What is a Qualified Retirement Plan?
Business owners seeking to accumulate significant retirement savings, offset current taxable earnings and protect assets from bankruptcy can achieve all these goals with a qualified retirement plan, or more simply put, a qualified plan. So, what exactly is a qualified plan?
There is a very technical answer to this question. Simplistically speaking however, a qualified plan, is an employer-sponsored retirement plan that receives specific federal and state tax advantages in return for following specific Internal Revenue Service (IRS) regulations.
The most central piece of legislation governing qualified plans is the Employee Retirement Income Security Act of 1974, or ERISA. Over the years, ERISA has been amended by various other legislations. These requirements must be satisfied in both form and operation. Compliance in form means you have a definite written program, known as a plan document, that is kept current as required. Compliance in operation means all mechanical aspects of plan administration (deposits, distributions, eligibility, vesting…) comply with both the plan document and the regulations. Advantage of compliance is tax-advantaged plan contributions. Egregious failures of form or operation can result in disqualification, and that’s bad. Most failures are not egregious however, and remedies are readily available.
Defined Contribution (DC) & Defined Benefit (DB) Plans
In DC plans, employers promise only contributions made today. The benefit, i.e., the accumulation of the contributions, is NOT guaranteed. The IRS issues limits to restrict the level of annual contributions made. Employer contributions to the plan are usually discretionary; but a 3% of pay minimum will typically apply. The employer can choose to direct the investment of plan assets (trustee-directed). The employer can also authorize participants to direct the investment of their account (participant-directed). A participant’s retirement benefit is the accumulated value of the account, which again, is not guaranteed. Contributions, investment gains and losses will directly affect account values. The participant bears the investment risk associated with the account. Two of the most commonly used DC arrangements by small businesses are the Simplified Employee Pension (SEP), and the §401(k) Profit Sharing Plan (the “401(k)”).
DB Plans
In DB plans, employers promise only the benefits paid tomorrow. The contribution is the annual amount actuarially determined to fund the benefits and can vary from year to year. DB plans are often called Pensions because the annual contribution is required. Interestingly enough, IRC §414(j) defines a DB plan to be “Any plan that is not a DC plan.” IRS issues limits to restrict the level of annual benefits paid. The annual contribution is required and can change from year to year. The annual contribution is calculated by an Enrolled Actuary. All plan assets must be pooled—individual participant accounts or participant-direction are not allowed. The employer bears the investment risk.
In general, it’s helpful to think of DC plans as relatively discretionary, flexible plans but in return for such flexibility the annual limits are relatively low. In contrast, DB plans are neither discretionary nor flexible in the immediate sense; and in return for assuming such a substantive obligation, the employer is rewarded with much higher limits in terms of annual contributions. The most common DB arrangement adopted by small businesses is the Cash Balance Plan (link to CB blog).
Why does a business adopt a qualified plan?
Businesses adopt qualified plans for 2 basic reasons: taxes & competition.
Taxes
With regard to taxes, qualified plans have 2 specific advantages. First, any contributions made to the plan by the employer will offset the business’s taxable earnings on a dollar-for-dollar basis, as indicated in the table below. Any contributions made by plan participants may also be made before income taxes. While remaining in the plan, assets grow income tax-deferred, so long as the plan remains qualified. The advantage of tax-deferral is that assets can accumulate throughout a participant’s working career, without the negative drag of income taxes—which are typically highest when working. At retirement, income taxes are paid as participants draw down their retirement assets. But since income tax rates in retirement are generally lower than rates while working, the amount of taxes ultimately paid is ostensibly minimized.
| XYZ, Inc. | Before Qualified Plan | After Qualified Plan |
|---|---|---|
| Net Earnings | $1,000,000 | $1,000,000 |
| Plan Contribution | $0 | $250,000 |
| Taxable Earnings |
$1,000,000 |
$750,000 |
Competition
Businesses with non-owner employees use qualified plans as a part of their overall benefits package, to attract and retain talented and loyal recruits. Imagine you’re one of those talented recruits, choosing between two employment offers. Both employer’s offer the same income. One employer offers a qualified plan, and the other does not. All else remaining equal, which employer would you choose?
Creditor Protection
Not necessarily a driver of plan adoption, but often an appreciated consequence, is that qualified plan assets are not subject to the claims of an employer’s creditors. This is particularly true in litigious professions. As an example, if a builder is sued for using faulty materials in a building that collapses, the assets in that employer’s qualified plan aren’t generally attachable by any creditor. Owner-only plans don’t always enjoy full creditor protection, however, but generally do retain bankruptcy protection.
What questions should business owners ask about qualified plans?
How much will it cost?
The costs associated with a qualified plan can be placed into 3 basic categories:
- Service provider fees—administrative cost, investment cost
- Procedural impact on the business—time cost
- Employer plan contributions—benefit cost
We cover costs extensively in another blog post. For now, recognize that business owners must be acutely aware of fees, particularly fees paid by plan assets. There is a tax credit is available for new plans, but only for employers with 100 or fewer employers. The tax credit is generally not available to owner-only plans—plans covering no non-owner participants.
“How do we change it, or get out of it altogether?”
Similar to previous answers, it depends on the plan type. With very simple DC plans the discretionary nature of the contribution is very flexible. In other words, the plan is so flexible that the employer doesn’t have to make any contribution all. And in years where a contribution is made, it’s controllable—i.e. everyone gets X% of pay. These types of plans are easy to change and/or terminate.
With DB plans and more complex DC plans, changes—including terminations—are generally made with formal plan amendments, which must be drafted, signed and maintained with the plan document. These changes often require participant notifications and must follow certain timelines. Some DB plans must file for government approval as a requirement of termination. Additional fees often apply for plan amendments and terminations.
It’s important to note that regulations require a qualified plan to be permanent in nature. However, there is no required length of time for which a plan must exist either. So, while a plan adopted in documented and plainly visible contemplation of termination after only a one -time tax offset may be at risk for inquiry, regulations also contemplate that there are valid business reasons for terminating a qualified plan sooner rather than later. Terminations soon after adoption aren’t completely unexpected.
How much of every dollar contributed to the plan will attribute to US?
The answer to this question often determines whether the business owner will actually adopt the plan. Most business owners understand that they can’t contribute more for themselves than they can for non-owners. While this is true generally, regulations do allow flexibility in the way employer plan contributions can be allocated to different groups or classifications of non-owners, so long as certain non-discrimination tests are met. Owner-only plans are not limited by these regulations because there aren’t any non-owners. Owner-only plans therefore, have broad flexibility in designing plans to benefit specific owners more or less than others.
Again, with very simple DC plans, there isn’t as much flexibility. But with DB plans and more complex DC plans, complex testing methods can help business owners control the cost of allocations to certain owners, while providing targeted allocations to others.
How can business owners determine if a qualified plan is appropriate?
The very first step for business owners considering a qualified plan is to get a plan design done by a professional. TPA and actuarial firms offer this sort of work, oftentimes for a fee. Actuaries and other pension professionals are uniquely skilled at the design and implementation of qualified retirement plans. Common actuarial and pension professional designations are:
- ASA—Associate of the Society of Actuaries,
- EA—Enrolled Actuary, and
- QPA—Qualified Pension Administrator
The plan design professional will request the employer’s census data for all employees. Typical census data is as follows:
- Business structure: C-Corporation, S-Corporation, Limited Liability Company, Partnership, Sole Proprietorship,
- Names or job titles, ownership percentages, lineal relatives of owners,
- Birth dates, hire dates, annual hours, annual compensation, and
- Related businesses, maybe more depending on the situation.
An effective plan design will project the employer’s cost obligation in terms of discretionary and non-discretionary contributions. Based on the employer’s specific census demographics, the plan design will identify how to maximize benefits for certain owners while controlling the cost of benefits for other owners. Equally important, the plan design will help business owners understand how census changes can impact the allocation of contributions in future years.
|
Sample §401(k) Profit Sharing Plan Design |
||||||
| Position | Age |
W2 Pay |
Employee Voluntary |
Employer Profit Sharing |
Total | |
| Owner A |
55 |
$235,000 | $30,000 | 18.5% | $43,500 | $73,500 |
| Owner B | 50 | $235,000 | $30,000 | 18.5% | $43,500 | $73,500 |
| Owner C | 50 | $150,000 | $10,000 | 5.0% | $7,500 | $17,500 |
| Owner D | 55 | $100,000 | $7,000 | 5.0% | $5,000 | $12,000 |
| Owner E |
35 |
$90,000 | $5,000 | 5.0% | $4,500 | $9,500 |
|
Total |
$186,000 | |||||
| % to Owners | 79% | |||||
| For illustrative purposes only | ||||||
Even if a plan is not ultimately adopted, the plan design process can help business owners understand when and how a qualified plan will benefit them; as well as provide valuable insight regarding the structure of owner compensation (earned income vs. salary vs. earnings distribution) as it relates to self-employment taxes.
Third Stone Plans can help!
If you’re considering or need help with a qualified retirement plan, Third Stone Plans has a pension professional (QPA) on staff with over 25 years of experience in pensions and qualified plan design. We can provide detailed plan design support at no cost, to help determine if or which qualified plan arrangement will meet your goals and objectives as a business owner.
Contact Third Stone Plans today to learn more!