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Why should a company adopt a qualified retirement plan?
A qualified retirement plan is one of the best tax shelters available. The company is allowed a current deduction for its contributions to the plan; the employee pays no tax on money contributed for the employee's benefit until a distribution is made; earnings from investments made with funds in the plan may accumulate tax free; and distributions from the plan may be afforded favorable income tax treatment. A qualified retirement plan is especially attractive to working owners of closely held corporations and to self-employed individuals. Their long-term service with their companies gives them the best opportunity to accumulate large sums of money through the tax-free build-up of capital. Although benefits must be provided for other employees as well, the owner usually receives a much larger benefit than the other employees. The non-tax reasons for adopting a qualified retirement plan include the following: (1) attracting employees, (2) reducing employee turnover, (3) increasing employee incentives, and (4) accumulating funds for retirement. How does the adoption of a qualified retirement plan reduce a corporation's tax liability? To illustrate how a qualified retirement plan reduces a corporation's tax liability, assume the corporation had taxable income of $45,000 in 2001 and no qualified plan. Its income tax liability would be $6,750. If, however, the owners decided to adopt a qualified retirement plan and make a tax-deductible contribution of $21,000 to the plan, the corporation's taxable income would now be $24,000 ($45,000 - $21,000). Its income tax liability would be reduced to $3,600. By adopting the plan and making the contribution, this corporation would cut its tax liability by almost 50 percent. [IRC § 11(b)] What are the annual reporting requirements? Each employer (subject to a limited exception) that maintains a qualified retirement plan is required to file an annual report. The annual report is commonly referred to as the Form 5500 series return/report. The appropriate Form 5500 series return/report (Form 5500 or 5500-EZ) must be filed for each qualified retirement plan for each plan year in which the plan has assets. Therefore, the year of complete distribution of all plan assets is the last year for which a Form 5500 must be filed. [IRC §§ 6058, 6059] What is a 401(k) plan, and why is it so popular? "401(k)" refers to a section of the Internal Revenue Code, which was enacted back in the late 1970's. Under this type of plan, employees may defer a portion of their salary, and not owe any tax, either federal or state, on the amounts deferred. The amounts deferred go into a qualified trust and can be invested. The investment income generated by the employee's 401(k) account is not taxed until the money is taken out of the plan. What type of employer organizations can offer a 401(k) plan? Almost any type of entity may adopt a 401(k) plan, including: corporations, S-corporations, partnerships, limited liability companies, sole proprietors, and non-profit organizations. Some government organizations may not be allowed to offer 401(k), but they can usually offer a 457 plan instead. Also, some non-profit entities (501(c)(3) organizations) can offer something similar called a 403(b) plan as well. Do all employees have to be eligible for the plan? No. Employees under age 21 or with less than 1 year of service can be excluded. Also, certain categories of employees can be excluded, such as union employees and non-resident aliens. Other groups may be excluded as well, but the plan will have to show that it is not discriminatory in coverage. Complicated IRS testing may be required to show the plan is not discriminatory in coverage. This is why a competent retirement benefit specialist should design the plan. How much can an employee defer? The current limit in the year 2003 is $12,000 each employee. It will move to $13,000 in 2004, $14,000 in 2005, and to $15,000 in 2006. This limit is then indexed annually. Also, beginning in year 2002, employees over the age of 50 can make additional "catch-up" contributions as follows: $2,000 in 2003; $3,000 in 2004; $4,000 in 2005; and $5,000 in 2006. Is there some type of contribution test that the plan must pass? Yes. It is called the Average Deferral Percentage (ADP) Test. The plan is separated into the Highly Compensated Employees, or HCEs, (those making more than $90,000 in 2002, or owning more than 5% of the business) and the Non-Highly Compensated Employees, or NHCEs, (everyone else who is eligible). The amount that the HCEs may defer is limited by the amount that the NHCEs actually defer. The difference in the averages is usually limited to 2% (that is, if the NHCEs average 4% deferrals, the HCEs can average 6%). The test can be more complicated that this and the plan may be subject to a similar test on the employer match. In order to see that the plan passes this test each year, money may have to be refunded to the HCEs. This is why enrollment among the NHCEs should always be encouraged. Does the employer have to match the employee deferrals? No. The employer may match a portion of what the employees defer, providing in effect an instantly guaranteed rate of return. Employers are under no obligation to match, but many do, in order to encourage employees to defer. A typical employer match might be 25% of the first 6% of pay deferred by each employee. In this example, if an employee making $30,000 deferred 6% of pay, or $1,800, into the plan, the employer would match $450 (25% of the amount deferred). Some employers match 100% of deferrals, although studies have shown this is not necessary in order to encourage enrollment. What is the Safe Harbor 401(k) Plan about? Beginning in the year 2001, employers may avail themselves of a new rule that eliminates the ADP test described above. (Actually, the rule has been available since 1998, but plans with this feature could not be submitted for IRS approval until 2001). If an employer elects to use the Safe Harbor rules, and notifies each eligible employee of that election, then the plan may omit the ADP test if it also provides either of these contributions for all the eligible non-highly compensated employees:
Employers who have had problems passing the ADP test, especially those who are spending more than 3% of pay on employee contributions, will welcome this provision. This is ONLY effective for plan years beginning in the year 2001 and later. Does the plan have to give employees control over the investment of their money? No. There is no requirement that employees be able to decide how their money is invested. This duty can be taken on completely by the employer, or delegated to an outside trustee. However, the plan is certainly more popular among employees, and stands to have better enrollment, if the employees have some control over their deferrals. After all, it is their money. Most 401(k) plans offer several mutual fund options, and allow employees to direct their deferrals into the funds in some proportion. Employees can usually transfer money between funds at periodic intervals (annually, semi-annually, quarterly, or even daily). Some plans also offer a self-directed option, where an employee can buy and sell stocks and bonds through a brokerage account. Other plans allow employer stock as an investment option. Are employees taxed when they take their money out? Yes, if they take a lump sum and do not roll it into another qualified retirement plan or IRA within 60 days. Is there any penalty to the employee for taking the money out? Yes, if the employee terminates employment (other than by retirement, death, or disability) and is under age 55, and does not roll the money into another qualified plan or an IRA. The penalty is 10% of the amount taken out. Is the top-heavy test the same as the ADP test? No. The ADP Test compares the ratio of contributions between highly compensated employees and all other employees. The Top-Heavy test compares the assets of the plan as allocated between key employees and non-key employees at the beginning of a plan year. What happens when the plan is deemed top-heavy? When a plan is deemed to be top-heavy, the employer must make a minimum profit sharing contribution to non-key employees equal to the contribution received by any key employee up to, but not in excess of 3% of pay. For example, a key employee defers 6%, then the employer must make a 3% contribution for all the non-key employees. It is important to note that the non-key employees' own salary reduction contributions are not counted towards meeting the 3%. The minimum contribution is waived in any plan year that the only contributions to the plan are employee deferrals and employer safe harbor contributions. |
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