The primary goal of most employers in establishing any type of retirement savings program is to provide retirement income in a tax-efficient manner. The best way to achieve this is through a qualified retirement plan.

The benefits of establishing and maintaining a qualified plan are numerous. Although different types of qualified retirement plans have different design characteristics, they all share the following attributes:

• Contributions made to the plan by the employer are immediately tax deductible.

• Earnings accumulate within the plan on a tax-deferred basis.

• Plan participants do not recognize taxable income until benefits are distributed from the plan.

• Taxable income can be further delayed by rolling over the proceeds to an individual retirement account.

• With very few exceptions, plan assets are protected from creditors of the employer as well as those of the individual plan participants.

This article discusses the different types of qualified retirement plans—and their available features—available for closely held businesses.

TYPES OF QUALIFIED RETIREMENT PLANS

There are two main types of qualified retirement plans: defined contribution plans and defined benefit plans. Although the features of particular plans differ, they each generally have the basic characteristics described below.

A. Defined Contribution Plans

1. In General

Defined contribution plans are designed to provide employees with a specified contribution rate or amount each year. These plans are written with a specific formula to determine exactly how each employee qualifies for a share in the contribution and how that contribution is then allocated among each of the employees who qualify. 

A plan participant’s benefit is expressed as an account balance. Each year, a participant’s plan account is credited with their annual contribution and then either credited or debited with their portion of net investment earnings within the plan. A participant’s retirement benefit in a defined contribution plan is always based on the actual earnings of the investments within the plan.

The different types of defined contribution plans are summarized below.

2. Profit-Sharing Plans

A profit-sharing plan is the most common form of defined contribution plan and, in many cases, the most flexible. It is employer-funded based on one of the following allocation formulas:

• Non-integrated. With a non-integrated formula (sometimes referred to as “pro rata” or “comp. to comp.”), each participant is allocated the same percentage of compensation.

Example: Corporation A sponsors a profit-sharing plan with a non-integrated formula of 10% of compensation. Employee 1, with compensation of $200,000, will receive a profit-sharing allocation of $20,000.

• Integrated. With an integrated formula, each participant receives an employer profit-sharing contribution based on a uniform percentage of compensation, as is the case with a non-integrated formula. Further, each participant whose compensation is in excess of the Social Security taxable wage base receives an additional employer contribution based on a percentage of the participant’s compensation in excess of the taxable wage base.

Example: Corporation B sponsors a defined contribution plan with an integrated formula of 10% of compensation, plus 5% of compensation in excess of the taxable wage base ($147,000 for 2022). Employee 1, with compensation of $200,000, will receive the same base allocation of 10% of compensation as other employees, or $20,000. Because Employee 1’s compensation exceeds the 2022 taxable wage base by $53,000, he will also receive an additional allocation of $2,650, for a total of $22,650.

• New comparability. A “new comparability” (sometimes called “age-weighted”) plan affords the employer the maximum flexibility in allocating discretionary employer profit-sharing contributions. Most new comparability formulas provide that each participant is in his or her own allocation group, giving the employer far more control over how much each employee is receiving. Because this formula allows employers to increase or decrease contributions for owners or select employees, new comparability plans must pass an annual nondiscrimination test under the Internal Revenue Code.

Nondiscrimination testing initially divides an employer’s employees into one of two categories: highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). HCEs are any employees who either:

• earned more than the compensation threshold in the prior year ($130,000, the 2021 limit, applies in determining HCEs for 2022), or

• owned directly or by attribution more than 5% of the ownership interest in the employer.

This test essentially weighs the contributions by age, yielding larger allocations for employees who are closer to retirement age and smaller allocations for employees who are further from retirement. New comparability allocations can be ideal for closely held businesses whose owners want to maximize their tax-deductible contributions. An older business owner may be able to make substantial contributions to a new comparability plan without having to make the same level of contribution for staff plan participants.

3. 401(k) plans

A 401(k) feature of a defined contribution plan allows eligible employees to defer a portion of their compensation into the plan. Elective deferrals under a 401(k) plan may be either:

• Traditional 401(k):  Deferrals are made on a pre-tax basis, whereby the employee defers recognition of taxable income until funds are distributed from the plan at retirement or termination of service, or

• Roth 401(k): Deferrals are made on an after-tax basis, whereby the employee pays tax when the deferral is contributed to the plan and then recognizes no taxable income when the deferrals and any associated earnings are distributed from the plan.

An employee may choose to make traditional 401(k) contributions, Roth 401(k) contributions, or a combination of both, as long as the employee’s total 401(k) deferrals do not exceed the annual limit published by the IRS ($20,500 for 2022). Employees who are age 50 or older by year-end may make “catch-up” 401(k) deferrals, increasing their annual limit from $20,500 to $27,000 in 2022. Both the $20,500 deferral limit and the additional $6,500 “catch-up” limit are subject to annual cost-of-living increases.

a. Nondiscrimination testing

The 401(k) contributions are subject to a special type of annual nondiscrimination testing called the actual deferral percentage (ADP) test, which limits the permissible contribution levels of HCEs if contributions by NHCEs are insufficient.  Plans that fail this test either need to allocate an employer contribution, called a Qualified Nonelective Contribution (QNEC) to the NHCEs, or issue taxable refunds of elective deferrals to the HCEs.

b. Safe Harbor 401(k) Plans

Some employers have difficulty passing the ADP test due to the low level or lack of participation by NHCEs. These employers may bypass the numerical ADP test entirely by adding a “safe harbor” component to their 401(k) plan.  

There are two types of safe harbor plans:

i.          Safe harbor match. The employer is required to make a matching contribution, generally equal to (a) 100% of the employee’s first 3% of compensation contributed as a 401(k) deferral, plus (b) 50% of the employee’s next 2% of compensation contributed as a 401(k) deferral.  This contribution caps out at 4% of the employee’s compensation when the employee contributes at least 5% of compensation as a 401(k) deferral.

ii.         Safe harbor non-elective. The employer is required to make an employer contribution equal to 3% of compensation for all eligible employees, without regard to whether an employee chooses to make a 401(k) deferral for the plan year.

The choice between the two alternative safe harbor designs may be driven by employee demographics, compensation levels, the industry in which the employer operates, and human resources and other considerations.

Historically, a safe harbor feature could generally only be added to an existing plan before the beginning of plan year in which the safe harbor feature is first effective. The SECURE Act, enacted in late 2019, allows safe harbor 3% non-elective (but not safe harbor matching) contributions to be added to a plan as late as December 1, for a calendar year plan, of the calendar year to which the safe harbor first applies (or by the end of the following year if the safe harbor contribution is 4%, instead of 3% of compensation). This may allow a plan that is expected to fail the ADP test to add a 3% safe harbor nonelective feature mid-year to avoid refunds to HCEs, or additional contributions for NHCEs to pass numerical ADP testing.

4. Single Defined Contribution Plan May Have Various Components

Many employers choose to design their plans with a combination of these components.  For example, an employer might want to set up a 401(k) plan for its employees and may have a safe harbor component to ensure there are no ADP testing failures. A new comparability profit-sharing component can be added to the plan to allow the owners of the business to maximize their retirement savings.

B. Defined Benefit Plans

In contrast to defined contribution plans, defined benefit plans provide employees with a guaranteed benefit to be paid out of the plan at retirement. Rather than expressing the employee’s interest in the plan as an account balance, the employee’s interest in a defined benefit plan is generally expressed as a monthly annuity beginning at their retirement age and payable for life. Although an employee’s account balance in a defined contribution plan fluctuates with actual investment earnings, the investment risk of a defined benefit plan falls solely on the employer. If the plan experiences large investment gains, the employer’s funding requirement will be reduced. If, however, the plan experiences large investment losses, the employer might be required to contribute additional funds to the plan to make up for those losses.

In order to determine the employer’s annual contribution to a defined benefit plan, the employer must enlist an enrolled actuary. The plan’s actuary will calculate a range of permissible contribution options to satisfy the plan’s obligation to pay retirement benefits.

Although defined benefit plans are often associated in the public mind with traditional industry employers that have very large workforces, in reality, many closely held businesses establish defined benefit plans because of the potential for much larger tax-deductible contributions than a defined contribution plan alone would allow. Under a defined contribution plan, in 2022, each participant is limited to $61,000 in annual contributions [increased to $67,500 if the individual makes use of the 401(k) catch-up component described above]. In a defined benefit plan, participants are limited in what they can withdraw, rather than what the employer may contribute on their behalf; for example, an individual age 62 who has participated in a defined benefit plan for 10 years may withdraw close to $3.15 million.  Funding to that number amounts to an average tax-deductible contribution of more than $250,000 per year.

1. Defined Benefit Plan Formulas

a. Flat benefit.  A flat benefit formula provides a benefit percentage or amount projected to retirement and earned over the employee’s working lifetime. An employee may earn the full benefit upon attaining a certain age or by completing a certain number of years of service.

Example: Corporation C sponsors a defined benefit plan that provides each employee with a benefit equal to $800 per month payable at age 65.  Employee 1 enters the plan at age 40.  Employee 1 will earn or “accrue” 1/25 of the projected $800 benefit for each year she works for Corporation C because she entered the plan 25 years away from normal retirement age.

b. Unit benefit. Unit benefit plans are more common than flat benefit plans. Unit benefit plans provide employees with a percentage of pay or fixed dollar amount for each year of service. Unit benefit formulas could cap the number of years an employee earns a benefit (e.g., 4% of compensation for each year of service, limited to 10 years) or provide a formula for employees without a service limit (e.g., 3% of compensation for each of the first 10 years of service and 2% of compensation for each year of service thereafter).

2. Cash Balance Plans

A defined benefit plan with a cash balance formula is similar to a unit benefit defined benefit plan. Cash balance plans are subject to the same funding requirements, operations, and benefit limitations of traditional defined benefit plans but appear similar to a defined contribution plan. 

Cash balance plans still provide employees with a fixed benefit at retirement. Instead of expressing this benefit as a monthly annuity payable for life, a cash balance benefit is expressed as a “hypothetical account balance.” This hypothetical account balance is comprised of contribution credits and interest credits. The contribution credits may be a fixed dollar amount or a percentage of compensation and look similar to the contribution allocation of a defined contribution plan. Contribution credits are frequently skewed significantly in favor of the business owner, with select staff receiving much small contribution credits necessary to allow the plan to pass participation and nondiscrimination testing. Interest credits are generally not based on actual investment gains or losses in the plan, but on a formula specified in the plan document. Interest credits are generally either a fixed percentage earned per year or indexed on a specific yield (such as the 30-year Treasury rate).

Many employers choose to establish both a cash balance plan and a defined contribution plan for their businesses. This allows them to benefit from the higher deduction limits provided by the cash balance plan while also retaining the added flexibility of their defined contribution plan.

III.      CONCLUSION

Regardless of the type, qualified retirement plans in any form can be a valuable tool to save for retirement in a tax-efficient manner. These plans can be custom designed to fit the needs of the employer and its owners. Employers should have their current retirement plans reviewed by pension experts to ensure their plan has adapted and grown to fit their ever-changing business needs. Whether an employer takes advantage of the flexibility of a defined contribution plan, the large tax-deductible contributions of a defined benefit plan, or even a combination of the two, a qualified plan is a “must-have” for closely held businesses.