VARIOUS RETIREMENT PLANS

The following is a general approach to each of the qualified retirement plans that can be installed by a business. By qualified, we refer to those sections of the Internal Revenue Code that permit employer income tax deduction. These plans consist of:

• Profit Sharing Plan
• 401(K) Plan
• Money Purchase Pension Plan
• Defined Benefit Plan with a Flat Benefit Formula
• Defined Benefit Plan with a Unit Benefit Formula
• Target Benefit Plan
• Employee Stock Option Plan (ESOP)
• Leveraged Employee Stock Option Plan (LESOP)
• Simplified Employee Plan (SEP)

It is difficult to digest extensive data about different types of plans as well as determine when one should use a particular type of plan under particular circumstances. This document discusses the decision, information pertinent to the decision making process and generally clarifies each type of plan.

PROFIT SHARING PLAN

A Profit Sharing Plan is normally considered by a young company with a history of fluctuating profits. Due to uncertain future earnings, the amount the owner would be willing to contribute is relatively small. However, if the company has a particularly good year it would like the ability to make a larger contribution.

Also, consider the age of the owner and employees. If they are young (40’s), it is another indicator for profit sharing. The reason is that a Profit Sharing Plan is a form of Defined Contribution Plan which favors the younger employees due to the greater number of years for making contributions, time for investments to produce significant yield and, in this case, the allocation of forfeitures to the long term employees.

Look for turnover and tenure. Even an older owner may benefit from a Profit Sharing Plan if turnover is high since he or she will normally receive the greatest portion of non-vested forfeitures.

THE 401(K) PLAN

A 401(K) Plan is a type of Profit Sharing Plan. The employer can choose to match the employee savings in this plan. This provision acts like a “sweetener” or extra benefit for rank and file employees. The important feature is that the employee’s contributions are treated as adjustments from gross earnings rather than a deduction as with an IRA. Even though it is subject to the overall contribution limitation, most employee/employer contributions will not be that high.

Consider the 401(K) when an employer is forced to provide an additional benefit due to possible union involvement or lack of funds to provide additional benefit packages.

This plan is also suitable when the employer may not be able to commit to a large contribution, but employees are extremely interested in contributing on the most tax favorable basis. Furthermore, if the employer has a year of high earnings, additional contributions may be made.

MONEY PURCHASE PLAN

A Money Purchase Plan is a type of Defined Contribution Plan. That is, the actuary or plan administrator determines (usually by formula based on gross or net profit) the contributions that will be made on behalf of the participants. The major drawback is that the retirement benefit for each employee will not be known until time of retirement.

The maximum contribution is similar to most defined contribution plans, the lesser of the participant’s compensation or $40,000 per participant.

The owner usually is fairly young or is trying to benefit young key employees, such as younger siblings or children in the firm.

This plan holds appeal when profits have been stable and/or growing with a promising future. The contribution commitment is higher than with a Profit Sharing Plan.

DEFINED BENEFIT PLAN WITH A FLAT BENEFIT FORMULA

There are two areas to review with this type of plan. The first is the plan itself with the second being a type of formula.

A Defined Benefit Plan is one in which an actuary determines the benefits each participant will receive at retirement. Using those figures, it is simply a matter of determining funding (payments) needed to arrive at future values. Therefore, the benefit is known but the contribution is not. Each year the actuary recalculates the contribution since the assumptions are rarely going to be exact. Interest earnings, or losses, will have a great effect on annual plan costs.

This type of plan is frequently used when dealing with an older owner who is looking to shelter a large sum of money. In the case of a defined benefit plan, the highest “annual benefit” payable under the plan (or under all such plans aggregated, if the employer has more than one) must not exceed the lesser of: (a) 100% of the participant’s average compensation in his high three consecutive years of employment while he was an active participant, or (b) $160,000, for limitation years ending after December 31, 2001. IRC Sec. 415(b)(1), as amended by EGTRRA 2001. Depending upon the age of the owner, it could take substantial sums, especially for older individuals since there may not be much time to fund the plan. The Defined Benefit Plan is an ideal plan for older ages, because it offers the ability to make a large financial commitment. It is suitable for companies with stable profits and taxable income.

A Flat Benefit Formula deals only with salary, that is, when the actuary is determining the benefit, only salary is taken into consideration.

For example, a Flat Benefit Pension Formula may state that the participant will be eligible for 50% of compensation. Therefore, if compensation were $50,000, the participant would be eligible for a retirement benefit of $25,000 per year. A larger portion of the contribution is given to the owner under these conditions. Quite often, the owner will be seeking maximum contributions since he or she is usually making a substantial income and retirement is near.

DEFINED BENEFIT PLAN WITH A UNIT BENEFIT FORMULA

The facts stated above hold true under the Unit Benefit Formula except for the way retirement benefits are determined. Under the unit benefit formula, compensation as well as years of service are taken into consideration.

For example, the formula may state that each participant will receive 2% of salary for each year employed. Therefore, Mr. A, who makes $50,000, would be eligible for $1,000 times the number of years he has been under the plan. If he had been employed for 40 years, the benefit would be $40,000 per year at retirement.

Frequently, the owner or key person of a small to medium sized business will have worked for the organization since he or she was quite young and consequently accumulated a substantial number of years of service. He or she may also have valued employees who also contributed much of their lives to the organization. Here, the Unit Benefit Formula may be the answer.

Look at the personnel profile sheet. Check to see how long the owner and key employees have worked in relation to the rank and file. If there is a difference great enough to provide greater benefits to those the owner would like to reward, use the Unit Benefit Formula.

TARGET BENEFIT PLANS RETIREMENT

Target Benefit Plans are a little more complex. Consider them to be a combination or hybrid between a Defined Contribution and a Defined Benefit Plan since they have characteristics of both.

They are similar to Defined Contribution Plans in that the maximum contribution is limited to the lesser of 100% of compensation or $40,000. Another similarity is that the participant does not know what the account balance will be until date of retirement. Finally, since benefits are not guaranteed, there is no reason for actuarial services each year as in a Defined Benefit Plan.

They are similar to Defined Benefit Plans in that there is a limit on the amount of benefit to the lesser of 100% of pay or $160,000 per year. In the first year, the plan is funded on a predetermined benefit as in a Defined Benefit Plan. However, once set the contribution does not change, but remains stable subject to increases in the number of employees.

Probably the most prominent characteristic of the Target Benefit Plan is that the excess earnings are allocated to each account, providing a larger retirement benefit. Unlike a Defined Benefit Plan, excess interest does not decrease future employer contributions although it was a Defined Contribution Plan. In addition, the Target Benefit Plan permits excess interest to remain in the participant’s accounts! This type of plan could be the best of all worlds.

This is a good plan when the owner wants to receive the maximum from the plan, but is not able to use a Defined Benefit Plan because of age or financial constraints. Consistently higher investment earnings will accrue a greater benefit for the primary participants.

EMPLOYEE STOCK OPTION PLAN

This is a type of Profit Sharing Plan. The big difference between an ESOP and Profit Sharing Plan is that a Profit Sharing Plan is limited to 10% of its investments in employer stock where no such limitation applies to an ESOP. A primary portion of the employer contribution is made in stock in the company. If the stock grows well as result of excellent performance, the employee is highly rewarded. Gradually more of the company’s outstanding stock becomes owned by the ESOP and the company becomes “employee owned.”

LEVERAGED EMPLOYEE STOCK OPTION PLAN

This is a form of Employee Stock Option Plan. With a LESOP, the retirement trust may borrow or leverage the stock acquisition, which an ESOP cannot do.

This technique can move a very large block of stock into the plan, and frequently the LESOP calls for a major block of stock to be acquired at the death of the founder or primary owners. In many cases, the owner is insured and the death proceeds are used to fund the purchase. The estate receives cash and the employees - through the plan - receive the business.

This provides a greater reward to the employees if the company experiences substantial growth.

SIMPLIFIED EMPLOYEE PENSION PLAN

A SEP is a form of profit sharing having a contribution limitation of the lesser of 100% of compensation or $40,000. The major advantage to this form of plan is reduced documentation and reporting requirements.

In exchange for simplicity, it requires very early eligibility for employees and equal treatment for all those covered.

Source: Tax Facts 2002, National Underwriter Company