The IRS has created a number of retirement savings vehicles for employers of all sizes to use to save for their and their employees’ retirement.
A qualified plan must meet a number of Internal Revenue Code requirements under Section 401(a) such as minimum coverage, benefits, participation, and vesting to name a few.
In return, the IRS provides the following tax advantages when businesses set up plans:
In addition to tax benefits, qualified retirement plans have the following advantages:
Defined Contribution Plans operate, per their name, with a “defined contribution” or determinable amount allocated to eligible employees.
These contributions along with any earnings are maintained in an account (either pooled or segregated) for each employee’s benefit. Contributions to the plan may consist of pre-tax employer and/or pre-tax and/or post-tax employee contributions.
The ultimate retirement benefit or benefit upon distribution of each participant will be dependent on the contributions and earnings experienced by the account, with investment control either by the employer or by the employee. For this reason, the future retirement benefit cannot be determined or guaranteed.
Employer contributions may be subject to a vesting schedule. Non-vested account balances forfeited by former employees can be used to reduce employer contributions or be reallocated to active participants.
For 2023, an employee’s contributions to the plan may not exceed $22,500 (or $30,000 for employees age 50 or over).
The employer contribution, when combined with the employee contribution may not exceed the lesser of $61,000 for 2022 and $66,000 for 2022 or 100% of an employee’s compensation. The company may make a deductible plan contribution up to 25% of the overall eligible payroll.
The maximum eligible compensation that can be considered for any single employee is $305,000 in 2022 and $330,000 in 2023.
The 401(k) feature allows employees to voluntarily elect to make contributions (deferrals) into a qualified plan through payroll deductions up to an annual $22,500 limit for 2023 ($30,000 if age 50 of over). The term 401(k) comes from Section 401(k) of the Internal Revenue Code relating to employee deferral of compensation.
It may be helpful to think of qualified retirement plans as having multiple potential buckets or sources of funding (i.e. profit sharing, deferrals, matching).
Employee contributions to the plan will be made on pre-tax basis, and subsequently reduce the reportable income on an employee’s W-2. Their account will grow tax deferred until the time the funds are withdrawn and reported as income.
If elected as a plan option, employees may elect to have their voluntary deferral be made to the plan on a post-tax basis. These contributions will grow tax free and be able to be withdrawn upon retirement with no further tax consequences. Roth is offer preferred if you believe you will be in a higher marginal tax rate during retirement.
Employers may choose to match some portion of the amount deferred by the employee to encourage greater employee participation, i.e., 50% match on the first 6% deferred by an employee. These employer contributions may be subject to a vesting schedule
Employee deferrals and employer matching contributions are subject to annual nondiscrimination tests which limit how much “Highly Compensated Employees” can defer or benefit based on the “Non-Highly Compensated Employees” contributions. A “Highly Compensated Employee” is an employee that:
An option exists to offer certain “401(k) Safe Harbor” plan designs which are deemed to pass the discrimination testing mentioned above. By promising certain employer profit sharing or matching contributions that are 100% vested, Highly Compensated Employees can defer up to the annual limit regardless of participation of other employees.
The Compensation Planning team
Defined Benefit Plans operate, per their name, with a “defined benefit” provided to employees at retirement.
On an annual basis, an actuary determines a minimum required, maximum allowed, and recommended contribution for the employer based on the current plan assets when compared to the current plan liabilities to meet projected retirement benefits. The responsibility for funding the individual liabilities lies with the employer who invests all of the overall plan assets. Investment gains/losses will not affect participants’ benefits, but may require smaller or larger contributions by the employer.
Defined Benefit Plans are often appealing to employers who are looking to contribute more than that $66,000 maximum defined contribution limit.
In a DB Plan, the maximum benefit that can be funded for is the lesser of $265,000/yr at retirement or 100% of highest 3 year average compensation.
Substantial deductible contributions are allowed to be made to the plan in order to create a large enough funding source to fund the accrued benefits.
A Cash Balance Plan is a type of Defined Benefit Plan that will appear more like a Defined Contribution Plan to participants, but operate like a Defined Benefit Plan for funding purposes.
For this reason, these plans are referred to as hybrid plans. Participants will receive a Cash Balance statement with a hypothetical balance and earnings, instead of a traditional Defined Benefit statement expressed as a fixed monthly benefit upon retirement.
In a Cash Balance Plan, each employee’s “account” receives an annual contribution credit and an interest credit based on a guaranteed rate as stated in the plan document. An employee’s plan benefit is equal to the hypothetical account balance which represents the sum of all contributions and interest credits. For employees, they can more easily understand their plan benefit and count on a determinable amount that is not affected by market fluctuations for financial planning purposes.
As in a traditional defined benefit plan, the employer in a cash balance plan bears the investment risks and rewards. An actuary will determine the minimum required, maximum allowed, and recommend contribution to keep the plan funded on a termination basis.
Though unlike a traditional DB Plan, the liabilities in a Cash Balance plan are more predictable, since benefits are credited on a year by year basis in relation to the current year and will grow at the plans stated interest rates.