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Qualified Plans:
Contributions
A qualified plan may
be funded by both employer and employee contributions. Contributions are
mandatory for some plans and discretionary for others, but the limits on
employer contributions are the same for all defined contribution plans.
Profit
Sharing and Stock Bonus Plans
Contributions to profit sharing and stock bonus plans are typically
based on business profits and are made on a discretionary basis. This means that
the employer decides each year whether or not to contribute to the plan. An
employer, however, may choose to contribute to the plan without regard to
profits.
Money
Purchase Plans
Contributions to a money purchase pension plan are fixed and are not
based on business profits. For instance, if the plan stipulates that each
eligible employee receive a contribution in the amount of ten percent of
eligible compensation, each eligible employee must receive the contribution
regardless of whether the employer made profits for the year.
An employer who
adopts a money purchase pension plan must take care not to over or
under-contribute to the plan. The funding limit is stated in the plan and must
not be exceeded. For instance, an employer that elects to make a ten-percent
contribution to the plan may not exceed this amount for the year. On the other
hand, employers who under-fund a money purchase plan could owe penalties up to
100 percent of the shortfall. In addition to paying this penalty, the employer
must meet the funding requirement. Employers that fund the plan in excess of the
plan limit will owe a ten-percent penalty on the excess amount.
Contribution Limit
An employer may contribute up to 25 percent of compensation to each
eligible employee's account providing the contribution does not exceed $40,000.
Any employee's compensation in excess of $200,000 (indexed) is not considered
because $200,000 is the compensation cap, which is the maximum compensation that
may be considered for employer plan purposes. Within IRS established limits, the
employer is eligible to receive a tax deduction for contributions made to the
plan. The following example illustrates how the contribution limits apply:
Example 1
XYZ Corporation has decided to make a 25-percent contribution for each eligible
employee for the 2003 tax year. Employees receive W-2 wages in the following
amounts:
Mark
$250,000
Jane $160,000
Mary $80,000
Jim $40,000 |
Each employee's
Contribution is allocated as follows:
Contribution Formulas
An employer may chose among several formulas to calculate contribution
allocations.
- Pro-rata -
This formula results in each eligible employee receiving the same percentage
of his or her eligible compensation. The pro-rata formula is demonstrated in
the example above, with XYZ Corporation.
- Social
security integration - This formula awards higher paid employees with a larger
percentage of their compensation. The employer assigns to the qualified plan
an amount that is a percentage of the accumulated total of all eligible
employees' compensation. Using a special formula, the employer then allocates
a contribution percentage to each eligible employee. The allocation must be
done according to specific IRS-provided requirements; otherwise, the plan may
be disqualified.
Example 2
For the employees and the figures in Example 1, XYZ determines that the total
contribution to the SEP plan will be $110,000. Instead of allocating 25 percent
to each employee, XYZ decides to allocate the $110,000 among the employees using
the social security integration formula. As a result, higher paid employees will
receive a higher percent (based on eligible compensation) than lower-paid
employees.
401(k)
Plans
A qualified plan can include a cash or deferred arrangement (CODA)
under which employees can choose to have part of their before-tax compensation
allocated to the plan rather than receive the compensation in cash. This
contribution is called an elective deferral because employees choose (elect) to set aside the money,
and they defer the tax on the money until it is distributed to them. A plan with
this type of arrangement is popularly known as a 401(k) plan.
Deferral
Contribution Limits
An employee may elect to defer 100 percent of compensation up to dollar
limit for that year (see chart below):
| Tax
Year |
Elective deferral contribution limit |
| 2004 |
$13,000 |
| 2005 |
$14,000 |
| 2006 and after |
$15,000 plus cost of living
adjustments (COLA) increases |
Deferral
contributions in excess of these limits are excess deferrals, which must be
removed from the employee's 401(k) plan account within certain time frames.
Excess contributions require special administrative handling and will be
assessed penalties if not removed within specific time frame.
A plan may
implement additional contribution limits; a plan may, for instance, limit each
employee's elective deferral contribution to a certain percent of compensation.
Eligible
employees who are at least age 50 by the end of the year may make additional
contributions, which are referred to as "catch-up contributions." The catch-up
contribution limits for different tax years are as follows:
| Tax
Year |
Catch-up contribution limit
(for eligible employees age 50 and older) |
| 2004 |
$3,000 |
| 2005 |
$4,000 |
| 2006 and after |
$5,000 plus cost of living
adjustments (COLA) increases |
The combined
elective deferral and employer contribution cannot exceed $40,000 (plus catch-up
contributions).
Contribution Deadline
Employer contributions must be made to each employee's account by the employer's
tax-filing deadline (including extensions).
An elective
deferral contribution must be transmitted to the employee's account as soon as
the contribution can be reasonably segregated from the employer's general
assets. The deadline, however is the 15th business day of the month immediately
after the month in which the contributions either were withheld or received by
the employer.
Deducting
Contributions
For their contributions made to a qualified plan, employers are allowed a tax
deduction, which they claim on the business's income tax return. Employers,
however, should not make contributions in excess of the deductible limit, as the
excess amounts may not be tax deductible and could result in penalties being
owed (to the IRS).
The deduction for
contributions cannot be more than 25 percent of the total compensation paid (or
accrued) during the year to eligible employees participating in the plan.
When figuring the deduction limit, the following rules apply:
- Elective
deferrals are not subject to the limit.
- Compensation
includes elective deferrals.
- The maximum
compensation that can be taken into account for each employee is $200,000.
Example 3
ABCD Inc. adopted a money purchase pension plan and elected to make a
ten-percent contribution to the plan each year. Eligible employees earn
compensation as follows:
The total
contribution that ABCD Inc. may make to the plan is $53,000 dollars ($530,000 x
0.1 = $53,000), to be allocated in accordance with the allocation formula chosen
by the plan.
Example 4
WXYZ Corporation adopted a 401(k) plan and will make a profit-sharing
contribution of ten percent of eligible compensation to the plan. Compensation
and elective deferral contributions are as follows
Compensation, for
purposes of determining deduction limits, includes elective deferrals. WXYZ
profit sharing contribution will be $43,000 ($430,000 x 0.1 = $43,000) to be
allocated among employees in accordance with the plan's chosen allocation
formula.
Deduction
Limit for Self-Employed Individuals
The examples used in this module use w-2 wages, which are paid to
employees. Self-employed individuals, including apartments in a partnership,
must use a special formula to determine their compensation for plan purposes.
For assistance, these individuals may consult with a tax professional and refer
to IRS publication 560, which can be found at
www.irs.gov.
Excess Contributions
If plan contributions exceed the deductibility limit for the year, the
employer may carry over and deduct the difference in later years and combine it
with contributions for those years. The combined deduction in a later year is
limited to 25 percent of the participating employees' compensation for that
year.
Investing Plan Assets
A qualified plan may direct the investments of the plan assets for
employees. Others may allow the employees to direct their own investments by
selecting from a list of investments provided by the plan.
The U.S.
Department of Labor provides that the party responsible for directing the
investment of plan assets is responsible for the consequences of the investment
decisions. If the employee is allowed to choose from a number of investments,
the employee is responsible for the consequences of investment decisions. If the
plan makes the investment decisions, the plan has a fiduciary responsibility for
investment decisions.
If allowed to
make their own selections, employees are entitled to receive a broad range of
information about the investment choices available. Thus, a plan that intends to
relieve plan officials of fiduciary duties over investments must inform
employees of that fact. According to the U.S. department of labor, the
information that must be provided to employees includes the following:
- A description
of each investment option including the investment goals and the risk and
return characteristics.
- Information
about designated investment managers.
- An explanation
of when and how to make investment instructions and any restrictions on when
the employee can change investments.
- A statement of
the fees that may be charged to the employee's account when he or she changes
investment options or buys and sells investments.
- Information
about the employee's shareholder voting rights and the manner in which
confidentiality will be provided on how the employee votes his/her shares of
stock.
- The name,
address, and phone number of the plan fiduciary or other person designated to
provide certain additional information on request.
Investment Options
Permissible investments for qualified plans include publicly-traded
securities, real estate, and money
market funds. Some plans even allow investing in options. The plan document will state
the investment choices for plan assets.
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