This article will provide an overview of qualified retirement plan options, their differences, contribution and deduction limits, the factors that influence the choice of the right plan or plans, and an overview of the discrimination testing/compliance issues that a qualified Plan must satisfy.

Before we get into discussing the various types of qualified plans, we need to mention minimum coverage testing. You will hear minimum coverage testing referred to as 410(b) testing; 410(b) is a section of the internal revenue code that discusses minimum coverage testing. In order to be a qualified plan the plan must pass minimum coverage. If a plan does not pass minimum coverage in a year and the IRS finds out, the plan will be “thrown” into audit cap and will be considered disqualified unless the plan pays an audit cap penalty to the IRS. Minimum coverage and other discrimination testing issues are discussed at the end of the article.

 All discrimination testing compares highly compensated employees (HCEs) to non-highly compensated employees (NHCEs). The choice for how a plan determines which employees are HCEs is discussed at the end of the article. 

Defined-contribution plans (DCPs) define  the  contribution  to  be  deposited  into a participant’s account.  A separate account is maintained for each individual participant. There is no promised benefit paid at retirement like in a defined benefit pension plan—you get what is in your account. Participants that receive the same contribution amounts from the employer can end up with different account balances if they select different investments.

DCPs are easy to understand. Participants can receive a statement that displays a beginning balance, their share of plan contributions,  plan earnings or losses and an ending balance for the reporting period.  Plans that are “daily valued” often allow the participant to look at their account balances online at any time.

DCPs generally favor younger employees as contributions and interest will accumulate over a longer period of time. Ignoring earnings, a 25-year-old receiving an annual $500 allocation would have a balance at 65 of $20,000 ($500 x 40 years). However, a 50-year-old would only have a $7,500 balance ($500 x 5 years) at age 65. 

Profit-sharing plans (PSPs) are a type of DCP that can have required contributions spelled out in the plan document or discretionary contributions that can vary from year to year, including zero. PSPs can be trustee directed or comprise participant directed investments; they can allow either employer or employee contributions or both. PSPs can allow 401(k) contributions. Employer contributions, except 401(k) safe harbor contributions and qualified non-elected contributions (QNECs) can be subject to vesting schedule. (Safe harbor and QNECs must always be 100% vested.) A vesting schedule determines the percentage of the account a participant gets to take with her, based on her years of service, if she leaves at a particular point in time.

All qualified plans are subject to a maximum compensation limit ($290,000 in 2021) when calculating employer deductions, allocation of employer contributions and in discrimination testing. If you are to receive 10% of your pay contribution and your pay is $400,000, you will receive a $29,000 contribution ($290,000 x 10%). There is also a limit on the maximum amount that can be allocated in a plan year to an individual participant from both employer and employee contributions in a DCP; this is referred to as the section “415 limit” ($58,000 in 2021). A participant’s 401(k) deferrals are counted towards the 415 limit. In addition to the 415 limit, if a PSP has a 401(k) feature, there is a maximum amount—the 402(g) limit ($19,500 in 2021)—that employees can defer into the plan in a calendar year. (This deferral limit also applies to 403(b) plans.) A person has only one 402(g) limit, regardless of the number of plans he participates in; if he changes jobs and defers into two different 401(k) or 403(b) plans in a year, he needs to ensure that the total deferrals between the two plans don’t exceed the 402(g) limit. A 401(k) plan can allow employee deferrals in the form of traditional pretax deferrals, Roth or both. The 402(g) limit applies to both, and is an overall limit. The 401(k) may allow catch-up contributions, ($6,500 in 2021) above the 402(g) limit and the 415 limit. These are additional pre-tax or Roth elective deferrals that may only be made by a participant who is at least age 50 by the end of the calendar year.

Roth deferrals are elective deferrals that are made on an after-tax basis to a 401(k) or 403(b) plan. The earnings generated by the Roth deferrals are tax-free when distributed if the distribution is made after the participant is age 59½, has died or has become disabled and if distributed at least five years after January 1 of the year in which the first Roth deferral was contributed to the Plan. Deferrals and any match contributions are subject to actual deferral percentage/actual contribution percentage (ADP/ACP) testing. ADP/ACP testing is discussed at the end of this article.

Automatic Enrollment/Safe Harbor 401(k) Plans

If a 401(k) plan fails the ADP test, then either deferrals must be refunded to the HCEs, or a special contribution (e.g., a QNEC), must be made to the NHCEs. To help pass the ADP test, employers may make matching contributions to encourage employees to defer. The plan can also add a provision that automatically enrolls participants at a specified percentage unless they opt out; this has the effect of getting more NHCEs deferring into the plan because they have to take action to not defer instead of having to take action to defer.  Testing must still be conducted, and refunds are possible.           

Another solution for a failing ADP/ACP test is to add a safe harbor 401(k) contribution. If the safe harbor requirements are met, the plan will be deemed to pass the ADP and ACP tests. There are safe harbor match contributions (100% of the first 3% a participant defers, plus 50% of the next 2%), and safe harbor non-elective contributions (at least 3% of pay). Safe harbor non-elective contributions (SHNECs) can also be used to satisfy top heavy requirements and used towards the minimum gateway contribution if a new comparability formula is used). See end of article for a discussion on top heavy vesting.

Profit sharing contributions are commonly allocated on a pro rata basis, (uniform dollar amount or percentage of compensation), on a permitted disparity/integrated allocation basis that allows slightly larger contribution for participants that earn over the Social Security wage basis (currently $142,800). The reasoning behind this is that people who make below the Social Security wage base are receiving Social Security, based on all of their income. People who earn more than the Social Security wage base are only receiving Social Security based on a portion of their income. New comparability allocations can provide much higher contributions for older participants without the required annual contributions of a defined benefit plan; this is because the contributions are tested like a defined benefit plan, looking at what a participant will have at retirement instead of the amount being contributed annually. An older participant has less time to accumulate their “pot of gold”  at retirement, so larger contributions can be made for him. Participants can be placed into groups, and each participant can be a group. Different amounts of contributions can be made for each group as long as the minimum NHCE gateway contribution is provided and the plan passes an additional  discrimination test that compares the contributions received and the ages of the HCEs to the other participants. The minimum NHCE “gateway” contribution is equal to the lesser of either 5% of compensation or 33% of the highest percentage allocated to any HCE. So, if the highest percentage allocated to any HCE is 9% of compensation, then the NHCEs must receive at least 3% of pay contribution.

403(b) plans are similar to 401(k) plans. Only certain employers such as charitable foundations or educational organizations operated by a state may sponsor a 403(b) plan. A money purchase plan looks very similar to a PSP. However, a money purchase plan obligates the employer to contribute a specific amount or percentage of the participant’s compensation to the plan each year. There are also IRA based plans for smaller employers.  

Defined benefit plans (DBPs) promise to pay a benefit at retirement. Contributions are determined by an actuary.  The investments are trustee directed. If the investments have a bad year, the sponsor will probably need to contribute more to make up for it. Employer contributions only (in almost all cases). Benefits to be provided at retirement are spelled out in the plan document. Often it is a formula such as “x% of final average annual compensation multiplied by years of service.” Assets are not allocated to specific employees, and usually a vesting schedule applies. Currently benefits are limited to the lesser of 100% of high three-year average compensation or $230,000/year. An actuary calculates the annual required contributions based on the amount necessary to fund the promised benefits at retirement; these can offer much larger contributions/deductions than DCPs. DBPs are harder for Employees to understand. Communication of the value of the benefits earned can be a challenge. Younger participants may not find much value in a $1,000 per month annuity that begins at age 65. They may require PBGC coverage/premiums.

Cash Balance Plans. A cash balance plan is a defined benefit plan that looks like a defined contribution plan (easier for participants to understand).  The benefit is expressed as a hypothetical account balance.  Accounts grow at a defined interest rate, regardless of actual asset performance.  Accounts grow with service credits based on pay.  These credits must be specified in the plan. Credits can be higher for targeted participants.  The annual cost is the amount necessary to fund the theoretical balances.  The plan requires the services of an enrolled actuary.  Benefits may require pension benefit guaranty corporation (PBGC) insurance. The accrued benefit is in the form of a lump sum distribution. The plan must use three-year cliff vesting or a more generous vesting schedule. A three-year cliff means you are zero percent vested, unless you have three years of service. At three years, you become 100% vested in your benefit.

Which Plan?

For a relatively new entity, flexibility is important until you have established recurring profits. PSPs offer maximum flexibility. Cost equals the annual contribution (minimum contribution, $0; maximum deduction, 25% of eligible compensation). They can allow 401(k) deferrals with total amounts contributed to a participant’s account in a plan year up to the lesser of 100% of compensation or $58,000 (plus catch-ups if the participant is deferring and is at least age 50 by the end of the year.) If the employer doesn’t want to be required to make any employer contributions they may need to keep highly compensated employees (HCEs) and key employees out of the qualified plan due to ADP testing and top heavy requirements.  One can consider putting some or all of the HCEs/keys in a non-qualified Plan. 

Once the employer is able to or wants to make employer contributions, you can add a safe harbor match or safe harbor non-elective contribution. This allows the HCEs to make the maximum 401(k) deferrals without ever getting refunds. When able, add a larger profit sharing contribution.

Who wants a defined benefit or cash balance plan? If favored employee(s) is older than staff (generally over age 40) you can get much larger tax deductible contributions in a defined benefit plan or a cash balance plan than in a defined contribution (DC) plan. The maximum defined benefit/cash balance allocation is age dependent; someone age 55 can generate an allocation of $200,000 (at age 60, $265,000; at 65, $275,000). The business should be stable and able to sustain larger contribution. There are usually required annual contributions; this requires predictable profits. Defined benefit and cash balance plans often work well for small employers who want to maximize tax deferral such as attorneys, real estate agents, medical practices and board members.

In a cash balance plan, you can make contribution credits higher for targeted employees. Testing often works best when combined with a new comparability profit sharing/401(k) plan. The goal is often for a targeted participant to receive the maximum in both the profit sharing and in the cash balance plan. Whether that is possible depends on the information on other employees, such as age, compensation and the actuarial design and testing results.

 Discrimination Testing and Other Compliance Issues

Minimum coverage. To pass coverage testing a plan must benefit a minimum percentage of eligible NHCEs. (Each component of a plan, (employee deferrals, employer matching contributions, and employer non-elective contributions), is tested separately and must pass the coverage test. The easiest coverage test to understand is referred to as the ratio percentage test.  The ratio percentage test requires that a plan benefit a percentage of NHCEs equal to 70% or more of the percentage of HCEs who benefit under the plan. A plan’s coverage ratio is determined by dividing the ratio of NHCEs by the ratio of HCEs. If the plan fails this ratio percentage test, it may still pass under a more complicated testing procedure called the average benefit test.  So if there are 10 HCEs and all are eligible for a profit sharing only plan and 10 NHCEs but only 6 of them are eligible for the plan, the plan will not pass coverage. With 100% of the HCEs eligible, the plan would need to allow at least 7 of the NHCEs into the plan. If only 8 of the 10 HCEs were eligible for the plan, 80% of the HCEs are eligible, so then at least 56% (80% x 70%) of the NHCEs would need to be eligible.

Some employees do not need to be counted towards the test percentages. Generally, employees who are not counted for purposes of this test are employees who have not met the minimum age and service requirements of the plan or are not yet age 21 with one year of service, employees who are covered by a collective bargaining agreement (union employees) and certain non-resident aliens with no U.S. source income.       

HCEs. An employee will be considered an HCE if the employee owned more than 5% of the stock of the employer at any time during the current plan year or during the preceding 12 months of the plan year or if the employee earned more than $130,000 in the prior year. (This dollar mount is subject to cost of living increases.)

The plan may elect to use a different definition of HCE called the top paid group election. Any employee that is a greater than 5% owner is still an HCE.  However, if the employee does not own more than 5% of the stock in the current or preceding plan year they will only be an HCE if there compensation is over $130,000 during the 12 months preceding the plan year and the employee was in the top 20% of employees ranked by compensation during those 12 months. This election can help a plan that has many employees that would be considered HCEs under the first definition because it will limit the number of possible HCEs and push some of the highly paid employees into the NHCE category. These HCEs that are now considered NHCEs often help the NHCE discrimination testing results.

An employee who is a spouse, child, parent or grandparent of a more than 5% owner is treated as owning the same interest and is an HCE. This is because of the IRS attribution rules that apply to qualified plans.

ADP/ACP testing. Deferrals in a 401(k) plans must pass an ADP test. If match contributions are made, the plan must also pass an ACP test. To pass, one of two tests below must be met for both deferrals and match contributions:

• The average deferral/match contribution percentage of the HCE group must not exceed 125% of the average deferral/match contribution percentage of the NHCE group, or                                           

• The average deferral/match contribution percentage of the HCE group must not exceed the average deferral/match contribution percentage of the NHCE group by the lesser of 2 plus or 2 times the average deferral/match contribution percentage of the NHCEs.

IRS regulations allow the use of either prior year or current year testing methods. Under both the prior and current year testing methods, the ADP or ACP for the HCEs is always determined using data from the plan year being tested. If the current year method is used, the ADP or ACP for the NHCEs is also determined using data from the plan year being tested. If the prior year method is used, the ADP or ACP for the NHCEs is determined using data from the preceding plan year. Restrictions apply regarding switching between these methods. Prior year testing lets the employer know in advance how much the HCEs can defer because they know the ADP of the NHCEs.

What are the top heavy requirements? If more than 60% of the plan account balance belongs to key employees, then non-key employees are entitled to receive an employer contribution equal to the largest amount that a key employee deferred or received but not more than 3%, unless there are multiple plans.  (Employers may have a plan that only allows deferrals but if more than 60% of the account balances belong to key employees, then the employer may be required to make a top heavy contribution to the non-key employees in the plan. Non-keys are entitled to this top heavy contribution if they are employed on the last day of the plan year regardless of the number of hours worked during the plan year. Account values attributable to employer contributions must also be vested according to an IRS approved top-heavy vesting schedule. (Deferrals, safe harbor contributions and QNECs are always 100% vested.) Top heavy vesting must at least be as generous as 6 year graded (20% after 2 years, increasing 20% each year thereafter with 100% vesting after 6 years) or 3 year cliff (0% vested until you have 3 years of service, whereupon you are 100% vested).

A key employee is any employee who at any time during the current plan year or the preceding plan year is/was:

•  A greater than 5% owner of the stock of the employer
•  A greater than 1% owner of the stock of the employer and earning annual compensation from the employer in excess of $150,000
•  An officer of the company receiving compensation in excess of $175,000 (the compensation limit is subject to cost of living adjustments of $5,000 each year)