FAQs – Basic Plan Types
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What are the basic types of qualified retirement plans?
These two categories are well named, in that the main distinction between the two types of plans is how benefits for participants are determined and contribution/benefit limits:
- Defined Contribution plans generally define and limit contributions based on current year compensation.
- Defined Benefit plans generally define and limit benefits to be paid at retirement, and generate current year contributions based on funding those future benefits (that is, an Actuary generally first determines the benefits to be funded at retirement, then calculates how much needs to be contributed to the plan each year to fund these benefits).
What is a Defined Contribution plan?
A 401(k) plan is a type of Profit Sharing plan that allows employees to elect to defer salary. However, the company may make discretionary profit sharing contributions if the plan document allows for such contributions. Money Purchase pension plans generally are no longer considered as an option, since the same contribution objectives can now be satisfied by a Profit Sharing plan in most cases.
What are the features of Defined Contribution plans?
- The plan sponsor’s deduction limit is 25% of total compensation of the employees who are participants in the plan.
- An individual cannot have more than $53,000 in 2015 (not to exceed 100% of compensation) added to his or her account each year (this does not include catch-up contributions, if applicable, or gain/loss on plan investments; but does include allocation of forfeitures).
- A Defined Contribution plan generally determines a plan’s annual contribution in terms of participant compensation in the current year.
- Participants have individual accounts under the plan. This is true even if all participant accounts are pooled into one trust investment account (in this case, the plan’s recordkeeper keeps track of the participant’s interest in the pooled investment account).
- The participant bears the investment risk. There is no limit on the amount that may be gained (or lost) on account investments. The participant’s benefit is whatever has accumulated in the account when distributions are taken.
What is a Profit Sharing plan?
Company contributions to a Profit Sharing Plan are limited to 25% of covered compensation. If an employer would prefer to make contributions in excess of 25% of covered compensation, or would prefer to make contributions for a targeted employee in excess of $53,000, a Defined Benefit Plan should be considered.
What are the features of Profit Sharing plans?
- No required contribution. Annual contributions are at the discretion of the plan sponsor.
- Maximum deductible company contribution is 25% of covered compensation.
- Maximum allocation to a participant: the lesser of $53,000 or 100% of compensation.
- Profit sharing contribution allocation methods:
- Pro Rata: The same percentage of compensation is allocated to all participants.
- Integrated with Social Security: Modestly skews contributions to participants whose compensation is greater than the Social Security Wage Base ($118,500 in 2015, indexed)
- Tiered: Allows contribution to be skewed towards owners and other targeted Highly Compensated Employees if special age-sensitive discrimination testing is satisfied. Contributions may be as high as $53,000 for owners, with as little as 5% being allocated to non-targeted participants.
What is a 401(k) Profit Sharing plan?
Salary deferrals lower participant compensation for most federal and (in most states) state tax purposes, though the participant and employer continue to pay Social Security and federal unemployment taxes on the gross wages before deferrals.
What are the features of 401(k) Profit Sharing plan?
- Basic types of contributions allowed:
- Employee salary deferrals
- Company matching contributions
- Company profit sharing contributions
- Profit sharing contributions to a 401(k) Plan have the same characteristics as Profit Sharing Plans.
- Maximum allocation to individual participants is $53,000 (2015 limit, indexed) or 100% of compensation.
- This limit includes salary deferrals (e.g., if a participant deferred $18,000, then the maximum company contribution allocated to that participant would be $35,000).
- This limit does not include catch-up salary deferrals for participants aged 50 or older. So, the maximum for such a participant would be $59,000 (2015 limit, indexed).
What allocation methods apply to Profit Sharing plans?
The standard allocation formulas are nondiscriminatory because they are uniformly applied according to certain rules. These formulas include “Pro Rata” and “Social Security Integration.”
However, there are also special methods for allocating contributions (e.g., the Tiered method). These methods require additional discrimination testing, but may result in a substantially higher percentage of the total company contribution allocated to targeted Highly Compensated Employees such as owners.
What is a Money Purchase plan?
Prior to 2002, some employers adopted a MPPP to get higher contribution levels than were available at the time with a stand-alone Profit Sharing Plan. Up until that time, a Profit Sharing Plan’s deduction limit was 15% of covered compensation (rather than the current 25% of covered compensation), but the limit for a MPPP was 25%. In 2002, the deduction limit for a Profit Sharing Plan was raised to that of a MPPP, so the higher deduction limit was no longer a reason to sponsor a MPPP.
For these reasons, MPPPs are generally no longer adopted.
What is a Defined Benefit plan?
What are the features of Defined Benefit plans?
- Deductible contributions may exceed 25% of covered compensation. The deduction limit is a function of rules regarding such factors as maximum retirement benefits, reasonable funding methods, and appropriate assumptions (such as assumptions about the future rate of return on plan investments).
- An individual participant may have contribution costs in excess of the Defined Contribution limits ($53,000 or 100% of compensation). The participant’s age has a dramatic effect on the contribution amount, in that an older participant will tend to have higher contribution costs than a younger participant.
- The company bears the investment risk. If the rate of return on plan investments does not keep pace with the rate of return assumed for funding purposes, then the required contribution amount will tend to increase. Similarly, a rate of return in excess of the assumption will tend to decrease contributions.
- Participants cannot have individual accounts. Plan assets are set aside to fund expected future benefits for all participants. For this reason, a participant cannot be allowed to direct the investment of plan assets intended to fund his or her retirement benefit.
What are the types of Defined Benefit plans?
- The traditional Defined Benefit plan shows the benefit as a monthly payment beginning at retirement. A participant statement generally does not give a lump sum value of that benefit at retirement, nor does it show a present value of that benefit.
- A Cash Balance plan shows the benefit as a current lump sum value. Generally, the current value of a participant’s benefit is the amount on the participant’s statement (subject to certain limits and possible adjustments).
Do Defined Benefit plans require minimum contributions?
Who bears the investment risk in a Defined Benefit plan?
Why do Defined Benefit plans favor older workers?
Older participants have fewer years for annual contributions to be made to build the required lump sum. The closer to retirement the participant is, the greater the annual contributions needed to accumulate the required lump sum.
Further, younger participants have more time for compound interest to work in their favor. Consider two persons with $100 each invested in a retirement account at 10% interest: one is age 55 and the other is age 25. At age 65, the first person’s investment is worth $259. But, with 40 years of compound interest working for him, at age 65 the younger person’s investment is worth $4,526!
These two factors combine to allow older participants to achieve greatly accelerated retirement accumulations when compared to any other option.
What is a Cash Balance pension plan?
However, the underlying requirements of a Cash Balance plan are the same as those of a traditional Defined Benefit plan, including the need for an actuarial valuation of the plan, and the fact that the plan sponsor bears the investment risk and must make sure the promised benefits are properly funded, etc.