401(k) A 401(k) plan, thus named after the Internal Revenue Code section that describes it, is not a type of plan at all, rather a type of funding arrangement (qualified cash or deferred arrangement) that is part of a profit sharing, stock bonus or pre-1974 money purchase pension plan. A 401(k) arrangement allows employees to defer a portion of their current compensation into a tax-qualified plan to accumulate tax-free, and to be taxed at a subsequent stage when the funds are distributed. These deferrals are non-forfeitable, i.e. 100% vested, and may be matched by the employer, but are not required to be. More

401(k) SAFE HARBOR The term “401(k) plan” merely refers to a type of funding arrangement that is part of a profit sharing, stock bonus or pre-1974 money purchase pension plan. A 401(k) arrangement allows employees to defer a portion of their current compensation into a tax-qualified plan to accumulate tax-free, and to be taxed only when the funds are later distributed. Operationally, many plans have to undergo the vexing problem of failed annual nondiscrimination ADP/ACP testing and the resultant chaos, namely, additional contributions to non-highly compensated employees, or refunds and amended individual tax returns for highly compensated employees. The Internal Revenue Service has provided an approach for plans to meet an exemption from these nondiscrimination rules provided the two requirements regarding notices and contributions are met:

1.  Notice Requirements: For an existing plan, notice must generally be provided to eligible employees 30 to 90 days before the beginning of the plan year; or 30 days before the end of the plan year, if notice was provided before the beginning of the plan year that the employer may use the safe harbor option. A new or converted 401(k) plan, including a plan that adds the 401(k) feature, may give notice up to the effective date of the plan, as long as at least three months remain in the plan year. A safe harbor 401(k) plan sponsored by a new business entity may have an initial plan year as short as one month.
2. Contribution Requirements: One of the following two fully vested minimum contribution requirements must be met:
   • (a) an employer non-elective contribution of 3% of pay to all eligible employees, regardless of active participation; or
   • (b) matching contributions of 100% of the first 3% of compensation deferred, and 50% of the next 2%.
     The basic safe harbor matching formula results in a contribution of 4% of compensation to employees who defer 5% of compensation or more.

It is possible to contribute more, but not less, than the basic contribution requirements: either as an enhancement of the basic formula, and/or as an additional fixed contribution specified in the plan document, and/or as an additional discretionary contribution limited to 4% of compensation. More

PROFIT SHARING A profit sharing plan is a type of employer-sponsored retirement plan maintained with the intention of allowing employees to share in company profits. Nonetheless, the employer is neither required to have profits in order to make a contribution, nor do the contributions need to be made out of profits. Amounts contributed to the plan are tax-deductible to the employer. The contributions accumulate tax-deferred, and become taxable to the employee when distributed, either at retirement, or upon the occurrence of a specified event, such as death, disability, termination of employment, etc. The employer enjoys discretion in making contributions, and has a broad range of options in determining how the contributions will be allocated among various eligible employees. More

NEW COMPARABILITY A new comparability plan is generally a profit sharing plan or a money purchase pension plan in which the contribution percentage is different for various classes of employees. A new comparability plan is designed to satisfy nondiscrimination requirements under cross-testing rules, wherein the contributions for the individual participants are compared using actuarial projections of future monthly benefits payable at normal retirement age. The calculated equivalent benefit accrual rates (EBARs) are tested on a benefits basis for nondiscrimination, as a defined benefit pension plan would. For these reasons, a new comparability plan is often referred to as a tiered plan or a cross-tested plan. The outcome of cross-testing is that younger employees have relatively high testing EBARs (see illustration under the “Example” section), thereby allowing the employer to reward with larger contributions certain classes of employees who are on average older than other classes of employees. Most new comparability plans are designed as profit sharing plans. Therefore, this article will reference a profit sharing plan when applying the term “new comparability plan. More

DEFINED BENEFIT A defined benefit pension plan promises participants a certain (or “defined”) monthly benefit beginning at normal retirement date. Retirement benefits are specified by a formula in the plan document typically based on factors including length of service and compensation. The annual benefit that may be paid to a participant under a defined benefit pension plan is limited by the Internal Revenue Code; it is the lesser of (a) $185,000 adjusted for inflation, or (b) 100% of the participant’s average compensation.The plan is funded using actuarial calculations that factor in variables such as life expectancy, salary increases, rate of investment returns, cost-of-living adjustments, plan expenses, employee turnover, death, disability, etc. The concept of account balances is absent in a traditional defined benefit pension plan. The participant’s accrued benefit in a defined benefit pension plan is the portion of retirement benefits earned thus far. More

CASH BALANCE A cash balance plan is a type of defined benefit pension plan that possesses certain characteristics of a defined contribution plan. Mandatory contributions are made to employees’ hypothetical accounts based on any number of objective factors defined in the plan document such as compensation, age, and length of service. Earnings, usually based on an external index, are also credited to employees’ theoretical accounts. The benefit accruals and earnings are guaranteed, i.e. the employer, not the employee, bears the risk of actual investment experience. More

MONEY PURCHASE A money purchase pension plan is a type of defined contribution plan to which the employer makes mandatory tax-deductible contributions according to a pre-determined formula. The formula for allocating the contribution to various employees is generally a specified percentage of each participant’s compensation, but other formulas are permitted. The contributions grow tax-deferred, and are taxable to the employee only when they are distributed. The contribution requirement and allocation formula are specified in the plan document. The plan must designate itself a money purchase pension plan. More

ESOP An Employee Stock Ownership Plan (ESOP) is a tax-qualified employee benefit (retirement) plan that is designed to invest primarily in stock or other securities issued by the employer. An ESOP must be custom designed to fit a company’s situation and needs.
Typically, an ESOP works like this:

• The employer implements an ESOP by adopting a written ESOP document and by naming a plan trustee
• The employer then makes tax-deductible contributions to the plan
• The plan trustee uses the contributions to buy employer stock
• The trustee holds the stock for the benefit of the participating employees
• When employees retire (or in certain other circumstances), the trustee makes distributions to the employees from the plan.The distributions may consist of employer stock or, under certain circumstances, an equivalent amount of cash.

An ESOP may be set up so that employer contributions provide the funds for the plan’s stock purchases. Or a debt-financed – leveraged- form of ESOP. With a leveraged ESOP, the trustee or plan sponsor borrows money from a lender. The borrowed funds are used to acquire stock from the company. In turn, the trustee uses company contributions to gradually pay both interest and principal on the debt. A leveraged ESOP can supply a corporation with substantial working capital funded with tax-deductible dollars. Under the right circumstances, a leveraged ESOP can be a very practical financing resource for a company. More