Qualified retirement plans appeal to both employers and employees. In today’s job market, such plans help employers compete with other firms that offer such plans. Employers find qualified retirement plans attractive because, like salaries, contributions to such plans are deductible. However, unlike salaries, contributions to a qualified retirement plan (other than employee elective salary deferrals) are not subject to Social Security and Medicare taxes (FICA taxes). This saves taxes for both the employee and the employer.
Advantages of Qualified Plans
A qualified retirement plan helps to attract suitable employees and retain existing employees. The use of a vesting schedule that requires an employee to complete a specified number of years of service before having a nonforfeitable right to employer contributions encourages employees to stay with an employer. Weighting the contribution or benefit using years of service may also serve to retain employees. Another advantage for both the employer and the employee is that funds accumulated in a qualified retirement plan are generally not subject to creditor claims.
Working owners of closely held corporations may find qualified retirement plans especially attractive. These shareholder-employees may benefit the most from a plan since they probably have the longest service in which to accumulate benefits. They may also be allowed a greater contribution because their compensation is likely to be higher than that of other employees. This is especially true if the shareholder-employee is the only participant or if contributions for other participants are small compared with those for the shareholder-employee. Long-term participants usually receive additional benefits from the forfeitures of the nonvested accounts of employees who do not stay with the employer long enough to become fully vested.
Qualified retirement plans appeal to employees because plan contributions are not currently taxed. Generally, earnings on these contributions also accumulate in the plan without current taxation. Employees are taxed when they receive a distribution from the plan. Another advantage for employees is the accumulation of retirement funds. Some plans (e.g., 401(k) plans) allow employees to make contributions from their compensation on a tax-deferred basis.
Disadvantages of Qualified Plans
The disadvantages to an employer of having a qualified retirement plan must also be carefully examined. To receive tax-favored status, these plans must meet a host of requirements. Therefore, the main disadvantage is often the cost of administrative functions that must be performed to comply with all of the requirements. The mandatory funding requirements of some types of plans may also be a significant burden to the employer.
The plan’s design can create or eliminate many administrative problems for the employer. Features might work well for some employee groups yet be an administrative nightmare for a different group. For example, loan and hardship distribution features may rarely be used by a high-income group and, when used, may require very little administrative time and effort. The same features for a different group may require considerable time and effort and become a source of ill will when the rules are not well understood by the employees.
In some cases, especially with lower-paid employee groups, employers find that employees will actually terminate employment just to receive a distribution of their vested benefits and then reapply for employment as soon as the distribution is received. This problem is in particular noted with 401(k) plans in which the employees are 100% vested in elective deferral contributions but cannot access the funds without terminating employment.
Another disadvantage is that some employees may not value the tax deferral offered by a qualified plan and may want current compensation instead. This is especially true of younger or lower-paid workers who may not be in a financial position to accumulate savings. However, there is usually strong enough employee interest for an employer to adopt a qualified retirement plan.
There is significant liability for the employer as a fiduciary of the plan. Plan fiduciaries must act in the best interest of plan participants and beneficiaries. Plan fiduciaries are not only subject to significant penalties if they breach this responsibility, they may also be personally liable for any losses to the plan resulting from the breach.
In order for a retirement plan to retain its qualified status, the employer must intend it to be permanent (Regs. Sec. 1.401-1(b)(2)). If the employer is unwilling to continue funding the plan, there is a risk that the IRS might disqualify it, which could result in disallowed deductions for earlier employer contributions to the plan. However, a profit-sharing plan will not be disqualified if the reason for not making contributions is lack of profits, as defined by the plan document.
Evaluating Key Questions
Several types of qualified retirement plans are available to corporate employers. The type of plan chosen affects the amount and timing of required employer contributions, the provision of benefits under the plan, and the employer’s tax deductions. Each employer has different goals in choosing a retirement plan. The following four questions are a good place to start in determining those goals:
- Is the employer willing to accept a mandatory funding requirement?
- How much will the employer contribute to the plan on a consistent basis?
- Which employees are intended to benefit the most from the plan?
- Is timing of the initial deductible contribution an important factor?
Will the employer accept a mandatory funding requirement? If the employer is not willing to accept a mandatory funding requirement of any amount, certain types of plans are quickly eliminated from consideration. There is little need to consider a defined-benefit plan, a SIMPLE IRA, a SIMPLE 401(k), or a safe-harbor 401(k). If the plan is small and is expected to be top-heavy, it is not likely that any type of 401(k) plan will work for the employer unless it is a one-participant 401(k) plan. From a practical standpoint, that leaves a basic profit-sharing plan or a SEP.
How much is the employer willing to contribute? The amount an employer is willing to contribute to a plan on a consistent basis determines in large part the type of plan that will be the best fit. If the employer is willing to make significant contributions and accept a mandatory funding requirement, a defined-benefit plan should be considered. A defined-benefit plan or an age-weighted or cross-tested profit-sharing plan should also be considered if the targeted employee group is older (at least age 50) than the average age for all employees. In most cases, these plans provide the highest deductible amount. Cross-tested and age-weighted profit-sharing plans also focus allocations on older employees and are generally less expensive to administer than defined-benefit plans, although deductions are limited to 25% of compensation.
Which employees are intended to benefit the most? Most plans are designed to maximize benefits for the shareholder-employees or key employees while minimizing contributions for rank-and-file employees. The most common way to do this is to use an integrated allocation formula (permitted disparity). However, unless an employer makes an annual contribution of more than 3%, the formula will not result in any additional contribution for the highly compensated. Age-weighted and comparability formulas also can help skew benefits to owners or key employees. These plans work well when the key group is older than the average employee.
Is the timing of the initial deductible contribution important? A qualified retirement plan (e.g., a profit-sharing plan) must be adopted before the end of the employer’s tax year in order for contributions made after the tax year’s end to be deductible. However, SEPs can be adopted after year end, and contributions made to them after year end can still be deducted in the earlier year.
Example: ABC Corp. will have a $340,000 taxable profit after payment of shareholder-employee salaries and bonuses. If ABC does no year-end tax planning, it will pay $115,600 in income taxes. The shareholder-employees, A (age 40) and C (age 43), suggest contributing to a retirement plan to reduce the corporation’s taxable income and to receive tax-deferred benefits. A and C each receive annual compensation of $120,000. Total compensation for the other employees is $600,000, $200,000 of which is for first-year employees.
ABC can adopt a generic profit-sharing plan before the tax year’s end and deduct a contribution of up to 25% of aggregate compensation paid to eligible employees (the maximum allowable deduction). Since A and C are primarily interested in retirement benefits for themselves, the profit-sharing plan can provide that employees are eligible to participate only after completing one year of service or, if later, after reaching age 21. If ABC implements the profit-sharing plan, the current-year deduction and tax savings will be as follows:
|Eligible Compensation Shareholder-employees||$240,000|
|Others (excluding first-year employees)||400,000|
|Total eligible compensation||640,000|
|Maximum annual percentage||× 25%|
|Maximum deductible contribution||$160,000|
|Tax savings ($160,000 taxed at 2008 rates)||$62,150|
To make a deductible contribution for the current tax year, ABC must adopt its plan before the end of the year. To exclude first-year employees and employees under age 21, the plan document must specify minimum age and service requirements. Excluding those employees could also substantially reduce plan administration costs. While the recommended plan provides a big tax deduction for the current year, it also creates future financial obligations for ABC because the plan must be intended as a permanent benefit for employees rather than just a short-term tax planning strategy for the shareholder-employees.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 20th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, Kellie J. Bushwar, Mary C. Danylak, James A. Keller, Penny Kilpatrick, and Michael E. Mares, published by Thomson Tax & Accounting, Ft. Worth, TX, 2007 ((800) 323-8724; ppc.thomson.com ).