Defined Contribution Plans

401(k) Plans

When your employees think of retirement plans, the first thing that may come to mind is the 401(k) plan.  Due to the tax advantages provided and its ability to make saving easy for the employee, the 401(k) has become the most popular qualified savings plan in the United States.

Employees voluntarily elect to make pre-tax contributions through payroll deductions up to an annual maximum limit  ($16,500 in 2010 and 2011).  Additionally, these plans have “catch-up contributions” that allow employees over the age of 55 to make additonal contributions to the plan to meet their retirement goals ($5,500 in 2010 and 2011)

Another important feature of the plan is that the employer has the option to match some portion of the amount deferred by the employee to encourage greater employee participation, i.e., 25% match on the first 4% deferred by the employee. Since a 401(k) plan is a type of profit sharing plan, profit sharing contributions may be made in addition to or instead of matching contributions. Many employers offer employees the opportunity to take hardship withdrawals or borrow from the plan.

Employee and employer matching contributions are subject to a special nondiscrimination test which limits how much the group of employees referred to as “Highly Compensated Employees” can defer based on the amount deferred by the “Non-Highly Compensated Employees.” In general, employees who fall into the following two categories are considered to be Highly Compensated Employees:

• A more than 5% owner of the employer at any time during the current plan year or preceding plan year (stock attribution rules apply which treat an individual as owning stock owned by his spouse, children, grandchildren or parents); or
• An employee who received compensation in excess of the indexed limit in the preceding plan year ($110,000 for 2010 and 2011). The employer may elect that this group be limited to the top 20% of employees based on compensation.

401(k) Safe Harbor Plans:

The plan may be designed to satisfy “401(k) Safe Harbor” requirements (certain minimum employer contributions and 100% vesting of employer contributions) which can eliminate nondiscrimination testing. The benefit of eliminating the testing is that Highly Compensated Employees can defer up to the annual limit ($16,500 in 2010 and 2011) without concern for what the Non-Highly Compensated Employees defer.

Profit Sharing Plans

The profit sharing plan is one of the most flexible qualified plans available. Company contributions to a profit sharing plan are usually made on a discretionary basis. Each year the employer decides the amount, if any, to be contributed to the plan. For tax deduction purposes, the company contribution cannot exceed 25% of the total compensation of all eligible employees.

The contribution is usually allocated to employees in proportion to compensation and may be integrated with Social Security which results in larger contributions for higher paid employees.

Age-Weighted Profit Sharing Plans: Profit sharing plans may also use an age-weighted allocation formula that takes into account each employee’s age and compensation. This formula results in a significantly larger allocation of the contribution to employees who are closer to retirement age. Age-weighted profit sharing plans combine the flexibility of a profit sharing plan with the ability of a pension plan to skew benefits in favor of older employees.

New Comparability Plans

These plans, sometimes referred to as “cross-tested plans,” are usually profit sharing plans that are tested for nondiscrimination as though they were defined benefit plans. By doing so, certain employees may receive much higher allocations than would be permitted by standard nondiscrimination testing. New comparability plans are generally utilized by small businesses who want to maximize contributions to owners and higher paid employees while minimizing those for all other employees.

Employees are separated into two or more identifiable groups such as owners and non-owners. Each group may receive a different contribution percentage. For example, a higher contribution may be given to the owner group than the non-owner group, as long as the plan satisfies the nondiscrimination requirements.

Automatic Enrollment Plans:

Many studies have indeed indicated that adding automatic enrollment features to a plan helps to facilitate participation rates going up significantly. From that perspective it is certainly a success. However, sponsors and their employees should not be lulled into a false sense of security. Source: Milliman, April 2011.