1. What is a qualified retirement plan?

A qualified retirement plan is a plan which meets certain requirements of the Internal Revenue Code and supporting regulations. If a plan meets those requirements, then:

• contributions by the employer are deductible by the employer, while
• those same contributions are not taxed to the employee(s) until they are distributed from the plan.

Since distributions typically occur many years after the contributions are made, this provides for significant opportunities for tax-deferred growth.

Employers of all sizes can benefit from these opportunities, from a one-person business, which can get a tax deduction simply by moving money from one “pocket” (the business) to another “pocket” (the plan), to a small business with employees, which can make contributions that predominantly benefit the owner(s), to a medium or large-sized company which wants to allow employees to make their own deductible contributions, and may wish to supplement those contributions with matching or discretionary employer contributions.

2. Are there different types of plans?

There are several different types of plans. Key differences are:

• some plans have required contributions, while others are optional,
• some plans base contributions on a percentage of current pay, while others determine contributions based on a formula to provide a projected benefit, and
• some plans permit deductible employee contribitions, while others do not.

Certain features and limitations are common to all plans. They include:

• Compensation for plan calculations is limited to $225,000 (in 2007).
• Deductible employer contributions on behalf of participants in “defined contribution” plans are limited to 25% of pay.
• Employee deferral contributions are limited to $15,500 (in 2007), plus an additional $5,000 (in 2007) permitted for participants over age 50.
• Total contributions to “defined contribution” plans are limited to the lesser of 100% of pay or $45,000 (in 2007).
• Benefits for participants in “defined benefit” plans are limited to $180,000 per year (in 2007).
• Age and service eligibilty requirements can’t exceed 21 and 2 years, respectively (1 year for 401(k) plans).
• Plans must benefit a certain number or percentage of employees.
• Plans that predominantly benefit owners must provide minimum contributions (3%) or benefits to other participants.
• Contributions are generally due by the time of filing the business tax return, with extentions.
• Certain reports and documents must be filed with the IRS, Department of Labor and participants at plan inception and annually.

Plan types and key features
Profit sharing plans (Note: “profit sharing” is a misnomer. Profits are not required in order to make contributions; in fact, contributions may be made even if they cause or deepen a loss.)

• Contributions are optional; up to 25% of covered payroll.
• Contributions are generally allocated as a percent of pay; may be “integrated” with Social Security contributions to provide a higher rate of contributions to the higher paid participants. More aggressive, but legal, formulas may allow disproportionately high contributions to Highly Compensated Employees.

Money purchase plans

• Contributions are required; up to 25% of pay.
• As with a profit sharing plan, contributions are generally allocated as a percent of pay; may be “integrated” with Social Security contributions to provide a higher rate of contributions to the higher paid participants.
• Since Congress increased the maximum profit sharing plan contribution from 15% to 25% effective in 2002, money purchase plans do not have any advantages for the typical small employer and we don’t expect to see many or any of them.

Target benefit plans

• Contributions are required; up to 25% of pay. (Target benefit plans are actually a subset of money purchase plans.)
• Contributions are based on a formula which is designed to provide a certain retirement income. However, that income is not guaranteed; benefits are actually based on the accumulated account balance at retirement.
• Since Congress reduced user fees on “new comparability” plans effective in 2002, the effect of the target benefit design, to get higher contributions to older/longer tenured employees, can be accomplished with a profit sharing plan and we don’t expect to see many or any of them.

401(k) plans

• 401(k) plans are a subset of profit sharing plans. Contributions are optional.
• In addition to employer contributions, which may be made and allocated as in a profit sharing plan, a 401(k) plan may provide for deductible employee contributions up to $15,500 (in 2007) as well as matching employer contributions.
• Employee contributions are subject to nondiscrimination testing, so Highly Compensated Employees (generally, owners and those who earned more than $100,000 in the prior year) may not be able to contribute the statutory $15,500.
• Employers can effectively buy their way out of nondiscrimination testing by using a safe harbor design that either gives every participant a 3% employer contribution or guarantees a match of at least 100% of the first 3% deferred plus 50% of the next 2%. This design has proven to be very popular with small employers.

Defined benefit plans

• Contributions are required; there is generally no limitation on the amount.
• Contributions are based on a formula which provides for specified retirement benefits, which are guaranteed by the sponsor.
• Defined benefit plans present an opportunity for large deductible contributions ($100,000+) for older, high-income participants.

Cash balance plans

• A cash balance plan is technically a special kind of defined benefit plan. A typical cash balance plan might give a “pay credit” to the participants, e.g. 5% of pay, so it looks like a defined contribution plan. The “accounts” are credited with an “earnings credit” which is an assumed interest rate, not related to actual investment performance. Although it looks like a defined contribution plan, since a cash balance plan is a defined benefit plan, effective contribution limits are much higher.

SEPs and SARSEPs

• SEP stands for Simplified Employee Plan. Contributions are optional; allocations can be similar to a profit sharing plan, but the difference is that contributions go directly into the participants’ IRAs. There is no annual reporting (plan tax return) so this plan is generally less expensive than a profit sharing plan. More, or fewer employees may be included in this plan vs. a profit sharing plan, depending on demographics and plan design. As in a profit sharing plan, contributions are limited to 25% of pay.
• SARSEP stands for SAlary Reduction Simplified Employee Plan. This plan is similar to a 401(k) in that employEE contributions are deductible; the primary difference is that they go directly into IRAs, as in SEPs. New SARSEPs are not permitted after 12/31/96.

SIMPLE IRAs and 401(k)s

• These plans permit deductible employee contributions, with a required employer match (or fixed employer contribution for all eligible employees). Contributions go directly into IRAs, or to a trust (with annual reporting), depending upon the design. Employee deferrals are limited to $10,500 ($2,500 catchup) in 2007.

3. What investments are typically used in a qualified plan?
   

   • Plan assets can be invested in almost anything you could buy as an individual investor: stocks, bonds, CDs, mutual funds, etc. (Due to valuation problems, limited partnerships and other non-publicly traded assets should be avoided.) However, trustees should be careful to avoid self-dealing.
   • For diversification, professional management, administrative simplicity, and maximum growth opportunities, mutual funds are an ideal choice for a small plan in which the trustee makes the investment decisions.
   • Plans which want to offer participant-direction of investments should choose either:
     • a single family of mutual funds which offers “sub-account” recordkeeping (the low-cost alternative), or
     • an insurance company group annuity which offers mutual funds from many different fund families (higher cost, but more choices).
   • Participant loans may be permitted if the plan provides for them.

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November 2006