Plan Types

Qualified Retirement Plans

A qualified retirement plan must satisfy specific requirements under the Internal Revenue Code, including rules for minimum coverage, participation, vesting, and funding. In return for meeting these standards, the IRS provides significant tax advantages that encourage employers to sponsor retirement plans, such as:

Employers may choose between two primary categories of retirement plans: defined contribution plans and defined benefit plans. Each type can be designed to maximize benefits based on the goals of the business and its employees. Our consultants can help you determine which plan structure is the best fit for your organization. Below is an overview of the plan types available.

Defined Contribution Plans

In a defined contribution plan, the employer specifies how contributions will be made to the plan and how those contributions will be allocated among eligible employees. Each participant has an individual account that grows through employer contributions, investment earnings, and, when applicable, forfeitures (amounts from non-vested accounts of employees who leave the company). Some plans also allow employees to contribute on a pre-tax and/or after-tax basis.

Because contributions, investment performance, and forfeiture allocations can fluctuate from year to year, the exact retirement benefit cannot be predetermined. A participant’s benefit at retirement, death, or disability is simply the value of their account at the time it becomes payable. Employer contributions may be subject to a vesting schedule, and any non-vested amounts forfeited by former employees may be used to reduce future employer contributions or reallocated to eligible participants.

Profit-Sharing Plans

A profit-sharing plan is a type of Defined Contribution plan and is one of the most flexible types of qualified retirement plans available. Employer contributions are typically discretionary, allowing the company to decide each year how much to contribute, if anything. Contributions are commonly allocated to employees in proportion to their compensation, and may also be allocated using formulas integrated with Social Security, which can increase allocations for higher-paid employees. All contributions grow tax-deferred and are distributed when a participant retires, reaches a stated number of years of service, or experiences a qualifying event such as disability, death, or termination of employment.

Many profit-sharing plans can also be structured as new comparability or cross-tested plans. In these designs, the plan is tested for nondiscrimination as though it were a defined benefit plan, allowing certain employee groups to receive higher contribution percentages than standard allocation methods would permit. Employers divide participants into reasonable business-based groups—such as owners and non-owners—and each group may receive a different allocation. This type of design is often attractive to small businesses that want to maximize contributions for owners or key employees while keeping required contributions to other eligible employees at a manageable level, provided the plan meets all nondiscrimination requirements.

401(k) Profit Sharing Plans

A 401(k) plan allows employees to save for retirement by making voluntary pre-tax payroll deferrals, even when the employer does not contribute. Employees may defer up to annual IRS limits and, if age 50 or older, may also make additional “catch-up” contributions. All employee deferrals are immediately 100% vested.

Many 401(k) plans also allow employees to make Roth after-tax contributions. While Roth contributions are taxed when made, they can later be withdrawn tax-free—along with their investment earnings—if certain distribution requirements are met.

Employers often encourage participation by matching a portion of employee deferrals. In addition, because a 401(k) is a type of profit-sharing plan, employers may choose to make discretionary profit-sharing contributions as well. Many plans also allow for participant loans or hardship withdrawals, providing flexibility for employees who may need access to funds.

Both employee deferrals and employer matching contributions are subject to IRS nondiscrimination requirements designed to ensure the plan benefits employees fairly. These rules limit how much “highly compensated employees” (HCEs) may defer based on the participation levels of non–highly compensated employees (NHCEs). An employee is generally considered highly compensated if they:

To satisfy these requirements, 401(k) plans must undergo annual ADP and ACP testing. In some cases, these tests may restrict HCE deferrals or require employers to make additional contributions. As an alternative, employers may choose to adopt a “safe harbor” 401(k) design, which exempts the plan from ADP and ACP testing if certain contribution and notice requirements are met. Safe harbor provisions can be changed from year to year with proper advance notification to employees.

Money Purchase Plans

A money purchase plan is a type of Defined Contribution plan in which the employer’s contributions are determined by a specific formula, usually a percentage of pay. Contributions are required each year and are not dependent on company profits.

Defined Benefit Plans

Unlike defined contribution plans—such as profit sharing or 401(k) plans, where contributions and earnings accumulate in individual accounts—a defined benefit plan promises each participant a specific monthly benefit at the plan’s stated retirement age. These plans are typically funded entirely by the employer, who is responsible for contributing enough money to ensure that all promised benefits can be paid, regardless of investment results or business profitability.

Defined benefit plans are often attractive to employers who wish to contribute more than the annual limits permitted under defined contribution plans. Because the required funding is tied to the benefit formula rather than a fixed contribution limit, contributions can be significantly higher and allow retirement savings to grow more rapidly.

Each plan includes a formula for determining a participant’s benefit, usually based on compensation and years of service, rewarding long-term employees. By law, the maximum benefit is 100% of a participant’s compensation—based on their highest consecutive three-year average—up to an indexed annual limit. Many plans also allow participants to choose an optional form of payment, such as a lump-sum distribution, in place of monthly payments.

An actuary determines the annual required employer contribution based on projected benefits for each employee and assumptions about investment returns, retirement age, turnover, and life expectancy. Employer contributions are mandatory, and investment gains or losses will affect the amount the employer must contribute in future years. If employees terminate before becoming fully vested, their forfeited benefits may be used to offset future employer contributions.

Cash Balance Plans

A cash balance plan is a type of defined benefit plan that incorporates features commonly associated with defined contribution plans, making it a “hybrid” design. Unlike a traditional defined benefit plan—which promises a fixed monthly benefit at retirement based on formulas involving compensation and years of service—a cash balance plan expresses a participant’s benefit as a hypothetical account balance.

Each participant’s hypothetical account receives annual “pay credits,” typically calculated as a percentage of compensation, along with “interest credits” based on either a fixed rate or an approved index, such as the 30-year U.S. Treasury bond rate. The interest crediting method must be defined in the plan document. At retirement, the participant’s benefit equals this hypothetical account balance, representing the total of all pay and interest credits. Although the plan must offer the option to convert the balance into an annuity, most participants choose to take a lump sum and roll it into an IRA—an option not always available in traditional defined benefit plans.

As with any defined benefit plan, the employer bears the investment risk. An actuary calculates the required annual contribution, which includes the total employee pay credits plus any adjustments needed to account for differences between the plan’s guaranteed interest credits and actual investment performance.

Employees tend to value cash balance plans because they can easily track the growth of their hypothetical accounts while still being shielded from market volatility. These plans also provide greater portability than traditional defined benefit plans, since participants can typically roll their cash balance into an IRA upon termination or retirement.

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