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What is a
Qualified Plan?
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Eligibility Requirements
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Contribution Rules
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What is vesting?
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Rules on Distribution
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Summary and Resources
"...The
question isn't at what age I want to retire, it's at what income..." --
George Foreman (1949- ), American Boxing Champion
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Qualified Plans: What is a Qualified Plan?
During retirement years, income
for retirees usually comes from three sources:
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Social security benefits.
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The regular savings account of the
retiree, and
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Retirement plan savings, such as
IRAs and employer-sponsored retirement plans
A qualified plan is established by
an employer to provide retirement benefits for employees and their
beneficiaries. Unlike a SEP and SIMPLE IRA, a qualified plan is not IRA based
and not subject to the same rules concerning contributions and distributions.
The same types of business may chose either a qualified or IRA-based plan, but
the decision usually depends on the contribution limits (and how much the
business wants to or can afford to contribute) and the employer's desire or
ability to handle the administration of the plan. Qualified plans, however,
require more complex administration than SEPs and SIMPLEs.
A qualified plan is established by an employer to provide retirement benefits
for employees and their beneficiaries. A qualified plan may be a defined benefit
plan or a defined contribution plan. Qualified plans allow the employer a tax
deduction for contributing to the plan, and employees do not pay taxes on plan
assets until these assets are distributed; furthermore, earnings on qualified
plans are tax-deferred.
In order for a plan to maintain its qualified status, it must operate in
accordance with requirements as provided by the Internal Revenue Code (IRC), the
Department of Labor (DOL) and the Employee Retirement Income Security Act
(ERISA) of 1974.
Defined Benefit Plans:
Under a defined benefit plan, employees' retirement benefits are predetermined
by his or her compensation, years of service and age. For example, the plan may
determine that upon retirement an employee will receive one percent of his/her
average salary for the last five years of employment for every year of service
with the employer. The plan may state this promised benefit as an exact dollar
amount, such as $100 per month at retirement. For example: Andrew was employed
by ABC Company for ten years, and during the last five years of employment,
John's compensation was as follows:
1999- $55,000
2000- $60,000
2001- $70,000
2002- $80,000
2003- $90,000
Andrew's average compensation for these last five years of employment is
$71,000, and one percent of John's average salary for these five years is $710.
Under the provisions of the plan, Andrew will receive $710 for ten years, that
is, one percent of his average salary for his last five years of employment for
the number of years he was employed by the company.
The employer will make contributions that, based on actuarial assumptions
including projected growth of investments, are required to reach the
predetermined retirement benefit. Should the performance of plan investments
fall below the projected amount, the employer is required to make additional
contributions to make up for the shortfall.
The contribution limits for defined benefit plans are significantly higher than
the limits of defined contribution plans. The operation of a defined benefit
plan, which is beyond the scope of this tutorial, may require the assistance of
an actuary as contributions are based on actuarial assumptions and formulas.
Defined Contribution plans:
A defined contribution plan does not promise a specific amount of benefit at
retirement. Employees or employers (or both) contribute to these plans.
Typically, the contribution will be a percentage of compensation up to a certain
dollar amount. Depending on the plan type, the contributions may or may not be
made each year, but they are invested on the employee's behalf, and the benefits
paid to employees are based on contributions and any earnings or loss. For
defined contribution plans, employers are not required to make up for any loss
on investments. A defined contribution plan can be a profit-sharing plan, an
employee stock ownership plan, a 401(k) plan, or a money purchase pension plan.
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Profit Sharing or Stock-Bonus
Plans - A profit-sharing plan is used for sharing profits from the business
with employees, but an employer may make profit-sharing contributions regardless
of whether the business had profits for the year. Contributions to the plan are
discretionary, which means that the employer may choose not to contribute to the
plan every year. Despite this flexibility, however, the employer must take care
not to allow too many consecutive years to pass before contributions are made.
The IRS does not specify how many consecutive years are unacceptable but does
indicate that contributions to the plan must be substantial and recurring.
A stock-bonus plan is a type of profit sharing by which a corporation uses its
own stock to make contributions and distributions. These plans, however, are not
available to sole proprietorships and partnerships. The profit-sharing and
stock-bonus plan may include a 401(k) plan. The profit-sharing and stock bonus
plans are suited for employers who are newly established and are unable to
determine profit patterns or who want to have flexibility with making plan
contributions.
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Money Purchase Pension Plan -
In general, an employer has more flexibility in contributing to a profit-sharing
plan than to a money purchase pension plan or a defined benefit plan.
Contributions to a money purchase pension plan are fixed and are not based on
business profits. For example, if according to the plan each participant will
receive ten percent of eligible compensation, each eligible employee must
receive the contribution without regard to the employer's profits for the year.
A money purchase pension plan is suited for employers who are able to determine
profit trends and do not mind being mandated to make contributions to the plan
each year.
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401(k) Profit Sharing Plan -
A 401(k) plan is a qualified plan that allows employees to defer receiving
compensation in order to have the amount contributed to the plan. This
arrangement is commonly referred to as a cash or deferred arrangement (CODA).
Contributions deferred by employees are referred to as elective deferrals, which
are typically made to the 401(k) plan on a pretax basis. An employer may chose
to have a stand-alone 401(k) plan or a profit-sharing plan with a 401(k)
feature. The employer may also chose to make matching, non elective, or profit
sharing contributions to the plan. A 401(k) plan is suited for an employer who
wants employees to assist with funding the plan.
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Age Weighted Plans - To a
profit-sharing plan, an employer may add an age-weighted feature, which
allocates a higher percentage of plan contributions to older employees. The
assumption is that older employees have less time before they retire and
therefore less time to accumulate retirement savings. Age-weighted plans are
suitable for business owners who are considerably older than their employees and
who may not have had the opportunity to accumulate retirement savings in their
earlier years.
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Employee Stock Ownership Plans
(ESOPs) - Employee stock ownership plans (ESOPs) are a form of defined
contribution plan by which the investments are primarily in the employer's
stock. Congress authorized the creation of ESOPs as one method of encouraging
employee participation in corporate ownership.
Why Establish a Qualified Plan?
For a business, choosing the right retirement plan is one of the most important
financial decisions because the plan must suit not only the employer's immediate
needs but also his or her financial and business profile.
A qualified plan offers benefits to both employer and employees:
Employers
Employer may receive a tax-deduction for plan contributions. Employers are able
to attract and retain high-quality employees. A qualified plan may be the
tiebreaker that wins over a skilled person who is offered relatively similar
compensation packages from different potential employers.
Employers may be able to claim a tax credit for part of the ordinary and
necessary costs of starting up the plan, if these expenses are incurred in tax
years beginning after December 31, 2001. With a maximum of $500 per year for
each of the first three years of the plan, the credit equals 50% of the cost to
set up the plan, administer it, and educate employees about it. The employer,
meeting certain requirements, can choose to start claiming the credit in the tax
year before the year in which the plan becomes effective.
Employees
Employees are provided with some guarantee that their retirement years will be
financially secure. For plans that provide salary-deferral features, employees
are able to defer paying taxes on a portion of their compensation until their
retirement years, when their tax bracket is usually lower.
Some plans allow employees to borrow from the plan. The interest paid on the
loan amount is credited to the employee's account, unlike interest on loans
obtained from financial institutions.
Next-->>
Eligibility Requirements for employers and Employees
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