MODULE 1 - MAJOR TYPES OF RETIREMENT PLANS
1-2 WHO CAN ESTABLISH A QUALIFIED PLAN
Any sole proprietorship, partnership, corporation, or limited liability company (LLC) may establish a qualified plan. However, it must be established by the end of the tax year for which a tax deduction is desired. An LLC must elect to be treated as either a corporation or partnership for tax purposes. As we will discuss later, nonprofit organizations and governmental organizations may establish certain types of qualified plans.
1-2 Explain the main types of qualified retirement plans and their basic characteristics.
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1-1 Describe the major types of retirement plans.
1. qualified plans; 2. nonqualified plans; 3. tax-deferred individual plans; 4. tax-deferred plans; and 5. individual retirement accounts (IRAs).
DEFINED CONTRIBUTION QUALIFIED PLANS
A defined contribution plan is a retirement plan in which the benefits ultimately received by plan participants are not specified but are determined by contributions and investment results Defined contribution plans are also referred to as individual account plans because each participant has a separate account in which accruing plan contributions and investment earnings are reflected. Defined benefit plans, in contrast, pool the plan funds; participants receive statements that reflect their accrued benefits, but the plan does not segregate funds into individual accounts.
1-2 NON QUALIFIED PLANS
A nonqualified plan, in contrast, does not need to meet these requirements. It may be established by either the company or the employee, and it may discriminate among employees (e.g., it can include only managerial employees and exclude others). However, a nonqualified plan does not have all of the tax advantages of a qualified plan. Another important difference between qualified and nonqualified retirement plans is that in determining contributions or benefits, qualified plans can take into account only up to $255,000 (2013, indexed for future years) of an individual's annual compensation.
1-2 QUALIFIED PLANS
A qualified plan is a retirement plan that meets the stringent requirements of the Internal Revenue Code as well as the Employee Retirement Income Security Act of 1974. Specifically, a qualified plan must meet minimum participation and coverage requirements; provide for contributions or benefits that are not discriminatory and that do not exceed certain limits ("not discriminatory" means that the plan must provide certain benefits to nonhighly compensated employees [NHCEs], such as clerical and other rank-and-file employees and the benefits cannot be skewed in favor of highly compensated employees [HCEs], as defined by the IRC, except as allowed by law); contain provisions for top-heavy plan modifications (a top-heavy plan must provide certain minimum benefits for non-key employees); 12 Types & Characteristics of Retirement Plans © 2002, 2004-2013, College for Financial Planning, all rights reserved. 1-2 Explain the main types of qualified retirement plans and their basic characteristics. be established in the United States, be set in writing and communicated to employees, be funded, be permanent, and meet plan-specific qualification requirements; meet minimum vesting standards; exist for the exclusive benefit of employees/beneficiaries; provide a method for allocating plan assets if the plan is terminated; provide that employees' benefits be protected if the plan is merged, consolidated, or transferred; provide for benefits that satisfy the rules regarding commencement of benefits and minimum distributions; provide for automatic survivor benefits; and prohibit the assignment or alienation of benefits (i.e., protect participant benefits from creditors and certain other claimants).
1-2 SUMMARY OF QUALIFIED PLAN BENEFITS
Both employers and their employees enjoy certain tax and nontax benefits as a function of having a qualified retirement plan. For employers: Employer contributions to the plan are tax deductible. Plan earnings are tax-deferred. The company's ability to attract and retain high-quality employees is enhanced. Employee morale is likely to improve. Employee morale is likely to improve. Employee productivity may improve. For employees: Employer contributions are tax-deferred until withdrawn. Earnings on plan assets are tax-deferred. Distributions may be eligible for favorable tax treatment. Greater financial security is achieved.
1-2 DEFINED CONTRIBUTION: ESOPs
Employee stock ownership plans (ESOPs) and leveraged employee stock ownership plans (LESOPs) are the most common types of stock bonus plans. An ESOP, which acquires shares of the corporation on behalf of the employees, is a useful device for rewarding employees for active service to the firm, sharing ownership with employees, and providing an orderly transfer of ownership. The primary purpose of an ESOP must be to invest in qualifying employer securities. ESOPs not only provide qualified retirement benefits for employees, but also benefit the employer in that they offer a market for the employer's stock, increase the firm's cash flow, provide financing for business expansion, and serve as an estate planning tool for the owners of a closely held corporation. One important difference between ESOPs and other qualified plans involves the ability to use leverage—ESOPs can borrow money to provide the contribution. (When money is borrowed, the plans are also called LESOPs.) In this case, the plan trustee can borrow money from a financial institution to purchase the employer stock. The employer can deduct not only the interest on the borrowed funds, but also the principal as the loan is paid off. In either an ESOP or a stock bonus plan, if the stock appreciates in value it generates dividends without current tax consequences. The value of the stock appreciation and dividend accumulation is not subject to taxation until the employee sells the stock following distribution.
1-2 DEFINED CONTRIBUTION: MONEY PURCHASE PENSION PLAN
Money purchase pension plans are a more formal type of defined contribution plan in which the employer is required to contribute a fixed percentage of compensation to employee accounts. Similar to simplified employee pensions (SEPs), profit sharing plans, and stock bonus plans, money purchase plans allow tax-deductible employer contributions of up Chapter 2: Qualified Plans 25 © 2002, 2004-2013, College for Financial Planning, all rights reserved. to 25% of the plan participants' total payroll to be made to the trust that is used to hold plan assets. The 25% employer contribution allowed by a money purchase plan is attractive from the employer's perspective in terms of tax savings. However, this fixed annual contribution requires committing a substantial portion of the company's annual cash flow in good times and bad. Ideally, an employer would prefer to have the flexibility to contribute the maximum 25% only when sufficient cash flow is available. For this reason, a profit sharing plan (which also allows a 25% employer contribution) is more attractive to most employers than a money purchase pension plan.
ON FORWARD AVERAGING
People who take lump-sum distributions from their qualified retirement plans may be eligible for forward averaging for tax purposes. (Forward averaging does not apply to distributions from IRAs, 403(b) plans, or Section 457 plans.) In many cases, forward averaging will reduce the total tax due on these distributions because it spreads out the recipient's taxable income over a number of years. Eligibility for forward averaging is predicated on 1. taking a distribution of the entire balance of the account and 2. the status of the recipient, who must be separated from service to the employer, or, if self-employed, disabled and who must have participated in the plan for five or more years. Effective for tax years after 1999, 5-year forward averaging has been repealed. Individuals born after January 1, 1936, are not eligible for forward averaging. However, those born before 1936 are still eligible to use 10-year forward averaging.
1-2 DEFINED CONTRIBUTION: PROFIT SHARING PLANS
Profit sharing plans, the oldest type of defined contribution plans, originally were established by U.S. employers in the mid-1800s to reward employees with current profit allocations. Profit sharing plans as deferral programs became more common in the mid-1900s, spurred on by wage controls and increased taxation of corporate profits. The underlying reason for installing a profit sharing plan, however, has not changed. Employees are motivated by participation in their company's profits. Larger employers, who are better able to handle the administrative expenses, frequently offer a profit sharing plan in addition to a defined benefit plan; smaller employers may offer a profit sharing plan alone. Although a profit sharing plan must specify how employer contributions will be allocated, the employer is not required to make contributions of any specified amount on an annual basis. This feature is especially important to the firm that experiences wide fluctuations in annual earnings. To retain the plan's qualified status, however, the employer must make "substantial and recurring" contributions to the plan. 22 Types & Characteristics of Retirement Plans © 2002, 2004-2013, College for Financial Planning, all rights reserved. Similar to simplified employee pensions (SEPs), money purchase pension plans, and stock bonus plans, profit sharing plans allow tax-deductible employer contributions of up to 25% of the plan participants' total payroll to be made to the trust that is used to hold plan assets. As a defined contribution plan, a profit sharing plan is an individual account plan; individual account plans allocate investment earnings in proportion to each participant's account balance. Employer contributions to a profit sharing plan, on the other hand, generally are allocated based on relative compensation. Profit sharing plans can protect the employer by making contributions contingent upon the employer having a profit. However, the Tax Reform Act of 1986 allows for profit sharing contributions in years in which there is no profit. A plan may specify that contributions will be made only if the profits exceed a certain level. A plan also may set a limit on the amount of profit that will be available for contributions, and it may specify that the board of directors has the discretion to determine what, if any, contribution is made each year, regardless of the firm's profit. Under such plan designs, the employer has the discretion to use the profits for other purposes, such as expansion. Another important aspect of profit sharing plans (other than 401(k) elective deferrals after 1998) is that they give the employer the freedom to invest substantially all of the plan's assets into the company's own stock. Such investments are rare, however, because of the fear of fiduciary liability. In addition, profit sharing plans (and any other type of contribution plan) maintained by publicly traded companies are subject to ERISA Section 204(j) and Internal Revenue Code (IRC) Section 401(a)(35) diversification and investment rules (discussed below). Under certain narrowly defined conditions, the employer may contribute substantial amounts of its stock to its profit sharing plan. (Note: Stock bonus plans and ESOPs are designed so that plan investments will be made in employer stock.) Pension plans, in contrast, can invest no more than 10% of a plan's assets in the employer's stock.
1-2 DEFINED CONTRIBUTION: STOCK BONUS PLAN
Stock bonus plans are essentially profit sharing plans in which employer contributions and plan distributions are generally made with employer shares of stock. The employer can contribute treasury stock instead of cash—i.e., a stock bonus plan provides the potential for a cashless contribution.
1-2 DEFINED CONTRIBUTION: TARGET BENEFIT PLANS
Target benefit plans are defined contribution plans that establish a fixed contribution formula based on an initial actuarial determination of the contributions required to meet a targeted benefit level. No subsequent adjustments are made to the annual contribution except to add new participants or reflect changes in compensation; the targeted benefit level may or may not be reached, depending on the performance of fund investments. Annual employer contributions are limited to 25% of the plan participants' total annual payroll. Target benefit plans favor older, more highly compensated employees. For example, suppose two employee-participants have the same annual compensation. A target benefit plan will make a larger contribution on behalf of the older employee-participants. Because of the inherent advantages of profit sharing plans, it is anticipated that many employers who maintain target benefit plans will terminate them and offer an age-weighted or cross-tested profit sharing plan only. These types of profit sharing plans are more flexible, offer the same tax benefits, and may cost less to administer than target benefit plans.
1-2 DEFINED CONTRIBUTION: 401K PLANS
The four defined contribution plans previously discussed—profit sharing plans, stock bonus plans, money purchase plans, and target benefit plans—were presented in their basic form, funded solely by employer Chapter 2: Qualified Plans 27 © 2002, 2004-2013, College for Financial Planning, all rights reserved. contributions. A fifth type of defined contribution plan, the thrift and savings plan, generally provides an opportunity for qualified employees to make after-tax contributions—that is, to contribute a portion of their already taxed earnings to these plans. Many employees are better off, however, if they can contribute pretax earnings to these plans because monies that would otherwise take a one- way trip to the coffers of the Internal Revenue Service (IRS) can be placed in accounts that have the potential to appreciate. (For more about the benefits of tax deductibility and tax deferral, see Individual Retirement Accounts [IRAs].) Tax-favored employee contributions are made possible through Section 401(k) of the Internal Revenue Code—hence the term 401(k) plan. Section 401(k) provides for two types of tax-favored employee contributions to qualified retirement programs: (1) salary reduction plans, and (2) cash or deferred arrangements (CODAs). In either type of plan, the employee has an option to defer receipt of income. Salary reduction plan. Through a salary reduction plan, an employee can elect to defer receiving and paying taxes on a limited percentage of his or her compensation. The salary reduction amount is deducted from the employee's paycheck and contributed to a retirement fund, where it accumulates tax-deferred earnings until distribution. Cash or deferred arrangement. Through a cash or deferred arrangement, the employee can choose to receive an employer contribution either in cash (which would be currently taxable) or as a tax-deferred retirement plan contribution. Under a CODA, employees can opt to have compensation that would otherwise be paid directly to them by their employers deferred to the plan instead. 28 Types & Characteristics of Retirement Plans © 2002, 2004-2013, College for Financial Planning, all rights reserved. Neither a salary reduction plan nor a CODA can be established as a plan in itself but must be combined with an eligible profit sharing plan. All types of employers other than state and local governments and their agencies may offer 401(k) plans to their employees. Thus, 401(k) plans are popular for sole proprietorships, partnerships, limited liability companies, and both S and C corporations. Tax-exempt organizations may also offer 401(k) plans. Plans established by government prior to 1986 also continue. Section 401(k) plans are enormously popular. The Society of Professional Asset-Managers and Record Keepers Institute (SPARK Institute) estimates that there were about 74 million active participants in 401(k) plans in 2010. Section 401(k) plans are one of the most popular types of defined contribution retirement plans with approximately $3.075 trillion in assets as of year-end 2010 (www.pionline.com). According to the Investment Company Institute estimates, 401(k) plans hold about 17% of all U.S. retirement assets amounting to $3.0 trillion (www.ici.org). As of tax year 2013, these plans enabled employees to make salary deferral elective contributions (of pretax income) up to a maximum of $17,500. Table 4 shows the maximum elective deferrals permitted for 2013 and 2014. Table 4: Maximum 401(k) Elective Deferrals Individuals who are at least age 50 by the end of the plan year may make additional elective deferrals ("catch-up contributions") to a traditional 401(k) plan. The maximum catch-up contribution for 2013 is $5,500. Chapter 2: Qualified Plans 29 © 2002, 2004-2013, College for Financial Planning, all rights reserved. Year Elective Deferral Limit for Individuals Under Age 50 2013 $17,500 2014 The elective deferral limit for 2013 will be adjusted in 2013 for inflation, in $500 increments Employers can—and often do—match 401(k) contributions, either periodically or in a year-end, lump-sum contribution, to encourage contributions by lower-paid employees.
DEFINED BENEFIT QUALIFIED PLANS
cash balance pension plans Pension Equity Plan