is the lesser of either 100% of plan compensation or $49,000 ( for 2009). Company contributions are determined by the employer and can be allocated in a number of ways, based on a formula specific in the plan document.
If the company makes little or no profit during the year, no contribution is required, although low profits don’t restrict the contribution level. A profit sharing plan can include an option allowing the company to make contributions even if the company has no profit.
Advantages:
Contribution
is discretionary each year; although generally contributions should be substantial and recurring- Contribution is generally subject to a vesting schedule- promotes employee retention.
- Part-time employees may be excluded from participating
Design Options;
To weigh plan contributions to key employees, a profit sharing plan may utilize one of the allocation methods described below:
Age-Weighted Profit Sharing Plans
These plans utilize allocation methods that base contributions on both age and compensation of eligible employees, similar in concept to a define benefit pension plan, but with discretionary contributions. For such plans, non-discrimination testing is based on the anticipated benefits at retirement, similar to defined benefit plans, as opposed to the level of contributions made in that particular year.
In an Age-weighted plan, the participant’s age, or length of time until retirement, is factored into the allocation formula on an individual’s basis, so older participants receive a larger proportionate share of the contribution.
Cross-Tested (New Comparability) Profit Sharing Plans
The cross-tested plan allows the employer to select classes of employees that provide for a different contribution allocation levels for each group (e.g., by job title, salary, etc.), with each participant’s contribution converted to a benefit paid at retirement provided the non-discrimination tests are met, the employer can allocate a larger proportionate share of the company’s contribution to specific employees the employer wishes to benefit the most, generally owners and key employees.
This plan design is popular with clients as it often results in a large allocation to the owner and small allocation to the staff. The plan allocates the contribution based on classes which often consists of a business owner, and all other staff.
Integrated Profit Sharing Plans
These plans allow employers to integrate contributions made into company retirement plan with Social Security benefits. Integration results in tilting retirement benefits towards highly compensated employees (generally owners and key employee), while keeping the funding level for the rank-and-file minimums required to pass the non-discrimination testing.
Non-discrimination testing is required every year to demonstrate that plans do not favor highly compensated employees. The employer imputes benefits derived from Social Security in calculating the benefits received by highly compensated employees and non-highly compensated employees.
Integration is generally done in two ways:
Excess formula: provides higher benefit to employees who earn more than the plans established integration level, by more than twice what employees who earn less than the integration level receive, generally Social Security taxable wage base.
Offset Formula; reduced benefits earned by low-paid employees, generally no more than 50% of the plan benefit.
401(k) Profit Sharing Plans
A 401(k) profit sharing plan is a type of profit sharing plan established under Section 401(k) of the Internal Revenue Code. It includes an elective salary deferral provision which allows employees to set aside, or defer, a portion of their compensation for retirement purposes.
The employer typically has the ability to make matching contribution tied to the elective salary deferral. An additional profit sharing contribution may also be allocated to all eligible participants. Participants usually have the ability to select their own individual asset allocation from various investment alternatives available to the plan, although a pooled trust option, where all participating employee money is held is also available.
Advantages:
employee’s perception of the benefit being
provided by the employer.
- Salary deferral limits are greater than IRAs
- Salary deferral amounts are flexible
- Part-time employees who work less than 1,000 hours per year may be excluded from participating.
401(k) Safe Harbor (SH) Plans
Addition of a Safe Harbor provision to a 401(k) plan permits the owner and other highly compensated employees to defer the maximum without regard to the deferral levels of the non-highly compensated employees.
Safe Harbor Types:
Non-elective contribution: 3% of compensation for each eligible employee
- Match: Dollar for Dollar up to 4% of compensation
What you need to know and communicate about Safe Harbor 401(k) plans:
Employer Contribution Requirement: the 3% Safe Harbor Non-Elective Contribution or
Safe Harbor Match to all eligible employees must be made every year if the election is made Vesting Requirement: in contrast to a discretionary Profit contribution, the Safe
Harbor match or 3% non-elective contribution is 100% vested immediatelyWithdrawal Restrictions: - Safe Harbor contributions are subject to withdrawal
restrictionsAnnual Notification Requirements: Notice must state the rights and obligations of the
employees eligible to participate in the plan and should be provided:
o For existing SH 401(k) plans, on an annual basis, 30 to 90 days prior to the beginning of the year
o For new participants, 30 to 90 days prior to becoming eligible to participate in the plan.
o For a 401(k) plan that is adding the safe Harbor feature, plan must be amended and a notice provided 30 days before the new plan year begins.
Money Purchase Plans
A Money Purchase Plan is a pension plan that utilizes a fixed benefit formula which ranges from 0% to 25% of compensation. The plan could also be integrated and have formula such as 10% of compensation plus 5.7% of compensation which is above the Social Security Wage Base.
After increase in the Profit Sharing Plan deduction limit to 25%, this plan design has lost the advantage it once offered and thus its appeal. Considering its mandatory contribution nature this plan design is not widely used.
Defined Benefit (DB)Plans
Defined Benefit pension plan is designed to provide a specific benefit amount at retirement. This is a traditional pension plan funded by the employer, generally without employee contributions. Defined Benefit plans provide a monthly benefit beginning at retirement and payable until death. The amount is based on years of service and earnings during the highest three consecutive years of employment while participating in the plan, with a maximum annual benefit of $195,000 beginning in 2009.
A Defined Benefit Plan affords clients the opportunity to make yearly retirement contributions in excess of what they can do in a 401(k) Profit Sharing Plan therefore significantly reducing their tax losses. Depending on the age and income of the client, business contributions will range from $60,000- $200,000. The plan allows the owners to save up to $2.2 million for retirement in just 10 years. A de
fined Benefit Plan comes with a IRS Letter of Determination regarding tax benefits.
An employer can maintain both a defined benefit plan and a profit sharing plan at the same time.
Defined benefit plan sponsors can maximize contributions by providing an insured death benefit under IRS incidental benefit limits. These specially designed life insurance contracts protect participants from premature death, with the cash value of the policies funding retirement benefits.
Who can benefit from a Defined Benefit Plan? Ideal Candidates:
Self-employed individual with no employees: any age
Business owners age 45-60 with up to ten employees
Business with less then 3 principals
Business owners who can contribute more than
$60,000 annually ( inclusive of the current retirement plan savings)
Why consider a Defined Benefit Plan Solution?
No risk Pension Feasibility Study ( no cost if 10 employees or less)
Highest allowable deductable contributions to a qualified plan $100,000 or more
Annual tax savings of $40,000 or more (depending on the amount of the contribution)
Tax Deferral on contributions and earnings
Payroll tax savings: contributions not subject to payroll tax
Opportunity to purchase life insurance with pretax dollars within IRS Death Benefit
LimitsInvestments grow tax deferred, building wealth faster
Tax-Free rollover to IRA at retirement(or at plan termination)
Competitive annual plan administration fees
ERISA protection of assets from judgement creditors
Ability to jump start retirement savings or catch up before entering retirement
Cash Balance Plans
There are two general types of pension plans — defined benefit plans and defined contribution plans. In general, defined benefit plans provide a specific benefit at retirement for each eligible employee, while defined contribution plans specify the amount of contributions to be made by the employer toward an employee’s retirement account. In a defined contribution plan, the actual amount of retirement benefits provided to an employee depends on the amount of the contributions as well as the gains or losses of the account.
A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance. A cash balance plan is referred to as a Hybrib Plan.
In a typical cash balance plan, a participant's account is credited each year with a "pay credit" (such as 5 percent of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer.
The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.
Cash balance plans are defined benefit plans. In contrast, 401(k) plans are a type of defined contribution plan. There are four major differences between typical cash balance plans and 401(k) plans:
a. Participation - Participation in typical cash balance plans generally does not depend on the workers contributing part of their compensation to the plan; however, participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to make a contribution to the plan.
b. Investment Risks - The investments of cash balance plans are managed by the employer or an investment manager appointed by the employer. The employer bears the risks and rewards of the investments. Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. By contrast, 401(k) plans often permit participants to direct their own investments within certain categories. Under 401(k) plans, participants bear the risks and rewards of investment choices.
c. Life Annuities - Unlike many 401(k) plans, cash balance plans are required to offer employees the ability to receive their benefits in the form of lifetime annuities.
d. Federal Guarantee - Since they are defined benefit plans, the benefits promised by cash balance plans are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and to begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.