Retirement Plans – The Basics are Actually Quite Complicated

Posted by Casey Foulk

Occasionally, a tax client of our firm wants to set up a retirement plan. For a small employer with limited accounting and human resources personnel, the numerous options and complicated jargon can be overwhelming. Although our accounting firm does not provide third party administration or plan document services, we are often the first stop for small businesses who want to set up a new plan, because clients view their CPA as a trusted advisor with an independent and unbiased perspective.

When presented with these opportunities, our first step is often helping the client navigate the basic terminology and understand the key players that will likely take part in their plan administration. To streamline the process in the future, I created the following list as valuable take-away points for retirement plan basics:

Key Players
Many service providers are involved in plan administration, including:

Third party administrators, custodians, institutional trustees, ERISA attorneys, investment advisors, payroll personnel or a payroll company, human resources personnel, and plan officials who can bind the plan in legal matters on behalf of the plan sponsor,  the plan administrator.

The plan sponsor/administrator is responsible for creating the 401(k) plan and operating it in accordance with its terms. The plan sponsor/administrator is ultimately responsible for the day-to-day operations of the plan, even when they hire a third party administrator to maintain participant account balances, perform the recordkeeping on a plan basis, and complete any required discrimination testing.
The investments of the plan are held by the trustee/custodian. The plan trustee(s) can be individuals or an institution, such as a trust company charged with ensuring that the assets of the plan are being properly used for the benefit of the participants.
The recordkeeper or third party administrator is in charge of tracking and allocating contributions, distributions, plan investments, etc.
Payroll companies process participant elections after the plan sponsor’s internal accounting or payroll personnel have properly coded the system.
Many service providers claim that they will do everything for the plan sponsor, but the fact is that the information they use is initially compiled at the plan sponsor level, including wages, hours, and demographic information. As explained in detail in It Takes a Village…, there is no single organization that can perform all the functions needed to administer a retirement plan.
Unlike tomato and tomahto, matching and profit sharing contributions are not one in the same. Yes, both are employer contributions made into the plan to benefit plan participants, but these contributions are computed differently. A matching contribution is dependent upon the elective deferral contribution made by the employee. Generally, an employer will match a certain percentage of the employee’s 401(k) or 403(b) deferral. One should consider contributing at least enough to get the full match because who doesn’t like free money, right?
In the case of small employers, low participation by the rank and file can make it difficult for the owner to contribute the maximum 401(k) deferral, due to a discrimination test that limits the disparity between the average deferrals contributed by the non-highly-compensated employees as compared to the average deferrals of the highly compensated employees. To prevent or minimize potential problems caused by failing the discrimination tests, employers often consider automatic enrollment plans and safe harbor plans, which were discussed in Keeping it Simple and Straightforward (K.I.S.S.) With Safe Harbor Plan Designs.
While matching contributions are only available to employees who have deferred part of their compensation as a 401(k) or 403(b) contribution, profit sharing contributions stem from an arrangement in which the employer contributes to each eligible participant’s account regardless of whether they contributed to the plan.
Each plan has its own unique features, but one of the most common methods of calculating profit sharing contributions is by taking a specific percentage of a participant’s annual compensation. As stated in …about your deductibility question: The Answer is NO!, a company does not have to show profits in the current year to make a profit sharing contribution. Depending on the plan design, the profit sharing percentage can be the same for all eligible participants, or there can be a disparity in allocation percentages. A plan that is integrated with social security allows up to a maximum 5.7% additional contribution for wages in excess of the social security limit up to the maximum compensation that can be considered for retirement plans under Internal Revenue Code Section 401(a)(17).  See our blog which includes the 2012 Plan Limits. Additionally, cross-tested plans can allow even more disparity in allocation percentages to different groups of participants, within certain limits.
Defined Benefit Plans
With several waves of restructuring in some local Wilmington companies, many older employees have become self-employed consultants with no employees. Since many of these individuals are approaching retirement age, they are interested in contributing as much as possible to a retirement plan. Specifically, their goal is often to contribute more than the maximum annual addition allowed under a defined contribution plan such as a 401(k)/profit sharing plan. Defined benefit plans guarantee a benefit at retirement, and as such, an actuary computes the required amount of funding needed to achieve the targeted benefit. Unlike a profit sharing plan, funding a defined benefit plan is not an annual discretionary contribution, but a required contribution. The funding requirement is a consideration that attracts some defined benefit plan candidates and dissuades others. For our discussion of the basics, the goal is for the client to understand this is an option that they can pursue further with a document provider and an actuary.
Helpful Details
Compensation – Compensation does not automatically equal salary! Compensation could include overtime, vacation, fringe benefits, bonuses, etc. When making elections on the adoption agreement, it is important to define compensation in a way that is not discriminatory and that does not impose unnecessary administrative burdens to a small employer with limited accounting staff.
Plan features – The client will have to decide whether their defined contribution plan will allow participant loans, hardship distributions, other in-service distributions, Roth 401(k) or 403(b) accounts, what the eligibility requirements will be for the deferral feature as well as the employer contribution feature, and more.
In the end, the future plan sponsor understands one thing – the basics are actually quite complicated, but the numerous options that are available are a guarantee that the Company’s financial goals can and will be met.

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