The most common types of tax-qualified Retirement Plans adopted by small to medium-size employers are Profit Sharing Plans, 401(k) Plans, Defined Contribution (Money Purchase) Pension Plans, Defined Benefit Pension Plans, and Cash Balance Pension Plans. All such Plans share the basic attributes of tax-deductible employer contributions and tax-deferred earnings on the funds deposited, so long as all applicable rules and limitations are observed. Funds are taxed later when withdrawn – after retirement, death, permanent and total disability, or other termination of employment. Employees become Plan participants on the basis of the eligibility requirements established in the pertinent Plan document(s).
The following describes the differences among the types of Plans discussed:
Profit Sharing Plan - Deposits to a Profit Sharing Plan are discretionary. They can range from 0% to 25% of aggregate includable compensation of covered participants, and the percentage can vary on ayear-to-year basis. The maximum permissible contribution for any one individual for 2020 is $57,000.
401(k) Plan - This is actually a variety of a Profit Sharing Plan. In addition to allowing for employer contributions,
it permits employees to make tax-deductible deposits on a “salary reduction” basis, or on an after-tax “Roth contribution” basis, assuming that either the applicable “non-discrimination” rules are met or a minimum "Safe Harbor" contribution is made. The regular salary reduction contribution limit is $19,500 for 2020. For participants over age 50, the limit is $26,000 for 2020. Employers may choose to “match” all or a portion of the salary reduction contribution. The 2020 annual contribution limitation per participant, including both the salary reduction allocation and any employer contribution, is the lesser of 100% of includable compensation or $57,000. For those at least age 50, the contribution limit for 2020 is $63,500.
Defined Contribution (“Money Purchase”) Pension Plan - Contributions to this type of plan are based solely upon a designated percentage of current compensation. The ultimate accumulation of funds for retirement is determined by the level of contributions and the earnings actually generated. The Plan includes a specific contribution formula, which represents a fixed commitment of the sponsoring employer. The maximum permissible contribution for 2019 is $57,000 per participant. (Prior to 2001, a primary advantage of this type of Plan was its 25%-of-compensation deduction limit, compared to 15% of compensation for Profit Sharing Plans. However, as of 2001, the limit for Profit Sharing Plans was increased to 25% of compensation, putting such Plans on an equal footing with Defined Contribution Pension Plans.)
Defined Benefit Pension Plan - This type of Plan is inherently different from all of the others mentioned, in that contributions are determined by a formula which relates to the providing of a designated level of monthly income at retirement, as well as including current and past compensation levels of participants and a number of actuarial assumptions. This type of Plan favors older employees, in that the fewer the number of years to retirement, the higher the permissible annual deposit. The maximum annual benefit for 2020 is the lesser of 100% of includable compensation or $230,000.
Cash Balance Pension Plan – This is something of a hybrid in that it is a Defined Benefit Pension Plan that defines the benefit like a Defined Contribution Pension Plan – as a stated account balance. Each year the participants’ accounts receive both a “pay credit” (a percentage of compensation) and an “interest credit” (a fixed rate or a rate linked to a vehicle such as the one-year Treasury bill). In the right situation, a Cash Balance Pension Plan can allow deposits well in excess of the limits applicable to Profit Sharing, 401(k) or Defined Contribution Pension Plans.
Copyright, Mid-Atlantic Benefit Consultants, Inc. 2020