Types of Plans
All retirement plans fall into the general category of either a Defined Contribution (DC) plan or a Defined Benefit Pension (DB) Plan.
Defined Contribution (DC) Plans:
Any contribution to a Participant's account in a DC plan is as a percentage, or in compliance with a formula, based upon the Participant's current year Compensation. Eventual benefits are determined by the amount of contributions plus actual gains or losses. Some of the more common DC plans are as follows:
The most common type of DC plan is a profit sharing plan. Contributions to a profit sharing plan are made solely by the Employer. Contributions to the plan are discretionary and are subject to the limitations set forth in the section entitled Contribution Limitations.
One of the most popular types of plans in this country during the past 20 years is the 401K plan. A 401K plan is actually a profit sharing plan with an additional section entitled a Cash or Deferred Arrangement (CODA). The plan has all the provisions of a profit sharing plan, allowing the Employer to make discretionary contributions. But, in addition, the CODA allows the Employees to also make tax deferred contributions, entitled Elective Deferrals, into the plan. In addition to or in lieu of a profit sharing contribution, the Employer may also make a Matching Contribution to the plan. The Matching Contribution is typically a percentage of the Employee's Elective Deferral and, therefore, is allocated only to those Employees making contributions. Many Employers will match the Employee's Elective Deferral as a way of encouraging Employee participation in the plan.
An ESOP is a profit sharing plan that allows the plan to invest in Employer securities. This type of plan is typically used when (1) the Employer wants to allow Employees to share in the ownership of the company; (2) the Employer wants to generate a tax deduction without the requirement of expending cash; or (3) as a vehicle to help facilitate the sale of all or a portion of the company to Employees.
The primary difference between a MPPP and a PSP is that the Employer contribution to a PSP is discretionary and the Employer contribution to a MPPP is a specified required percentage or amount. Despite this disadvantage, MPPP’s were popular because the contribution limitation in a MPPP was higher than for a PSP. Therefore, if the Employer's objective was to maximize its contribution, an MPPP was often used. Effective January 1 2002, with the passage of EGTRRA, the contribution limits for profit sharing plans were increased to equate those of MPPP. As a result, very few MPPP exist anymore. When rewriting all of our client's plans for the required GUST restatements, we merged all our MPPP’s into PSP’s.
Defined Benefit Pension Plans (DBPP):
In contrast to a DC plan, which is defined by the amount of money contributed to the plan each year, DB plans focus on the amount of benefit an Employee will receive upon retirement. The benefit formula is generally stated as a promise to provide a guaranteed monthly benefit to the Participant beginning at a specified date in the future. The amount of the fixed benefit an Employee receives is usually determined by factors such as an Employee's Compensation and/or his number of Years of Service with the Employer.
A type of DBPP which has enjoyed increased popularity in the past few years is the Cash Balance Plan:
A cash balance plan is a qualified retirement plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In a Cash Balance Plan, a hypothetical account is maintained for each participant. This account grows annually in two ways: First, by an employer contribution (pay credit), and Second, by a guaranteed and pre-determined interest credit. Like any Defined Benefit Plan, benefits are based on the Plan’s Formula and not on the actual investment earnings of the Plan’s assets.
A Cash Balance Plan provides the opportunity for increased contributions and allows for the acceleration of retirement savings. Maximum Contribution amounts are age dependent, therefore the older the participant, the faster they can increase their savings. When combined with a 401(k) plan, Pre-Tax Contributions of up to $250,000 and more are not unheard of.
If your Business meets the following 3 Criteria they could potentially benefit from a Cash Balance Plan:
- Partners or Shareholders who want to accelerate their Retirement Savings by increasing their contributions above the $49,000 limit set on 401(k) Profit Sharing Plans.
- Companies that have and will continue to exhibit consistent profit patterns. Because Cash Balance Plans are Defined Benefit Plans with required contributions it is important for a company to demonstrate the Cash Flow to support the annual contribution requirements.
- Companies already consistently making or willing to make a contribution for the benefit of their employees. Cash Balance Plans normally require a minimum contribution of between 5% and 7.5% of pay for staff in either the Cash Balance Plan or in a combined Profit Sharing 401(k) Plan. Companies already making these type contributions into a Profit Sharing 401(k) Plan will have a nominal increase in contribution costs when adding a Cash Balance Plan.
Profit Sharing Plan (PSP):
