Qualified retirement plans can be divided into two basic categories: Defined Contribution plans and Defined Benefit plans.

The main distinction between the two types of plans is how benefits for the participants are determined and the 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 current year contributions are 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).

Defined Contribution plans tend to be more flexible in determining annual contributions. However, there are specific limits on the total amount that the plan sponsor can deduct, and the amount that can be allocated to each participant. The principal types of Defined Contribution plans are Profit Sharing plans and 401(k) Profit Sharing plans.

• Maximum deductible company contribution (404 limit) is 25% of the total compensation of the employees who are participants in the plan.
• Maximum allocation to a participant: the lesser of $66,000 (2023 415 limit), indexed annually) or 100% of compensation.
• A Defined Contribution plan generally determines a plan’s annual contribution based on participant compensation paid in the current year.
• Participants have individual account balances under the plan. This is true even if all plan assets are pooled into one trust investment account (in this case, the plan’s TPA 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 the amount that has accumulated in the account when distributions are taken.

A Profit Sharing plan is usually the most flexible and cost-effective option available to a small employer. Company contributions are at the discretion of the employer, and are not required in any particular year. Allocation methods available include basic formulas, such as the “Pro-rata formula,” “Social Security integration formula”, as well as special age-sensitive formulas such as the “Tiered” allocation method.

Company contributions to a Profit Sharing Plan are limited to 25% of the total covered compensation of the employees who are participants in the plan. If an employer would prefer to make contributions in excess of 25% of compensation, or would prefer to make contributions for a targeted employee in excess of $66,000 (indexed annually), a Defined Benefit Plan should be considered.

Profit Sharing Plans offer:

• No required contribution. Annual contributions are at the discretion of the plan sponsor.
• Maximum deductible company contribution (404 limit) is 25% of the total compensation of the employees who are participants in the plan.
• Maximum allocation to a participant: the lesser of $66,000 (2023 limit, indexed annually) 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 ($160,200 in 2023 limit, indexed annually).
• 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 $66,000 (2023 limit, indexed annually) for owners, with as little as 5% of compensation being allocated all others.

A 401(k) Plan is a type of Profit Sharing Plan, with additional provisions that allow employees to defer part of their compensation into the plan.  Company contributions, such as company match or profit-sharing contributions are a deduction for the employer and subject to the plan’s vesting schedule.

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.

• Employee pre-tax salary deferrals or ROTH after-tax deferrals
• Company matching contributions
• Company profit sharing contributions
• Safe Harbor Contributions (if elected)

 

• This limit includes salary deferrals (e.g., if a participant deferred $22,500, then the maximum company contribution that could be allocated to that participant would be $43,500).

 

• This limit does not include catch-up salary deferrals for participants aged 50 or older. So, the maximum for such a participant would be $73,500 (2023 415 limit, indexed annually).

A participant can make an election to defer a portion of his salary as a pre-tax or after-tax (i.e. ROTH) contribution to a 401(g) Plan. These contributions are known as “elective salary deferrals” (or “deferrals”). A participant’s deferral amount may not exceed the calendar year dollar limit set by the IRS ($22,500 in 2023 limit indexed annually), and may not exceed 100% of gross pay (in practice, the plan's limit should be set to 90%, to allow for Social Security and other withholdings). A participant age 50 or older may make an additional $7,500 “catch-up” deferral (2023 limit, indexed annually). Other plan limits or company contributions may further reduce the percentage a participant can contribute to the plan.

Basic elective deferrals are taken on a pre-tax basis: they are not subject to federal or (in most states) state income taxes (though they are subject to FICA and FUTA taxes). These assets are then invested on a tax-deferred basis. However, the entire amount (both deferral basis and any gain) is subject to taxation when a distribution is taken from the plan.

“Roth” elective deferrals allow a participant to make deferrals on an after-tax basis, rather than on a pre-tax basis. Roth deferrals are subject to normal payroll taxes at the time the wages are paid, but the entire amount (both Roth deferral basis and any gain) may be distributed tax-free (subject to certain restrictions on the timing of distributions).

In most cases, a participant’s deferral election is applied to all W-2 wages, including bonuses, overtime, etc. (that is, deferrals are taken from all W-2 wages). Allowing for alternative definitions of compensation in the plan require special discrimination testing each year.

Employee deferral accounts (pre-tax and Roth) are always 100% vested.

In addition to employee salary deferrals, there are two basic types of company contributions: company match contributions, and company profit sharing contributions. The match contribution is made to accounts of employees who deferred salary to the plan and satisfied the plan requirements to receive a match contribution. The match contribution can be discretionary and determined on an annual basis or it can be “fixed” in which case the contribution would be required each year. The discretionary profit sharing contribution is made to the accounts of all eligible employees.

Sponsoring a 401(k) Plan does not obligate the company to make a match or discretionary contribution. However, once made, participants are entitled to these contributions according to the plan’s Vesting Schedule.

Department of Labor (DOL) regulations require that Salary Deferral contributions (pre-tax and Roth) and Loan Payments be deposited in a 401(k) trust account by the earliest date the contributions can be segregated from the employer’s general assets following the date they are withheld from the employees’ wages. Whether the deposits are made timely is determined on a “facts and circumstances” basis. DOL considers the payroll frequency of the plan sponsor and the time that it takes for the plan sponsor to transmit their payroll taxes to be a relevant factor in determining when participant contributions should be transmitted and deposited to the plan’s trust.

The regulations do provide a safe harbor on deposits for small plans (less than 100 participants as of the first day of the plan year). Deposits that are made within 7-business days of the payday are considered timely. Though this safe harbor regulation is not available for large plans, it can still be used as a guideline. Deposits that occur after the fifteenth business day of the month following the payday are not considered timely.

Salary deferrals and loan payments must never be deposited prior to the payday; they must be deposited on or after the actual payday.

Yes. A deferring participant can elect to stop deferrals at any time. However, to otherwise change his deferral rate, or to commence deferring (if the participant has not been deferring), the participant may do so only on the plan’s Deferral Change Dates, as designated in the plan document.

The employer must notify participants of upcoming Deferral Change Dates so that participants have the opportunity to submit a new Salary Reduction Agreement specifying any changes.

Elective deferral contributions are subject to an Actual Deferral Percentage (“ADP”) Test to demonstrate nondiscrimination for plans with non-owner employees. Plans electing Safe Harbor provisions are generally exempt from ADP/ACP testing).

The nondiscrimination test for elective deferrals compares the average deferral percentage of the eligible Highly Compensated Employees with the average deferral percentage of the eligible Non-Highly Compensated Employees. The average deferrals of the Highly Compensated group must bear a specific relationship to the average deferrals of the Non-Highly Compensated group.

• If the average deferral of the Non-Highly Compensated Employee group is less than 2% of compensation, then the deferral percentage for the Highly Compensated Employee group may be twice as much (e.g., if the NHCE deferral rate is 1.5%, the HCE deferral rate may be 3%).
• If the average deferral percentage of the Non-Highly Compensated Employee group is 2% or greater, but less than 8%, then the Highly Compensated Employee group’s average may be two percentage points higher than the Non-Highly Compensated Employee group (e.g., if the NHCE deferral rate is 3%, the HCE deferral rate may be 5%).
• If the average deferral percentage of the Non-Highly Compensated Employee group is 8% or greater, then the Highly Compensated Employee group’s average may be 1.25 times the percentage of the lower group (e.g., if the NHCE deferral rate is 12%, the HCE deferral rate may be 15%).

If the test fails, there are two standard correction methods for ADP failures. Each method has certain restrictions and deadlines by which they must be completed to avoid penalties.

Discrimination testing for matching contributions (“ACP” Testing) is subject to similar rules.

The ADP test compares the current year’s deferral rate for the Highly Compensated Employee (HCE) group to either the current year Non-Highly Compensated Employee (NHCE) group’s deferral rate or the prior year’s NHCE group deferral rate.  The plan document will specify whether the plan uses the current plan year’s deferral rate, referred to as “current year testing method”, or the prior plan year’s rate, referred to as “prior year testing method”.

The purpose of allowing the election of the prior year testing method is the employer knows in advance the maximum percentage that is allowed to be deferred by the HCEs early in the plan year (rather than after the end of the plan year). This allows the employer to communicate the expected average deferral rate limit to HCEs during the plan year so that they can modify their deferral rates if needed.

The testing method must be specified in the plan document, and any amendment of the method must be made prior to the end of the plan year in which the testing method is to be applied. Once the testing method has been changed from the prior year method to the current year method, it must remain on the current year method for at least five plan years.

Note on catch-up deferrals in ADP Tests. Deferrals for a catch-up eligible participant are not characterized as “catch-up” deferrals until a limit has been exceeded. This means that, in most cases, deferrals less than the 402(g) deferral limit of $19,000 (2019 limit, indexed annually) are considered “regular” deferrals for purposes of the ADP test and calculating an ADP test correction (however, catch-up deferrals in excess of the 402(g) limit are not considered in the ADP test).

An ADP or ACP test failure must be corrected by certain deadlines. If handled in a timely manner and the plan document allows, the plan sponsor may choose from two corrections methods: the employer may process a return of deferrals to Highly Compensated Employees (HCEs); or the company may choose to make a Qualified Non-Elective Contribution (a “QNEC”) to certain Non-Highly Compensated Employees (NHCEs).

Return of Deferral Correction Method – Allowable for Plans Utilizing Either the Prior or Current Year Testing Method

• Under the Return of Deferral Correction Method, the employer reduces the average deferral rate of the HCEs by an amount sufficient to pass the ADP test. The employer does so by processing a return of deferral to HCEs according to an IRS-required two-step method. This correction must be completed within two and one-half months after the end of the plan year in which it occurred. If completed after this due date, the amount of the return of deferral is subject to a 10% excise tax, payable by the employer. Regardless, the correction must be made no later than the last day of the following plan year.
  
• This correction method is a two-step process specified by the IRS. First, the amount of the return is calculated based on how much each HCE has exceeded the NHCE average deferral rate. However, the actual return is taken first from those HCEs who have deferred the largest dollar amount. In certain situations, this could have the unexpected result that an HCE whose deferral rate has not exceeded the allowable HCE average deferral rate would still be required to take a return of deferral.
  

QNEC Correction Method – Allowable for Plans Utilizing the Current Year Testing Method Only

• Under the QNEC Correction Method, the employer increases the average deferral rate of the NHCEs in an amount sufficient to pass the ADP test. The employer does so by making contributions to certain NHCEs that conform to IRS regulations and provisions specified in the plan document. QNECs are always 100% vested, and the plan document must specify the “Current Year” ADP testing method for that plan year.

Penalty for Late Corrections

Corrections not completed by the end of the following plan year are subject to correction by processing both the late “return of deferral” for the HCEs and the QNEC to the Non-HCEs.

Effective with the 2020 plan year, a plan sponsor may adopt a retroactive amendment to add a 4% Safe Harbor non-elective contribution, in replacement of annual ADP/ACP testing. The amendment must be executed within 9 ½ months following the plan year end.

Plan sponsors that wish to eliminate ADP and ACP testing may elect to use Safe Harbor provisions. This would allow owners and other Highly Compensated Employees the ability to defer up to the annual maximum contribution amount without regard to the deferral rate of the other participants, provided certain contribution and operational requirements are met.

The sponsor has two basic Safe Harbor contribution options from which to choose: a 3% Non-Elective Contribution (“NEC”) to all eligible employees; or a mandatory matching contribution.  There are two match options: Basic or Enhanced.

Once elected, all Safe Harbor contributions are mandatory for that plan year, and are required by law to be 100% immediately vested.

Benefits

• The plan is not subject to ADP testing.
• The plan is not subject to ACP testing provided matching contributions (if any) are within Safe Harbor guidelines.
• Safe Harbor contributions are intended to satisfy Top Heavy contribution requirements if there is no allocation of additional employer contributions (including the allocation of forfeitures) other than employee deferrals and Safe Harbor contributions.

 
Considerations

• Safe Harbor contributions are 100% vested.
• Safe Harbor contributions, once elected, are required through such time during the Plan year (plus 30 days) that the Safe Harbor provisions are rescinded (in such case, the Safe Harbor protections do not apply for the entire Plan year).
• Safe Harbor notices must be distributed to participants on a timely basis (at least 30 days, but no more than 90 days, before the plan year begins).
• No allocation requirements may be imposed on Safe Harbor contributions: any Non-Highly Compensated Employee eligible to defer must also be eligible to receive the Safe Harbor contribution.
• Safe Harbor contributions must be made to all participants eligible for a contribution, including those that terminated during the year.
• If specified in the plan document, Safe Harbor contributions may be restricted to Non-Highly Compensated Employees only (that is, the employer is not obligated to give Highly Compensated Employees a Safe Harbor contribution if the plan document does not require such a contribution).
• In-service withdrawals of Safe Harbor contributions prior to age 59 ½ are not allowed (with certain limited exceptions).
• Allocation of employer contributions other than Safe Harbor contributions (including the allocation of forfeitures) could trigger a required Top Heavy minimum contribution of 3% of compensation to all eligible participants (regardless of their actual deferral rate).
• Matching contributions that do not conform to Safe Harbor requirements would subject the plan to ACP testing.
  

 
Existing 401(k) Plans Can Only Add a Non-Elective Contribution During the Plan Year

• Due to the notice requirements, an existing 401(k) plan can only add a Non-Elective contribution during the plan year. If the Safe Harbor provision is added no later than 30 days before the plan year end, then the Non-Elective contribution must only be 3%; however, a 4% Non-Elective contribution may be added within 30 days of the plan year end up until 9 ½ months following the plan year end.

 
New 401(k) Plans

• A new 401(k) plan with Safe Harbor provisions may be established at any time during the year provided that there are at least 90 days for participants to defer salary into the plan (for this purpose, an existing Profit Sharing Plan that is adding 401(k) provisions for the first time is considered a “new” 401(k) plan).

For example, a new Safe Harbor 401(k) plan with a plan year-end of December 31 must be in place and ready to accept participant deferrals no later than the first pay period after September 30.

• To be considered a “new” 401(k) plan, the company cannot have sponsored another 401(k) plan in the 12 months prior to the effective date of the new 401(k) plan.

The sponsor has two basic ADP Safe Harbor contribution options to choose from: a mandatory Non-Elective Contribution (“NEC”) to all eligible employees with a minimum cap of 3% of a participant’s compensation; or a mandatory matching contribution to employees who defer.

The plan document and safe harbor notice must specify the type of ADP Safe Harbor provision elected by the employer.

ADP Safe Harbor Non-elective Contribution (“NEC”)

A NEC is made to all participants eligible to defer, including those who choose not to defer. The NEC requires a minimum contribution of 3% of the participant’s compensation. A NEC can be used to help satisfy non-discrimination testing required by a Tiered 401(k) Profit Sharing Plan, so this is the Safe Harbor contribution of choice for Tiered 401(k) Profit Sharing Plans.

There is a “conditional” NEC option that may be implemented provided the plan is designed and operated properly, and additional notice requirements (described below) are met.

ADP Safe Harbor Match Contribution 

The most common Safe Harbor match option is the “Basic Safe Harbor Match” which requires that the employer make a matching contribution at the following rates of employee deferrals.

• 100% match on the first 3% deferred and;
• 50% match on the next 2% deferred

This basic match formula requires an employee to defer 5% of compensation to receive the full employer match contribution of 4% of their compensation.

Alternatively, the employer may elect an “Enhanced Safe Harbor Match,” which is slightly more generous than the basic match.  Many small employers prefer the simplicity of an Enhanced Safe Harbor Match of 100% of deferrals, capped at 4% of compensation compared to the stepped-rate of the Basic Safe Harbor Match.

Requirements for an Enhanced Safe Harbor Match include: the match must be at least as generous as the Basic Match at all deferral rates; the match cannot be made on deferrals greater than 6% of the participant’s compensation; the rate of match cannot increase as the deferral rate increases.

ACP Safe Harbor Match

In addition to the ADP Safe Harbor options described above, the employer may elect plan document provisions that allow an additional “ACP Safe Harbor Match.”

Unlike ADP Safe Harbor contributions, this additional match may be subject to the plan’s vesting schedule, and in-service distributions are permitted. Assuming that this additional match meets certain requirements, it would not jeopardize the Safe Harbor status of the plan.

Requirements for a discretionary ACP Safe Harbor Match include: the match cannot be made on deferrals greater than 6% of the participant’s compensation; the total match contribution for a participant cannot exceed 4% of the participant’s compensation; the rate of match cannot increase as the deferral rate increases; no allocation requirements may be used that excludes any Non-Highly Compensated Employees.

The plan sponsor must distribute a notice to participants at least 30 days, but no more than 90 days, prior to the beginning of each plan year. The notice must specify which Safe Harbor option the employer has elected, as well as certain other information about the plan.

Initial Safe Harbor Notice – Existing 401(k) Plans

An existing 401(k) Plan can only add a Safe Harbor Non-elective provision in the middle of a plan year. The Safe Harbor notice must be distributed to participants at the time the Safe Harbor provisions are adopted.

Initial Safe Harbor Notice – New 401(k) Plans

A new 401(k) Plan does not need to be in place for a full 12-month period provided there are at least three months left in the plan year. This is also true of amending an existing Profit Sharing Plan (with no 401(k) provisions) to add Safe Harbor 401(k) provisions mid-year.

This means a new Safe Harbor 401(k) Plan can be established as late as October 1st (assuming it has a December 31st plan year-end).

Conditional Safe Harbor Notice

If the employer is using the Safe Harbor Non-elective Contribution provisions (e.g., 3% to all eligible employees, including those who choose not to defer), a conditional notice (generally referred to as a “maybe” notice) may be used. This is a two-part notification process.  The first part is similar to the requirements of the standard notice except that the notice states that the employer may make a Safe Harbor NEC for the upcoming year.

The second part is a supplemental notice that is subsequently distributed to employees no later than 30 days before the end of that plan year informing participants of the employer’s intention of making the Non-Elective Contribution for that plan year. The plan document also must be amended by the end of the plan year to require this Non-Elective Contribution if the plan document does not support automatically implementing the conditional Safe Harbor election in the supplemental notice.

If this notice is not distributed, then ADP/ACP testing is required for that plan year. If the plan is Top Heavy, then the 3% Top Heavy Minimum Contribution requirement must also be satisfied.

Because of the added administrative complexity and potential Top Heavy contribution requirements of the “conditional” Safe Harbor NEC, most small employers prefer the standard Safe Harbor NEC, particularly if the plan is currently Top Heavy, or may become Top Heavy in the future.

A 401(k) Plan may be amended to remove Safe Harbor provisions mid-year, or the plan may be terminated altogether mid-year, provided the following steps occur:

• A notice to participants of the change must be made at least 30 days in advance of the Safe Harbor contribution being discontinued.
• The Safe Harbor contributions must be made on compensation paid from the first day of the plan year through the date the Safe Harbor is being discontinued or the plan is being terminated (30 days after the notice is distributed to employees).
• Employees must have a chance during this 30-day period to change their deferral elections.
• ADP and ACP testing would apply for the entire year (so Highly Compensated Employees may be required to take a return of deferral and/or match).
• If the plan is currently Top Heavy, Top Heavy contribution requirements (up to 3% of participants’ compensation) must be met for the entire year.

Generally, a small employer would not remove Safe Harbor provisions or terminate a Safe Harbor 401(k) mid-year as this could trigger unexpected Top Heavy required contributions or may result in a return of deferrals to Highly Compensated Employees.

Under auto-enrollment provisions (also known as “Automatic Contribution Arrangements”, “ACAs”, or “negative election”), a participant is deemed to have elected to defer salary into the plan at a rate specified by the plan unless the participant makes a positive election to defer at a different rate (including the election to defer $0).

“Behavioral finance” studies have shown that when it comes to making complex decisions, a person tends to postpone deciding. For many 401(k) participants, this tendency to procrastinate results in never actually enrolling in their company’s 401(k) plan.

On the other hand, studies of existing 401(k) plans with auto-contribution provisions have shown that such arrangements increase employee participation by making a person’s tendency to procrastinate work in favor of participating in the plan: inaction is a “positive” step towards enrolling in the plan

There are two principal types of auto-contribution arrangements:

• An Eligible Automatic Contribution Arrangement (EACA), which is the basic non-Safe Harbor auto-contribution arrangement; and
• A Qualified Automatic Contribution Arrangement (QACA), which provides a nondiscrimination test Safe Harbor, similar to a standard Safe Harbor 401(k) plan.

While auto-contribution arrangements have some appealing characteristics, they require plan sponsors to take on additional administrative responsibilities.

Also, auto-contribution arrangements may result in additional participant accounts with small balances. These additional accounts may entail additional administrative paperwork and increased fees for distributions and annual plan maintenance.

A small employer should carefully consider these additional costs and responsibilities prior to implementing auto-contribution provisions in their 401(k) Plan.

In order to qualify as an EACA, the following requirements must be met:

Opportunity to elect a deferral rate

Participants must have the option of electing to defer salary under the plan, including the option of not deferring any salary.

Deemed deferral rate

If a participant makes no election, the plan sponsor treats the participant as having elected to defer salary.

• The contribution-withholding rate used for this purpose by the plan sponsor must be a uniform rate of compensation. This rate may be increased over time, so long as the rate of increase is uniform as well.
• This assumed deferral rate remains in effect until the participant specifically elects to not have deferrals contributed to the plan, or to have them contributed at a different rate.
  

 
QDIA must be used

Auto-contributed deferrals must be invested in a Qualified Default Investment Alternative (“QDIA”) unless or until the participant makes a positive investment election.

Plan amendment required

A plan amendment adding EACA provisions must be executed in order to implement an EACA. 

Notice requirement

A written notice describing the rights and obligations of this arrangement must be given to each participant to whom this arrangement applies. This notice must be given within a “reasonable period of time” prior to the beginning of the plan year, and prior to the first salary deferral being withheld under this arrangement for a newly eligible employee.

The notice must explain the participant’s rights under the arrangement to elect to have deferrals withheld at a different rate, including the right to withhold nothing. It must also explain how auto-contributed deferrals will be invested if the participant fails to make an investment decision.

Annual Participant Notice: A notice given at least 30 days, but not more than 90 days prior, to the beginning of each plan year is considered reasonable.

Newly Eligible Participant Notice: For participants entering the plan, a notice given no more than 90 days prior to the participant’s entry date, but no later than the date the participant enters the plan, is considered reasonable.

A $1,100 a day penalty may apply for not satisfying this notice requirement.

For plans that meet the EACA requirements, the following features are available:

• ADP refunds may be distributed up to 6 months after the end of the plan year without being subject to a 10% excise tax (generally, these must be distributed within 2 ½ months to avoid the excise tax).
• Auto-contributions may be distributed without penalty if the participant makes an election within 90 days of the first salary deferral. This in an optional feature.

Defined Benefit plans have the potential for much higher contributions than those available under a Defined Contribution plan. However, a required minimum contribution is actuarially determined each year (based on provisions in the plan document and other factors).  For this reason, a Defined Benefit plan has limited contribution flexibility compared to a Defined Contribution plan.

Higher Deductible Contributions.

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).

Higher Contributions.

An individual participant may have contribution costs in excess of the Defined Contribution limits (lessor of $66,000, 2023 415 limit indexed annually, or 100% of compensation).  The participant’s age has a dramatic impact on the contribution amount, in that an older participant will tend to have higher contribution costs than a younger participant.

Because a DB Plan funds for a benefit at retirement, the maximum contribution is not directly limited by the owner’s compensation in the current year. Rather, what is limited is the benefit at retirement that the plan may promise the owner. This retirement benefit cannot exceed the lesser of (i) 100% of the owner's highest average compensation over three consecutive years, or (ii) the COLA-adjusted dollar limit (2023, indexed annually the dollar limit on retirement benefits is $265,000 per year for retirement ages between 62 and 65).

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.

Required Contributions.There is generally a minimum required contribution each year. While it is possible to modify the contribution target, this generally will apply to future plan years and must be done through plan amendment. The magnitude of the change may be limited by accrued benefits and current funding status, rate of return on investments, and other factors.

A Defined Benefit plan favors older participants because the plan promises to pay each participant a specific benefit at retirement. This benefit at retirement has a lump-sum value. The expected lump sum at retirement is a fixed amount regardless of the participant’s current age (assuming the same compensation and years of participation in the plan at retirement). 

Older participants have fewer years for annual contributions to be made to the plan to build the required lump sum amount. 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 $1,000 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 $2,590. But, with 40 years of compound interest working for him, at age 65 the younger person’s investment is worth $45,260! 

These two factors combine to allow older participants to achieve greatly accelerated retirement accumulations when compared to any other option.

Benetech generally recommends combining a DB Plan with a 401(k) Plan because Owner-Only DB Plan contributions are not affected by a contribution to a 401(k) Plan, provided that contributions to the 401(k) Plan are limited to: (i) salary deferrals, and (ii) a profit sharing contribution that does not exceed 6% of the owner's compensation. This allows the owner additional discretionary contributions of $22,500 salary deferral ($30,000 if the owner is age 50 or older), plus a 6% of compensation profit sharing contribution (not to exceed $330,000, which is 6% x $19,800 (compensation limit), The dollar amounts noted are the 2021 limits and are indexed annually.

This combined program both increases the maximum contributions to the program and adds some contribution flexibility, because the 401(k) contributions are not required in any given year.

EXAMPLE - DB Plan first-year contributions vary with age, service, and compensation.

Scenario #1 - Owner of a corporation, age 40, with W-2 wages of $180,000

Total Contributions = $131,300:

• $101,000 into the DB Plan
• $22,500 salary deferral into the 401(k) Plan.
• $10,800 profit sharing contribution to 401(k) Plan.

 
Scenario #2 - Owner of a corporation, age 62, with W-2 wages of $100,000

Total Contributions = $245,000:

• $213,000 into the DB Plan
• $30,000 salary deferral into the 401(k) Plan
• $6,000 profit sharing into the 401(k) Plan

There are two basic types of Defined Benefit Pension plans:  a traditional Defined Benefit pension plan, and a Cash Balance pension plan. The main difference between the two is how the participant’s benefit is presented to the participant:

• The traditional Defined Benefit plan reflects 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 reflects 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).
• One of the main distinctions between a traditional Defined Benefit plan and a Cash Balance Defined Benefit plan is that participants in a Cash Balance Plan are given statements that look similar to a traditional Defined Contribution plan. These statements show a participant’s hypothetical account balance as of the end of the year, so participants have a better idea of the value of the benefits under the 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.