Other Retirement Plan Options
- 401(k) Plans
A 401(k) Plan is an employer-sponsored plan that allows employees to make pretax contributions to their accounts. These contributions are usually made by payroll deductions. The maximum amount that an employee can contribute to a 401(k) plan in 2017 is $18,000. This limit is adjusted each year to reflect changes in the cost-of-living. Participants age 50 and older can make “catch up” contributions to a 401(k) plan. The maximum “catch up” contribution is $5,500.
IRS regulations require the use of nondiscrimination tests to determine the maximum contribution levels for highly compensated employees. These tests are designed to ensure that the plan benefits all employees in a nondiscriminatory manner.
- No employer contributions are required
- The employer can make discretionary matching and/or profit sharing contributions
- Employee participation is optional
- Employees are able to reduce their taxable income and save for retirement
Plans must satisfy nondiscrimination testing. If the plan fails these tests, corrective action must be taken.
- Roth 401(k) Plans
What is a Roth 401(k) contribution?
Traditional 401(k) contributions are excluded from an employee’s taxable income in the year they are made but the account balance, including earnings, is taxed as ordinary income when it is distributed.
On the other hand, Roth 401(k) contributions are not excluded from an employee’s taxable income when they are made. However, distributions of these contributions, along with their investment income, are tax free.
How does a Roth 401(k) differ from a Roth IRA?
There is no income threshold for a Roth 401(k) — all participants can contribute regardless of how much money they make. An individual can contribute to a Roth IRA only if his or her income does not exceed a threshold amount.
An individual can contribute up to $5,000 to a Roth IRA (subject to the income threshold rules). If the individual is age 50 or older, he or she can make an additional $1,000 “catch up” contribution.
In a Roth 401(k), the contribution limits are significantly higher: up to $18,000 plus an additional $5,500 for those age 50 or older. These amounts are adjusted annually for cost-of-living increases.
What other requirements will a plan have to meet?
Roth 401(k) contributions must be combined with pre-tax 401(k) contributions for purposes of the actual deferral percentage (ADP) test.
The combined Roth 401(k) and pre-tax 401(k) contributions for any individual cannot exceed the annual maximum ($18,000 plus an additional $5,500 catch up contribution for individuals age 50 and older.)
Employers will be able to make matching contributions with respect to both Roth and traditional 401(k) contributions. Matching contributions are treated the same as under current law regardless of whether they are based on Roth or traditional 401(k) contributions.
- Profit Sharing Plans
The Profit Sharing Plan is the most flexible qualified plan available. An employer can contribute up to 25% of the total compensation of all eligible employees. The maximum amount which can be allocated to any one participant is 100% of the participant’s compensation or $54,000, whichever is less. The $54,000 limit is adjusted each year to reflect changes in the cost-of-living index.
The decision to make a contribution to a profit sharing plan is made by the employer each year. It is not necessary to make a contribution every year. Many employers tie the level of contribution to the profitability of the business, but it is not required that the employer show a profit in order to make a contribution.
- Contributions are discretionary. This enables an employer to vary contributions from year to year.
- Nonvested account balances forfeited by terminating employees can be reallocated to the accounts of active participants or can be used to reduce future employer contributions.
- A profit sharing plan can be used in combination with another type of plan, such as a Cash Balance Plan, to achieve a higher contribution level.
A higher maximum contribution level can be achieved with other types of plans such as a Money Purchase Pension Plan or a Defined Benefit Plan.
The purpose of a retirement plan is to provide retirement income. It costs more to provide a specified level of income to an older employee than a younger employee. This is because a younger employee has many more years to invest his or her money.
To take this into account, our tax code allows larger contributions to be made on behalf of older employees. In many businesses, the key executives are older than most of the other employees. The tax code allows a greater contribution to be made for these older key executives.
- Defined Benefit Plans
A defined benefit plan promises to pay participants a specified monthly income when they retire. The amount of monthly benefits is usually based on the participant’s pay and years of service. A defined benefit plan can provide for a lifetime annual retirement income of up to the highest consecutive three-year average compensation or $241,000, whichever is less. The $241,000 limit applies to plan years ending in 2017 and is adjusted each year to reflect changes in the cost-of-living index.
The plan sponsor must make certain that there is enough money in the plan to pay the promised benefits. Annual contribution levels are determined by an actuary based on actuarial assumptions about future pay increases, investment performance, years until retirement and life expectancy after retirement.
Contributions to a Defined Benefit Plan are mandatory and must satisfy minimum standards. Larger contributions must be made on behalf of older participants because an older participant has fewer years remaining until retirement. This can be advantageous to key executives, who are often older than the other participants.
- Contribution for executives can be substantially higher in a defined benefit plan than in other types of retirement plans.
- Defined Benefit plans tend to favor older, higher-paid employees.
The promised benefit must be provided to all participants regardless of the actual investment performance of the plan. Poor investment performance could result in increased contribution requirements.
Termination of a defined benefit plan that is over-funded could result in an excise tax to the employer ranging from 20% to 50% on the excess assets.