Description of Retirement Plan Types

OVERVIEW

For many employers, the question isn't whether or not to offer a retirement plan. Employers generally realize the value of having a plan. Such plans can save the company taxes, increase employee loyalty, satisfaction and productivity and provide a means to recruit and retain qualified employees as well as enhance retirement benefits.

The primary question for employers is "What type of plan should we offer?" SEP, Profit Sharing Plan, Age-Based Profit Sharing Plan, 401(k) plan, Defined Benefit plan, IRA, etc.

For many employees, there may be only a single type of plan offered or a choice. In some cases the employees may request a certain type of plan be offered. Retirement plans can save you in taxes, in some cases provide a lender, insurance benefits, etc. Each type of plan has its advantages and disadvantages for employees

The purpose of these pages is to give you an idea of what is available so you can better choose the best plan for you. No plan should be started without consulting with a Pension Plan consultant. As you read these pages you will come to see how complex and involved this process can be. We urge you to contact a Retirement Planning Specialist, Pension Plan Consultant, etc. for full details on your particular circumstances. You may contact us at Advanced Corporate Planning,

Retirement plans can be described several ways. One way is the difference between defined benefit plans and defined contribution plans. The primary difference is that the defined contribution concept is driven by the amount of the annual contribution to the plan, with the "investment risk" being borne by the participant while the defined benefit concept is driven by the specific benefit promised to the participant, with the "investment risk" being borne by the employer. Some plans allow employee contributions, some don't. Some require full immediate vesting, some don't.

Another way to describe retirement plans is Qualified plan or Non-Qualified plan. A Qualified plan is IRS qualified by certain criteria and has certain Income Tax benefits over Non-Qualified plans (which have some tax advantages but fewer than the Qualified plan). An example of a Qualified plan is a 401(k) plan while an example of a Non-Qualified plan would be an IRA plan.

To help you decide on the best type of plan, you will need an understanding of the basic requirements and of the available choices in plan design. With a basic knowledge of different plans and when and why to use them, you can begin to develop your personalized plan.

Profit Sharing Plan

Profit Sharing plans are highly popular, for good reason. They offer the most flexibility when it comes to making contributions. Company contributions can be determined at the discretion of the board of directors or other governing body. If the company makes little or no profit, no contribution is required that year. Low profits don't mean you can't make a contribution, though. A profit sharing plan can include an option allowing the company to make contributions even if the company has no profit.

Profit sharing plan contributions are generally allocated to employees according to compensation. The maximum deduction that the company may take in 2007 is limited to a maximum of 25% of the annual compensation paid to participating employees. The individual limits applied to all defined contribution plans are; the lesser of 25% of compensation or $45,000. Depending on the allocation formula in a profit sharing plan, it is possible for individual participants to exceed the 25% level as long as the aggregated contribution does not exceed the 25% limit.

In general, profit sharing plans favor younger employees, since the longer an employee participates in the plan the greater the ultimate benefit will be. However, a new type of profit sharing plan, called an age-based plan, or expanded cross tested or super integrated plans are now available that favors older employees that have less time to accumulate dollars for retirement.

Age-Based Profit Sharing Plan

An age-based profit sharing plan works like a defined benefit plan with discretionary contributions. Since the participants age, or length of time until retirement, is factored into the allocation formula, older participants receive a larger proportionate share of the contribution. This can be advantageous in a situation where the key employees are significantly older than the other employees.

These plans might appear to be discriminatory in situations where higher paid employees receive a larger share of the contribution. The key factor, is that the projected benefits at normal retirement age actually are not discriminatory. A 48 year old making $30,000 a year could get a larger share of the contribution this year than a 30 year old with an annual salary of $50,000. The 30 year old would theoretically receive a share of the contribution for more years, however, and ultimately receive a larger retirement benefit.

Although this type of plan is available to any size company, age-based plans are especially well suited for small business and professional practices. The owners of these firms tend to be older than their employees, so the allocation formula allows a larger share of the plan contribution to flow into the owner's accounts. Other potential drawbacks are that employees with the same salary may receive a different allocation, and an older non-principal employee may receive a disproportionate share.

For a table comparing the advantages of a standard profit sharing plan vs. a age based plan click here.

New Comparability Plans

The "New Comparability" or "Rate Group" plans came about with the final 401(a)4 regulations, allowing defined contribution plans to be tested for discrimination based on benefits, just like a defined benefit plan. An allocation formula can be utilized that creates separate allocation levels. This formula is allowed by permitting "averaging" of projected benefits, similar to the old comparability rules, in a plan providing for two levels of allocations, one for the staff and one for the principals. The basis of the testing is comparing what the contributions of the staff will grow to at retirement age, with what the contributions for the principals will grow to at retirement. The results are divided by the cost of an annuity and expressed as a benefit for testing purposes.

This is an appropriate plan design in a situation where a small business wants to discriminate in favor of the highly paid participants. For an example of how a form of new comparability - Cross Testing - Works click here

Defined Benefit Pension Plans

Defined benefit plans pay fixed retirement benefits. These benefits are based on a formula written into the plan. Since the benefit is "defined", the ultimate risk is borne by the plan sponsor to deliver that benefit regardless of the company's profitability or the trust's investment performance. An Example of benefit formulas would be: A percentage of average compensation over a specified number of years; e.g. 50% of the average compensation in the participants last five years of compensation.

For more on Defined Benefit plans click here
For article comparing Defined Benefit and Defined Contribution plans click here
For Defined Benefit Plan Frequently asked questions click here

403(b) Plans

403(b) Defined benefit plans pay fixed retirement benefits for employees of a public school or university, or of a qualified tax-exempt organization such as a church, non-profit hospital or home health service agency. These benefits are based on a formula written into the plan. Since the benefit is "defined", the ultimate risk is borne by the plan sponsor to deliver that benefit regardless of the company's profitability or the trust's investment performance. An Example of benefit formulas would be: A percentage of average compensation over a specified number of years; e.g. 50% of the average compensation in the participants last five years of compensation.

For more on 403(b) Defined Benefit plans click here
For Defined Benefit Plan Frequently asked questions click here

Traditional IRA Plan

Mark Twain once said, "The rumors of my death have been greatly exaggerated." Like Mr. Twain's rumored demise, the notion that the traditional Individual Retirement Account (IRA) is no longer a useful part of a financial plan has been greatly exaggerated. Contributions to a traditional IRA continue to be a viable financial and retirement planning tool despite non-deductibility for some individuals.

All you need to make a traditional IRA contribution are earnings as an employee or as a self-employed person. The amount that can be contributed is the lesser of $4,000 ($5,000 with catch-up contribution) in 2007 or your earnings from your work. There is no minimum age for making a traditional IRA contribution for tax purposes. If a 16 year old works for the summer, makes $4,000 and blows it all at the mall, the tax code permits Mom, Dad or whomever to give him/her $4,000 to contribute to a traditional IRA. There is a maximum age for IRA contributions. No traditional IRA contributions may be made for people over 70 1/2, even if they are still working as hard as they were at 30 /2.

An additional contribution of $4,000 ($5,000 with catch-up) is permitted if the traditional IRA participant has a spouse who doesn't work outside the home. The total contribution in this situation is $8,000 ($10,000 with 2 catch-up's) and the spouses can divide the amount contributed up any way they choose, so long as neither receives more than $4,000 ($5,000 with catch-up) into his/her account.

The "Catch-up" provision: Plan participants OVER 50 years old may contribute an additional $500 per year.

Roth IRA Plan

The Taxpayer Relief Act of 1997 introduced a new Individual Retirement Account (IRA) called the Roth IRA. The primary inducement to make contributions to the Roth IRA is that distributions are tax-free if certain conditions are met. One drawback to the Roth IRA is that contributions to the account are never deductible.

For 2006 an individual may contribute up to $4,000 ($5,000 with catch-up) a year to a Roth IRA (less any contribution made to a traditional IRA). Contributions to Roth IRAs are not deductible and must be in cash when made. In addition, unlike regular IRAs, there is no age restriction on making contributions.

The Income limit that applies to IRA's refer to modified adjusted gross income (MAGI). For most people this will be the same as AGI but those claiming deductions for student loan interest, qualified tuition and fees, those who claim an exclusion for employer provided adoption assistance, or those claiming exclusion of interest on Series EE U. S. Savings Bonds must add these deductions back into AGI to get their MAGI.

The MAGI threshold for contributing to a Roth IRA is $95,000 for single individuals and $150,000 for married individuals filing a joint return. For single filers, the allowed contribution is phased out for AGI between $95,000 and $110,000. For married individuals, the allowed contribution is reduced proportionately if MAGI is between $150,000 and $160,000. No Roth IRA contributions are allowed if an individual is married and files separately.

For more on Roth IRA's click here

SIMPLE IRA Plan

A relative newcomer to the retirement plan market, the SIMPLE IRA plan can be a cost effective retirement planning alternative for small employers and their employees.

A SIMPLE IRA plan consists of a deferral program for eligible employees, along with a matching contribution by employers. An eligible employer is defined as an employer that has no more than 100 employees that received at least $5,000 in compensation from the employer in the preceding calendar year. And an employer maintaining a SIMPLE IRA plan may not maintain any other qualified retirement plan in which employees currently receive benefits.

Employers may either establish a SIMPLE 401(k) plan in which contributions are made into a trust account, or SIMPLE retirement accounts, in which contributions are made into IRA accounts. While the two types of plan arrangements are similar with regard to contributions, the SIMPLE 401(k) plan places considerably more burden for reporting and disclosure on both the employer and the custodian of the plan assets. For this reason, many employers favor the SIMPLE IRA plan.

Employees are eligible to make deferrals if they receive at least $5,000 in compensation from their employer during any two preceding years and they are reasonably expected to receive at least $5,000 in compensation for the current year. For 2006 they can defer up to $10,000 ($12,500 with catch-up contributions for participants over 50) with no set maximum percentage of compensation and must elect to defer a specified percentage of compensation as opposed to a dollar amount.

For more on SIMPLE IRA plans click here.

Simplified Employee Pension (SEP) IRA Plan

As the name suggests, a SEP IRA plan is a simple to implement and simple to operate retirement plan. SEP IRA plans have fewer administrative requirements and lower operating costs than the other types of retirement plans. For many doctors, lawyers, free-lance writers, artists, manufacturers representatives and other self-employed people, Simplified Employee Pensions (SEPs) may be too good a deal to pass up. They are also exempt from some of the restrictions that apply to other plans. There are, however, significant disadvantages to implementing a SEP IRA plan in certain situations.

Although they are technically a type of Individual Retirement Arrangement (IRA), SEPs seem more like a cross between an IRA and a profit sharing plan. Like a profit sharing plan, the employer tax deduction limit is the lesser of 25 percent of compensation or $45,000. However, note that while compensation is capped at $225,000 in 2007, the maximum contribution is still only $45,000 in effect reducing the compensation cap to only $180,000. Also like a profit sharing plan, the employer has complete flexibility (within the above limits) to set the amount contributed. The employer may even skip a year or more if business is bad. Like an IRA, distributions cannot receive lump sum distribution forward averaging treatment for tax purposes like qualified plans.

For more on SEP IRA and the related SARSEP Click here.

Rollover IRA Plan

A Rollover IRA plan is not an IRA plan that was rolled over but a Qualified Retirement Plan that was rolled over into an IRA. To Maintain the Qualified basis, you may not "contaminate" the IRA with any other IRA monies. for more on Rollovers, click here

Educational IRA Plan

The Education IRA was introduced to help pay for a child's college tuition. This relatively new type of IRA allows contributions up to $5000 a year on a nondeductible basis toward a child's future education expenses until the child turns age 18. You can withdraw tax free any money, including account earnings, to pay qualifying higher education expenses of the child. Education IRA's are subject to the same phaseout ranges as Roth IRA's.

This plan has been renamed Coverdell Educational Savings Account.

For more Coverdell Education Savings Accounts click here

For more on IRA's

Click here for Frequently Asked Questions about IRA's

For the New IRA Distribution Rules Click here

For IRA distribution Frequently Asked Questions Click here

For the Final Regulations for Retirement Plan Distributions click here

To download the full Final Regulations as a Microsoft Word File click here

for the Uniform Distribution table Click Here

IRA Required Distribution Table

IRA Joint Life Table

401(K) Qualified Retirement Plans

Traditional 401k Plan

A 401(k) Plan is a type of Retirement plan that gives the employees the opportunity to save for retirement on a tax favored basis. Participating employees elect to defer a portion of their compensation to the qualified profit sharing plan. In doing so, they avoid current income tax on the deferred amounts and on any earnings the deferred funds generate. No tax is due until the benefits are distributed.

Any business, Corporation, C Corporation, S Corporation, Professional Corporation, Limited Liability Corporation, Limited Liability Partnership, partnership, sole proprietorship, self-employed can establish a 401k Plan, even a one person company. The company sets the eligibility requirements, within certain guidelines, at the time the plan is established. If they wish, the employer can restrict individuals with less than 1 year service, union members, non-US citizens, part-time workers etc., from being eligible for the plan. For more on 401(k) plan documents, eligibility, vesting, etc. click here

Many employers provide a matching contribution, based on the employee's elective salary deferral, as an incentive for the employee to participate. In addition, the employer can make a straight profit sharing contribution that is independent of elective or matching contributions and is usually provided on an "across the board" basis to all eligible employees just like a regular profit sharing plan. Employer's can establish a vesting schedule, within certain guidelines, for the contribution the company(s) make to their employee's retirement accounts.

If an employer already sponsors a Qualified Plan, a 401(k) plan provision is easy and inexpensive to add. Many companies have in the last few years, added the 401(k) option to an existing profit sharing plan or defined benefit plan. Although there is a minimal increase in administrative costs, the additional benefits more than offset those costs.

A Traditional 401k Plan has full ERISA requirements and annual IRS 5500's series of filings. Plans are subject to top heavy testing and discrimination testing. These plans usually are best for larger companies because of the costs associated with documentation, cost associated with setting up plan and cost associated with administering the plan. Generally, outside third party administrators are hired to oversee the requirements of the plan, top high testing and the like.

Some 401K plans may offer very limited investment funding choices, couple with infrequent opportunity to switch investment choices within plan; others offer a wide range of investment choice within plan, with totally flexibility to switch investments within the plan investment choices. Some 401K plans may permit participant directed individual stock transactions, and some may permit company stock purchase within the plan. Some 401K mutual fund, variable annuity companies may offer credits to new accounts to offset expenses associated with 401K account transfers from one mutual fund, variable annuity company to another. Some plans may permit direct loan, hardship loan, disability loan provisions.

401k Plans can be switched from one fund (e.g. conservative) to another (e.g.conservative-aggressive) within one company; or from one fund source (e.g. Mutual Fund Company A) to another (e.g. Mutual Fund Company X); or from one fund type (e.g.mutual fund) to another (e.g. variable annuity). In some cases, 401K Plans can be terminated and other more efficacious and cost effective plans can be instituted. Moving 401K and other retirement plans from prior employers is a common ongoing occurrence. Once individuals become aware of the advantages associated with enhanced performance, better and more complete investment choices, unrestricted and cost free exchanges between funds and perhaps even a death benefit to heirs the decision to move frequently may make good economic sense.

SIMPLE 401(k) Plan

For Companies with 100 or fewer employees earning at least $5,000 each in the previous year who want a deferral plan but are concerned about the complexity, testing requirements and administrative expense of a traditional 401(k) plan there is the SIMPLE 401k Click here for more information on SIMPLE 401K Plan

to take the SIMPLE 401(k) Test and see if it is a good choice for you click Here

Safe Harbor 401k Plan

A safe Harbor 401(k) lets you avoid nondiscrimination testing by providing a minimum level of employer contributions. Safe Harbor 401(k) plans eliminate annual ADP and ACP tests that prevent highly Compensated Employees from contributing too much more than lower paid ones. So, you and your highly compensated employees can take full advantage of the $15,500 salary deferral limit, no matter what your other employees choose to do. For more on Safe Harbor 401k Plan click Here

Owner Only or 1 Person 401k Plan

Did you know that a firm as small as one-person can establish a 401(k) plan? This is not a new phenomenon. It just never made sense under the old tax law. However, recent changes in the tax codes have made 401(k) plans much more attractive for small employers.

Consider a small business owner at age 55, with $50,000 in income. Assume the business owner would like to contribute as much as possible to a tax-deferred retirement plan during 2006. By adopting a Simple IRA plan, the owner can contribute a maximum of $12,500. However, by adopting a 401(k) plan, the owner can contribute up to $20,000 for 2006.

For more information on One Person or Owner Only 401k plans click Here

For Frequently Asked Questions about 401k Plans click Here

To Calculate how much you can save to your 401k click Here

Click here for a table comparing the Bottom Line benefits of a qualified retirement plan vs. savings with no qualified plan

403(b) Plan

This is a salary deferral plan that is available only to employees of public education systems and employees of specific other tax-exempt organizations described in IRS Code Sec. 501(c)(3). Examples of these groups are hospitals, charities, religious, scientific, public safety, and educational organizations that qualify for tax-exempt purposes. As a general rule, state and municipal agencies do not qualify as 501(c)(3) organizations. For 2004, however, these organizations may also chose to use a 401(k) plan instead.

There are two basic formats for 403(b) plans; (1) employee contributions only; and, (2) those where the employer also makes a contribution. Generally speaking, 403(b) plans with only employee contributions do not fall under ERISA reporting and disclosure regulations and do not require plan administration such as discrimination testing and IRS Form 5500 tax filings. If the plan has both employee and employer contributions it becomes subject to ERISA regulations and requires plan administration that is, administratively speaking, similar to a 401(k) plan with similar cost structure.

For most small groups, eligible to offer a 403(b) plan to their employees, the most appropriate plan design is usually to have two separate plan structures, the 403(b) plan for employee contributions, and a simple defined contribution plan for employer contributions. Under most circumstances, this will be more cost effective than a 403(b) plan with both employee and employer contributions that requires plan administration.

Section 457 Plan

An IRS Section 457 plan is a non-qualified deferred compensation plan available to employees of state and local governmental entities, agencies of such entities, or certain tax exempt organizations under IRS Code Section 501.

The plan is usually "informally" funded by non-elective employer contributions, which are amounts credited to a general assets of the plan sponsor. A primary element of Sec. 457 plan is that the participant be a general unsecured creditor of the plan sponsor, thereby creating the "substantial risk of forfeiture" that allows the participant to avoid constructive receipt of any income in given year. Sec. 457 plans, unlike corporate non-qualified plans, have specified contribution limits and are subject to the minimum distribution rules.

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