401(k) and Qualified Plans: Introduction
Retirees normally receive their income from one of the following three main sources:
Benefits from the social security system
Their regular savings account
A retirement plan (for example, IRAs or employer-sponsored plans)
In some cases, employers will establish a “qualified plan” which is the mechanism that handles the retirement benefits for their employees and their families. Whereas SEP and SIMPLE IRSs are linked to the IRA, a qualified plan has no connection to the IRA and therefore it does not need to abide by the same regulations regarding contributions and distributions. Businesses can choose to set up a qualified plan or an IRA-based plan. This decision will generally be made based upon how much the business is prepared to contribute and if they want and have the capacity to administer the plan. Qualified plans are more difficult to administer than SIMPLE IRAs or SEP. Qualified plans can be defined either by their benefits or contributions. Employers receive tax deductions in return for the contributions that they make to the plan. Employees are generally not required to pay taxes on the assets in the plan until after distribution. Another advantage is that earnings are tax deferred with qualified plans. For a plan to have “qualified” status, it is required to comply with the requirements set out in the Internal Revenue Code (IRC), the Employee Retirement Income Security Act 1974 (also known as ERISA) and the Department of Labor (DOL).
Defined-Benefit Plans
A defined-benefit plan is a qualified plan in which the retirement benefits that an employee receives are based on their personal characteristics, such as their compensation, age and years of service. An example of this is a plan that says that when an employee retires, his or her benefits will be 1% of the average salary that they received in the last five years with the company for the same period of time as their length of service. Another option is that the plan may state the exact amount (for example, $200 a month) of the benefit.
EXAMPLE: John spent 10 years working for ABC Company. He earned $65,000 in 2004, $70,000 in 2005, $80,000 in 2006, $90,000 in 2007 and 100,000 in 2008. This means that his average salary for his last five years was $81,000. In turn, that means that 1% of his last five years average salary is $810. According to the plan, John is entitled to receive $810 for the same number of years that he worked for the company, that is, for 10 years.
This is the predetermined retirement benefit and the employer is required to make contributions to equal this amount. In making these contributions they will use actuarial assumptions that take into account the expected investment growth. When the investments made by the plan fail to perform and do not reach the required amount, the employer must contribute more to make up the balance. Contribution limits are much higher for defined-benefit plans than defined-contribution plans. Operating a defined-benefit plan will usually require actuarial assistance as it is based on formulas and actuarial assumptions.
Defined-Contribution Plans
With a defined-contribution plan, the specific amount that the employee will receive when they retire is not promised. Employees, employers or (in some cases) both make contributions to these plans. The contribution is usually a percentage of the employee’s compensation package. The employer contributions may be compulsory or discretionary, depending on the type of plan used. The plan will invest the contributions on behalf of the employee. The benefit that they will receive upon retirement is based on the contributions that were made and the investment results (earnings or loss). In these types of plans, employers don’t have to compensate for the possible loss on the investments. These plans may take the form of a profit-sharing plan, a 401(k) plan, an ESOP (employee stock ownership plan) or a money-purchase pension plan.
Plan Definitions
Profit-Sharing or Stock-Bonus Plans
As the name suggests, a profit sharing plan is used by businesses to share profits with their employees. Employers are able to make these types of contributions whether or not the business actually profited during the year. These contributions will usually be discretionary, meaning that the employer decides whether or not they want to contribute to the plan in a particular year. Although this may seem a very flexible system, the employer cannot let too many years pass without making a contribution. The IRS doesn’t exactly specify the number of years that are allowed, but there are requirements that the contributions must be recurring and substantial.
With a stock-bonus plan the employer will use stock in the company to make contributions or distributions. These types of plans cannot be used by sole proprietorships or partnerships.
Profit-sharing plans and stock-bonus plans can have a 401(k) feature. These plans are well suited for newly established employers who are unable to accurately predict their future profit levels or who would like their contributions requirements to be flexible.
Money-Purchase Pension Plan
Generally speaking, money-purchase and defined-benefit plans have less flexible contribution requirements than profit-sharing plans. Money-purchase plans have fixed contribution levels that are not related to the profits of the business. For example, if the plan says that members will receive 10% of their compensation, then the employer must contribute that amount regardless of the company’s profits. These types of plans suit employers that have a clear picture of their profit trends and who don’t mind making compulsory annual contributions.
401(k) Profit-Sharing Plan
In a 401(k) plan employees can defer receiving a portion of their compensation and elect to have that amount put into their plan. This is also commonly known as CODA, which stands for “cash or deferred arrangement”. The deferred contributions (also known as “elective deferrals”) are usually made to the plan before tax. Employers will choose the type of plan that they use and it could either be a stand-alone 401 (k) plan or a plan that combines profit-sharing with 401(k). The employer will also choose whether they want to make additional contributions to the plan. 401(k) plans are designed for employers that want their employees to help with the plan funding.
Age-Weighted Plans
An age-weighted feature can also be added to retirement plan. This basically means that an increased proportion of the plan contributions will be allocated to older employees. This is based on the assumption that these older employees are going to retire sooner and have less time to build their savings. These plans suit situations where the business owners are much older than the employees and they have not yet accumulated sufficient retirement savings.
Employee Stock Ownership Plans (ESOPs)
ESOPs are a type of defined-contribution plan which involves investments primarily in stock of the company. These plans were authorized by Congress in order to encourage increased employee involvement in corporate ownership.
Why Establish a Qualified Plan?
Choosing the most suitable retirement plan is a business decision with huge financial implications. The plan needs to suit the immediate needs of the employer and to be consistent with their business and financial profile. Qualified plans benefit both employers and employees.
Benefits for Employers
Some plans offer employers tax deductions when they make contributions
It may enable the employer to attract and retain the best employees. A qualified plan may be the factor that makes a sought after employee select one company over another.
In some situations the employer can claim a tax credit to cover part of the costs of establishing the plan. This is only possible if the expenses were incurred after December 31, 2001. The maximum credit available is $500 for the initial three years of the plans operation. This covers 50% of the establishment, administration and employee education expenses.
Benefits for Employees
Employees have peace of mind from some guarantee of their financial security in retirement.
Where the plan involves a salary-deferral feature, the employee can defer paying tax on the amount of compensation that they contribute to the plan until it is distributed. At this time their tax bracket will probably be lower so overall they will pay less tax.
In some plans employees are permitted to take out loans from the plan. Interest on the loan is credited to the employee’s account. This makes it a better option that loans from a financial institution where the interest goes to that institution.
401(k) and Qualified Plans: Eligibility Requirements
Any type of business can set up an establishment plan. It doesn’t matter if the business is a sole proprietorship, a partnership, or corporation of a government entity. Employees cannot set up a qualified plan. The plan must be established by the employer.
Establishing a Qualified Plan
A qualified plan normally is made up of two documents: 1) the adoption agreement and 2) the plan document. The plan document sets out the provisions of the plans operation. The plan is formally adopted when the employer passes a resolution which says that they are adopting the plan. They will then complete the adoption agreement and issue a summary plan description (SPD) to employees. The SPD is required to be written in plain language so that all employees are able to understand it clearly. The SPD must include the following information:
the plans location and identification number
how the plan will operate and what it will provide for employees
when it will commence
how the benefits and length of employee service will be calculated under the plan
when the employee will be entitled to their benefits
when and how employees will receive their benefits
how benefits should be requested
possible situations where employees could be denied or lose their benefits
rights of the employee under ERISA
It is important that employees read the SPD so that they are aware of the provisions of the plan that apply to them. When the plan’s provisions change, the employer must issue a revised SPD or a new document known as a summary of material modifications (SMM).
Choosing a Plan Provider
Employers have the option of establishing their own plan that is specifically designed for their business or choosing a plan designed by a sponsoring organization that has been approved by the IRS.
Individually Designed Plans
The point of an individually designed plan is to meet the specific needs of a particular employer. No other employers are permitted to use this document. These types of plans are typically used by large companies that have certain specifications in mind for their plan that they can’t get from a prototype. Individually designed plans are not required to be approved in advance by the IRS ,, however, the employer can apply for IRS approval if they want to be assured that the plan satisfies the regulations. They will need to pay a fee and ask for a determination letter. Lawyers and tax professionals are normally involved in drafting new plans and their fees will vary.
Master or Prototype Plans
Small businesses are often attracted to master or prototype plans that have already been approved by the IRS so there is no need to apply and pay for a determination letter. These types of plans can be used by more than one employer. In master plans, the operator will set up one trust or custodial account that will be used by all employers that adopt the plan. In prototype plans, separate trusts or accounts are set up for each employer. Several different types of organizations can sponsor master or prototype plans including:
banks (this includes certain approved federally insured credit unions and savings and loan associations)
trade unions or professional organizations
mutual fund or insurance companies
attorneys, financial planners or accountants
Establishment Deadline
Qualified plans are required to be established before the final day of the employer’s tax year. The employer is required to make contributions for that year and all subsequent years according to the provisions in the plan.
Eligibility Requirements for Employees (Plan Participants)
There are specific requirements that employees must meet in order to participate in the plan. It is important that business owners don’t implement requirements that would mean that they cannot participate in the plan. For example, if a business owner is 19 years old then a requirement that plan participants be over 21 would mean that he or she is excluded. Qualified plans will generally have the following eligibility requirements for employees:
The employee is over age 21. The minimum age of a plan cannot be more than 21 and employees under this age can be excluded. Maximum age limits are not permitted, meaning employees cannot be excluded for reaching an upper age limit.
The employee has been working for the company for at least one year. For plans other than 401(k) plans, this requirement is increased to two years of service. These plans also provide that after service of less than two years the contributions will be vested and the employee will have a non-forfeitable right to the total of his or her benefit. According to a qualified plan, one year of service is usually equivalent to 1,000 hours of service per plan year. Employees who don’t work 1,000 hours in a year are not considered to have worked for one year even if they worked over a 12 month period.
Exceptions to these eligibility requirements may be implemented by employers (for example, they may reduce the minimum age or change the required hours of service). There are some eligibility criteria though that must conform to the regulations governing qualified plans. Employers must consult with a lawyer regarding eligibility requirements that haven’t been approved by the IRS before implementing the plan.
Excludable Employees
Employers are permitted to exclude certain employees from the plan, for example those who are unionized or nonresident aliens.
Vesting - Employees Non-Forfeitable Rights to Employer Contributions
The term “vesting” refers to the process whereby the employee becomes entitled to a non-forfeitable right to access the benefits that their employer has contributed. Vesting schedules have been set up to meet regulatory requirements and qualified plans need to abide by these requirements. Employees will always have vesting rights in relation to the contributions that they make to the plan. There are two different type of vesting schedules that an employer can choose from. They are:
Cliff Vesting. With a cliff-vesting schedule the employee is required to stay with the company for three years of service before the employer contributions will be considered vested. Following three years, these contributions will be 100% vested.
GradedVesting. With graded-vesting schedules, the employer contributions will become 20% vested after the employee has completed two years of service. The vesting then increases by 20% in each subsequent year until it gets to 100%. This will occur following six years of employee service.
Retirees normally receive their income from one of the following three main sources:
Benefits from the social security system
Their regular savings account
A retirement plan (for example, IRAs or employer-sponsored plans)
In some cases, employers will establish a “qualified plan” which is the mechanism that handles the retirement benefits for their employees and their families. Whereas SEP and SIMPLE IRSs are linked to the IRA, a qualified plan has no connection to the IRA and therefore it does not need to abide by the same regulations regarding contributions and distributions. Businesses can choose to set up a qualified plan or an IRA-based plan. This decision will generally be made based upon how much the business is prepared to contribute and if they want and have the capacity to administer the plan. Qualified plans are more difficult to administer than SIMPLE IRAs or SEP. Qualified plans can be defined either by their benefits or contributions. Employers receive tax deductions in return for the contributions that they make to the plan. Employees are generally not required to pay taxes on the assets in the plan until after distribution. Another advantage is that earnings are tax deferred with qualified plans. For a plan to have “qualified” status, it is required to comply with the requirements set out in the Internal Revenue Code (IRC), the Employee Retirement Income Security Act 1974 (also known as ERISA) and the Department of Labor (DOL).
Defined-Benefit Plans
A defined-benefit plan is a qualified plan in which the retirement benefits that an employee receives are based on their personal characteristics, such as their compensation, age and years of service. An example of this is a plan that says that when an employee retires, his or her benefits will be 1% of the average salary that they received in the last five years with the company for the same period of time as their length of service. Another option is that the plan may state the exact amount (for example, $200 a month) of the benefit.
EXAMPLE: John spent 10 years working for ABC Company. He earned $65,000 in 2004, $70,000 in 2005, $80,000 in 2006, $90,000 in 2007 and 100,000 in 2008. This means that his average salary for his last five years was $81,000. In turn, that means that 1% of his last five years average salary is $810. According to the plan, John is entitled to receive $810 for the same number of years that he worked for the company, that is, for 10 years.
This is the predetermined retirement benefit and the employer is required to make contributions to equal this amount. In making these contributions they will use actuarial assumptions that take into account the expected investment growth. When the investments made by the plan fail to perform and do not reach the required amount, the employer must contribute more to make up the balance. Contribution limits are much higher for defined-benefit plans than defined-contribution plans. Operating a defined-benefit plan will usually require actuarial assistance as it is based on formulas and actuarial assumptions.
Defined-Contribution Plans
With a defined-contribution plan, the specific amount that the employee will receive when they retire is not promised. Employees, employers or (in some cases) both make contributions to these plans. The contribution is usually a percentage of the employee’s compensation package. The employer contributions may be compulsory or discretionary, depending on the type of plan used. The plan will invest the contributions on behalf of the employee. The benefit that they will receive upon retirement is based on the contributions that were made and the investment results (earnings or loss). In these types of plans, employers don’t have to compensate for the possible loss on the investments. These plans may take the form of a profit-sharing plan, a 401(k) plan, an ESOP (employee stock ownership plan) or a money-purchase pension plan.
Plan Definitions
Profit-Sharing or Stock-Bonus Plans
As the name suggests, a profit sharing plan is used by businesses to share profits with their employees. Employers are able to make these types of contributions whether or not the business actually profited during the year. These contributions will usually be discretionary, meaning that the employer decides whether or not they want to contribute to the plan in a particular year. Although this may seem a very flexible system, the employer cannot let too many years pass without making a contribution. The IRS doesn’t exactly specify the number of years that are allowed, but there are requirements that the contributions must be recurring and substantial.
With a stock-bonus plan the employer will use stock in the company to make contributions or distributions. These types of plans cannot be used by sole proprietorships or partnerships.
Profit-sharing plans and stock-bonus plans can have a 401(k) feature. These plans are well suited for newly established employers who are unable to accurately predict their future profit levels or who would like their contributions requirements to be flexible.
Money-Purchase Pension Plan
Generally speaking, money-purchase and defined-benefit plans have less flexible contribution requirements than profit-sharing plans. Money-purchase plans have fixed contribution levels that are not related to the profits of the business. For example, if the plan says that members will receive 10% of their compensation, then the employer must contribute that amount regardless of the company’s profits. These types of plans suit employers that have a clear picture of their profit trends and who don’t mind making compulsory annual contributions.
401(k) Profit-Sharing Plan
In a 401(k) plan employees can defer receiving a portion of their compensation and elect to have that amount put into their plan. This is also commonly known as CODA, which stands for “cash or deferred arrangement”. The deferred contributions (also known as “elective deferrals”) are usually made to the plan before tax. Employers will choose the type of plan that they use and it could either be a stand-alone 401 (k) plan or a plan that combines profit-sharing with 401(k). The employer will also choose whether they want to make additional contributions to the plan. 401(k) plans are designed for employers that want their employees to help with the plan funding.
Age-Weighted Plans
An age-weighted feature can also be added to retirement plan. This basically means that an increased proportion of the plan contributions will be allocated to older employees. This is based on the assumption that these older employees are going to retire sooner and have less time to build their savings. These plans suit situations where the business owners are much older than the employees and they have not yet accumulated sufficient retirement savings.
Employee Stock Ownership Plans (ESOPs)
ESOPs are a type of defined-contribution plan which involves investments primarily in stock of the company. These plans were authorized by Congress in order to encourage increased employee involvement in corporate ownership.
Why Establish a Qualified Plan?
Choosing the most suitable retirement plan is a business decision with huge financial implications. The plan needs to suit the immediate needs of the employer and to be consistent with their business and financial profile. Qualified plans benefit both employers and employees.
Benefits for Employers
Some plans offer employers tax deductions when they make contributions
It may enable the employer to attract and retain the best employees. A qualified plan may be the factor that makes a sought after employee select one company over another.
In some situations the employer can claim a tax credit to cover part of the costs of establishing the plan. This is only possible if the expenses were incurred after December 31, 2001. The maximum credit available is $500 for the initial three years of the plans operation. This covers 50% of the establishment, administration and employee education expenses.
Benefits for Employees
Employees have peace of mind from some guarantee of their financial security in retirement.
Where the plan involves a salary-deferral feature, the employee can defer paying tax on the amount of compensation that they contribute to the plan until it is distributed. At this time their tax bracket will probably be lower so overall they will pay less tax.
In some plans employees are permitted to take out loans from the plan. Interest on the loan is credited to the employee’s account. This makes it a better option that loans from a financial institution where the interest goes to that institution.
401(k) and Qualified Plans: Eligibility Requirements
Any type of business can set up an establishment plan. It doesn’t matter if the business is a sole proprietorship, a partnership, or corporation of a government entity. Employees cannot set up a qualified plan. The plan must be established by the employer.
Establishing a Qualified Plan
A qualified plan normally is made up of two documents: 1) the adoption agreement and 2) the plan document. The plan document sets out the provisions of the plans operation. The plan is formally adopted when the employer passes a resolution which says that they are adopting the plan. They will then complete the adoption agreement and issue a summary plan description (SPD) to employees. The SPD is required to be written in plain language so that all employees are able to understand it clearly. The SPD must include the following information:
the plans location and identification number
how the plan will operate and what it will provide for employees
when it will commence
how the benefits and length of employee service will be calculated under the plan
when the employee will be entitled to their benefits
when and how employees will receive their benefits
how benefits should be requested
possible situations where employees could be denied or lose their benefits
rights of the employee under ERISA
It is important that employees read the SPD so that they are aware of the provisions of the plan that apply to them. When the plan’s provisions change, the employer must issue a revised SPD or a new document known as a summary of material modifications (SMM).
Choosing a Plan Provider
Employers have the option of establishing their own plan that is specifically designed for their business or choosing a plan designed by a sponsoring organization that has been approved by the IRS.
Individually Designed Plans
The point of an individually designed plan is to meet the specific needs of a particular employer. No other employers are permitted to use this document. These types of plans are typically used by large companies that have certain specifications in mind for their plan that they can’t get from a prototype. Individually designed plans are not required to be approved in advance by the IRS ,, however, the employer can apply for IRS approval if they want to be assured that the plan satisfies the regulations. They will need to pay a fee and ask for a determination letter. Lawyers and tax professionals are normally involved in drafting new plans and their fees will vary.
Master or Prototype Plans
Small businesses are often attracted to master or prototype plans that have already been approved by the IRS so there is no need to apply and pay for a determination letter. These types of plans can be used by more than one employer. In master plans, the operator will set up one trust or custodial account that will be used by all employers that adopt the plan. In prototype plans, separate trusts or accounts are set up for each employer. Several different types of organizations can sponsor master or prototype plans including:
banks (this includes certain approved federally insured credit unions and savings and loan associations)
trade unions or professional organizations
mutual fund or insurance companies
attorneys, financial planners or accountants
Establishment Deadline
Qualified plans are required to be established before the final day of the employer’s tax year. The employer is required to make contributions for that year and all subsequent years according to the provisions in the plan.
Eligibility Requirements for Employees (Plan Participants)
There are specific requirements that employees must meet in order to participate in the plan. It is important that business owners don’t implement requirements that would mean that they cannot participate in the plan. For example, if a business owner is 19 years old then a requirement that plan participants be over 21 would mean that he or she is excluded. Qualified plans will generally have the following eligibility requirements for employees:
The employee is over age 21. The minimum age of a plan cannot be more than 21 and employees under this age can be excluded. Maximum age limits are not permitted, meaning employees cannot be excluded for reaching an upper age limit.
The employee has been working for the company for at least one year. For plans other than 401(k) plans, this requirement is increased to two years of service. These plans also provide that after service of less than two years the contributions will be vested and the employee will have a non-forfeitable right to the total of his or her benefit. According to a qualified plan, one year of service is usually equivalent to 1,000 hours of service per plan year. Employees who don’t work 1,000 hours in a year are not considered to have worked for one year even if they worked over a 12 month period.
Exceptions to these eligibility requirements may be implemented by employers (for example, they may reduce the minimum age or change the required hours of service). There are some eligibility criteria though that must conform to the regulations governing qualified plans. Employers must consult with a lawyer regarding eligibility requirements that haven’t been approved by the IRS before implementing the plan.
Excludable Employees
Employers are permitted to exclude certain employees from the plan, for example those who are unionized or nonresident aliens.
Vesting - Employees Non-Forfeitable Rights to Employer Contributions
The term “vesting” refers to the process whereby the employee becomes entitled to a non-forfeitable right to access the benefits that their employer has contributed. Vesting schedules have been set up to meet regulatory requirements and qualified plans need to abide by these requirements. Employees will always have vesting rights in relation to the contributions that they make to the plan. There are two different type of vesting schedules that an employer can choose from. They are:
Cliff Vesting. With a cliff-vesting schedule the employee is required to stay with the company for three years of service before the employer contributions will be considered vested. Following three years, these contributions will be 100% vested.
GradedVesting. With graded-vesting schedules, the employer contributions will become 20% vested after the employee has completed two years of service. The vesting then increases by 20% in each subsequent year until it gets to 100%. This will occur following six years of employee service.
