Basic Overview of Retirement Plans

March 19th, 2008

Currently, the IRS allows employers to establish retirement plans for their employees that have certain tax benefits for employers and employees. The main benefits are that the employer’s contribution can be deducted as a business expense when it is made, employees can defer taxes on the funds until they are distributed, and earnings on the employer contributions are tax deferred. There are two main types of plans – Defined Contribution (DC) plans and Defined Benefit (DB) plans.

Defined Contribution (DC) Plans

A DC plan is a type of pension plan where there is an individual account for each participant and for benefits are based solely upon the amount contributed to the participant’s account and their earnings. The annual contribution is defined in the plan document, and the contribution is subject to minimum and maximum allocation rules.

The actual benefit a participant receives from a DC plan upon retirement depends solely on the accumulation of annual contributions and fund earnings. Provided that the sponsoring employer prudently invests the plan assets in the best interests of the plan participants, the employer is not liable for investment losses. In these plans the investment risk is borne by the participants.

There are four categories of DC plans that are allowed. These are profit sharing plans, money purchase plans, stock bonus plans, and target benefit plans. Examples of these plans include 401(K) plans, Savings Incentive Match Plan for Employees (SIMPLE) plans, and Employee Stock Ownership Plans (ESOPs).

Defined Benefit (DB) Plans

A DB plan is defined as “any pension plan other than” a DC plan. These plans are the traditional “pension plans”, where an employer pays their retirees a set monthly benefit until the retiree’s death. In a DB plan, the plan document specifies the benefit due to a participant at retirement.

These plans are subject to minimum funding requirements and must provide a qualified joint and survivor annuity option. The accrued benefit amount is guaranteed to the participant, regardless of any investment fluctuations; therefore, the employer bears the fund’s investment risk, not the participant.

There are generally three types of DB plans, based on the method of calculating the accrued benefit. These are a flat benefit plan, a fixed benefit plan and a unit benefit plan.

Requirements for Plan Qualification

In order to become a “qualified” plan under the Code, all plans must meet certain requirements. Although the substantive requirements under the Code can vary depending on what type of plan is at issue, the fundamental and formal requirements of qualification apply to all “qualified” plans.

The fundamental requirements include that the plan must:

  • Be provided for the exclusive benefit of the participants and/or beneficiaries;
  • Be established with the intent to be permanent; and
  • Prohibit the use of plan assets for anything other than providing plan benefits or paying administrative and investment expenses.

The formal requirements for plan qualification are that the plan:

  • must be in effect by the end of the employer’s taxable year in which the deduction is claimed;
  • must be documented as a formal, written plan; and
  • must be communicated to employees.

Additionally, all qualified plans must follow certain basic requirements, including minimum coverage requirements, non-discrimination requirements, minimum vesting requirements, limitations on benefits and contributions, and distribution requirements.

Qualified retirement plans can be complex and the rules that govern them are very specific. Additionally, the laws relating to these plans can change. One of the most recent laws that affect retirement plans is the Pension Protection Act of 2006 (PPA). Employers should periodically review or have their benefits attorney review their plans to ensure compliance with changing laws. Additionally, when contemplating establishing a plan, employers should work with their benefits attorney to discuss options and find a plan that will work best for them.

3 Responses to “Basic Overview of Retirement Plans”

  1. Mike Harmonon 08 Apr 2008 at 11:39 am

    I came across your blog on Technorati. Nice site layout. I will stop by and read more soon.

    Mike Harmon

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