A 401(k) plan is a defined contribution plan offered by an employer which allows employees to make pre-tax contributions through payroll deductions for retirement purposes. In some instances, employers may choose to match the employee’s contribution by a certain percentage or dollar amount. The employer can receive certain tax benefits for contributions made to a 401(k) Plan. 401(k) plans are subject to annual top-heavy testing, discrimination testing, and IRS Form 5500 filings.

The safe harbor 401(k) plan is not subject to many of the rules that are associated with a traditional 401(k) plan. When an employer provides a safe harbor contribution, the plan is exempt from ADP/ACP discrimination testing which allows the highly compensated employees to maximize their salary deferral and match contributions, without concern that excess refunds will be necessary. However, employers need to be aware that all safe harbor contributions are immediately 100% vested, and that all non-highly compensated employees who meet the eligibility requirements must receive a safe harbor contribution. Also, there can be no service or last day requirements placed on the safe harbor contributions.

There are two types of safe harbor contributions:

  1. Safe Harbor Non-Elective Contribution: An employer is considered to have satisfied the safe harbor feature by providing a safe harbor non-elective contribution (SHNEC) of at least 3% or more of compensation. This contribution must be made to all employees that are eligible to make elective deferrals to the plan, regardless of whether or not the employee elects to make such contributions.

  2. Safe Harbor Match Contribution – Basic or Enhanced Match Formula:
    • The alternative safe harbor contribution is an employer match contribution. The safe harbor match contribution (SHMAT) must be provided to all eligible employees who defer to the 401(k) plan.
    • There are two options, the basic or the enhanced safe harbor match.
    • The basic safe harbor match contribution is defined as a 100% match on the first 3% of compensation deferred and a 50% match on deferrals between 3% and 5%.
    • The safe harbor enhanced match formula requires that a contribution equal to 100% of the first 4% deferred must be given to all employees participating.

Either type of safe harbor contribution selected (SHNEC or SHMAT) must be described in the plan document and in the annual notice to eligible employees between 30 and 90 days before the beginning of the plan year. The contribution requires that the respective safe harbor contribution be made each plan year, unless the employer amends the plan document and removes the provision before the start of the new plan year. If the contribution is made, discrimination testing of elective deferrals (and matching contributions) is not required; if the contribution is not given, elective deferral contributions (and matching contributions) must be tested.

A discretionary profit sharing plan is a defined contribution plan in which employers allow employees to share in company profits. The employer’s contribution is discretionary which means that the amount may fluctuate each year with no minimum required. The amount of the contribution can either be a total dollar amount or based on a percentage of the employees’ compensation.

Age weighted profit-sharing plans have become more and more common in large corporations. ERP helps businesses and partnerships provide sufficient income at retirement for both the business owner and their employees. By implementing an age weighted profit-sharing plan, you will receive the same tax advantages that officers in large organizations and partners in large law firms enjoy. At the same time, you can offer your staff annual contributions to a tax-deferred retirement account. The tax savings very often exceed the cost of providing contributions to the employees of the company or firm.

Depending on the demographics of your company or firm, these types of plans can allocate a contribution to the owners or partners of up to $58,000 (including 401(k) salary deferrals.) Often a 401(k) safe harbor is incorporated into the overall design to maximize the total benefits that can be provided to the owners or partners.

What is an age weighted profit-sharing plan?

An age weighted profit-sharing plan is a Defined Contribution (DC) plan with a tiered contribution schedule based on either age, service, or job classification. To satisfy IRS nondiscrimination requirements, the plan contributions are cross-tested as defined benefits.

Although Defined Benefit (DB) plans are not as common as Defined Contribution (DC) plans, a DB plan may be the best solution to providing sufficient retirement income with the most tax-efficient design possible.

Do you need to be limited by the $58,000 Profit Sharing Limit? Hint: The answer is NO!

Defined Benefit plans are qualified retirement plans where the benefit is defined, rather than a defined contribution plan where the contribution is defined and limited to $58,000. The benefit is usually defined as some percentage of final pay, payable as a life annuity at normal retirement age (typically age 62 or 65). The sponsoring employer usually includes lump sum payment options.

The maximum benefit that you can provide under a defined benefit plan is a life annuity of $230,000, payable at age 62. The lump sum value of this maximum benefit fluctuates, but it is approximately $2.7 million. The contribution amounts required to fund these future benefits are actuarially determined each year. To determine the contribution amount, an actuary projects each participant’s projected benefit payable at the plan’s normal retirement age and determines an annual contribution amount such that there will be sufficient assets available to provide these benefits. The factors that affect the contribution requirements include the benefits provided under the plan, the age of the plan participants, investment performance and plan experience.

For example, if the investment performance of the plan assets was greater than assumed, the contribution requirements in future years will decrease because there are more assets to fund the projected benefits provided under the plan. Conversely, the future contribution requirements will increase if plan assets do not perform as well as assumed. For an older employee, the funding requirements to provide an annual life annuity of $230,000, payable at age 62 can be much higher than $58,000. For example, a participant age 60 could receive an annual contribution of $300,000 or more. The older the participant, the higher the maximum contribution, because you have a shorter period of time to fund the benefit that is provided under the plan.

Alternatively, a defined benefit plan can be combined with a 401(k) profit-sharing plan to integrate the best features of each plan.

The pension for the 21st century

How Would You Like the Flexibility of a Defined Contribution Plan With the Larger Contributions of a Defined Benefit Plan...A Cash Balance Plan May Be the Answer for You!

A 412(i) is a defined benefit plan that is funded exclusively with fully guaranteed insurance products such as annuities and may also include life insurance. No actuarial funding certification is required because appropriate funding has been priced by the insurance company that sponsors the 412(i) program. However, these plans are subject to all of the other rules and requirements of any other defined benefit plan. Consequently, we strongly recommend having an Enrolled Actuary administer the plan.

Frequently, the guaranteed return on investments that are provided under the 412(i) defined benefit plans have made them a more attractive alternative following the poor performance of the equities market during 2007-2008. Simply put, a business owner that is nearing his anticipated retirement age cannot make up the investment losses incurred after two or three straight years of poor investment returns.

What are the advantages of a 412(i) over a traditional defined benefit plan?

  • Greater Tax Deductions
  • The rate of return on plan investments is fully guaranteed, and therefore, immunizes the business owner from any investment risk
  • Accelerated savings for retirement

What are the disadvantages of a 412(i) over a traditional defined benefit plan?

  • Higher contribution requirements for the same level of benefits
  • The long-term rate of return is much lower than a blended equity/bond plan investment policy — in essence, you pay for the guarantees with lower long-term investment returns

Are you a good candidate for a 412(i) plan?

A 412(i) is not for every business owner. The low investment return and the overall cost of the plan may make a traditional defined benefit plan a better alternative, particularly to a younger, less conservative saver. However, if an older employer is nearing retirement, and he cannot afford a few years with poor investment performance, the guarantees that 412(i) plans provide can make them an excellent option. A good candidate for a 412(i) is an employer who:

  • Is in need of a significant tax deduction
  • Has no employees, or few employees that are younger and lower paid
  • Is adverse to risk
  • Is near desired retirement age
  • Has a significant life insurance need
  • What is the maximum contribution under a 412(i) plan?

    It depends. Like any defined benefit plan, the contribution is based on the benefit that is provided under the plan payable at the plan’s normal retirement age. Therefore, the older the participant, the nearer he or she is to retirement would require higher contribution amounts to fund the benefit under the plan. The maximum benefit permitted under any defined benefit plan is a $230,000 annual life annuity payable at age 62. The annual contribution requirement for a 52-year-old that will receive the maximum life annuity is as follows:

    Annual Life Annuity Traditional DB Annual Contribution Requirements 412(i) w/o Life Insurance 412(i) with Life Insurance
    $230,000 $230,000 $380,000 $490,000