Frequently Asked Questions

What is a 401(k) Plan?
What is a Defined Benefit Plan?
What is a Cross-Tested Plan?
What is a Profit Sharing Plan?
What is a Money Purchase Plan?
What is a Target Benefit Plan?

The term "401(k) Plan" has been grossly overused in the news media. It seems to have become synonymous with the term "retirement plan." Make no mistake, a 401(k) plan is only one of many different types of tax-qualified retirement plans.  Most retirement plans are not 401(k) plans. In fact, many times when an employer asks us about our 401(k) plan services, we are able to use our Plan Design experience to find a much better match for their objectives in one of the other types of plans.

A 401(k) plan is really just a Profit Sharing Plan, with the added feature that individual employees can voluntarily add to their accounts within the Plan on a pre-tax, payroll-deduction basis. The rules governing these "employee deferrals" of income are found primarily in section 401(k) of the Internal Revenue Code. That's why they are most commonly called 401(k) plans.

Since the employee deferrals are just an "add-on" to the Plan, a 401(k) plan acts for the most part like any other Profit Sharing Plan. They have mostly the same eligibility, employer contribution, vesting and distribution rules as any other plan.

Perhaps the biggest misconception regarding Defined Benefit Plans is that they only apply to large companies. This is completely false. Small and even one-employee companies often use Defined Benefit Plans to their advantage. A Defined Benefit Plan frequently allows for many times more in tax-deductible contributions than any other type of plan. Because of this, any one owning a small company with a large tax bite should look seriously at a Defined Benefit Plan.

A Defined Benefit Plan has the characteristics which most people think of when they hear the term "pension plan." Under a Defined Benefit Plan, employees earn benefits which are payable beginning at retirement age, and continuing for the rest of the employee's life. These benefits are often expressed as a percentage of compensation.

For example, a plan's benefit could be two percent of compensation multiplied by the employee's years-of-service. Under this example, an employee who earns $40,000 per year, and has twenty years of service, would earn a pension benefit of $16,000 ($40,000 times .02 times 20). Since this pension benefit is an "annual" benefit, the employee's benefit would be to receive $16,000 each year for as long as he or she lives.

"Cross-Testing" is a term used by the IRS to describe a retirement plan (usually a profit sharing plan) which has different contribution percentages for different groups of employees. For example, the business owners may want to contribute 25% of compensation for themselves, but only 5% of compensation for each of the other employees.

Because retirement plans cannot discriminate against Non-Highly-Compensated Employees, plans must prove non-discrimination by "testing" benefits "across" the various groups. This can sometimes allow the business owners (or favored employee groups) to have larger contributions than the rest of the employees.

In general, Cross-Testing works if the owner is older than the average age of the other employees. This is because they are closer to retirement age and therefore have fewer years to accumulate for retirement. With fewer years to accumulate, their individual contribution must be higher than the other employees just to get the same level of benefits at retirement age. In some cases we can even get a Cross-Tested plan to work if the average employee is older than the business owner. To run an in-depth Cross-Tested proposal, just contact us. To see a sample of how Cross-Tested calculations work, be sure to visit the calculator page of our Website.

A Profit Sharing Plan is the most flexible of all retirement plans. It allows (but does not require) an employer to contribute money into a trust on behalf of its employees. Each year, the employer decides how much to contribute. These "discretionary" contributions are subject to limits established within the Internal Revenue Code. No specific benefits are promised to any employee. Instead, at retirement they will receive whatever is contributed on their behalf, along with any earnings (or losses) associated with the trust's investment of those contributions.

The available contributions and their limits are defined in the Plan's documents. This makes a Profit Sharing Plan one type of a broader classification of plans known as "Defined Contribution" plans. It is not a Defined Benefit Plan since no promises are made about the amounts of future benefits.

A Profit Sharing Plan is also not a pension plan. A pension plan's contributions are never discretionary. Under a pension plan, the employer is required to contribute certain amounts to the Plan. Failure to contribute the required amounts incurs penalties which must be paid to the IRS. With a Profit Sharing Plan, there are no penalties for failure to meet the minimum funding requirements since no requirements exist.

A Money Purchase Plan is a defined contribution plan like a Profit Sharing Plan. The main difference is that the contribution amount defined in the Plan document is a required contribution. The employer MUST contribute the required contribution amount on time or pay penalties to the IRS.

The amount of required contribution is usually defined in the document as a percentage of each employee's compensation. For example, the Plan could define the contribution amount as ten percent. This would mean that the employer must contribute ten percent of each employee's "eligible" compensation each year. The amount of compensation to use (the "eligible" compensation) in the calculation is also defined in the Plan document. If an employee's eligible compensation were $40,000 for a given year and the contribution was defined as ten percent, the employer would be required to contribute $4,000 to the Plan's trust account on behalf of that employee for that year.

Money Purchase Plans are mostly obsolete. Since similar contribution amounts can be achieved in a Profit Sharing Plan with discretionary contributions each year, there needs to be a special reason for the employer to commit to the requirements of a Money Purchase Plan.

A Target Benefit Plan is a defined contribution plan like a Profit Sharing Plan. The main difference is that the contribution amount defined in the Plan document is a required contribution. The employer MUST contribute the required contribution amount on time or pay penalties to the IRS.

The amount of required contribution is calculated from special formulas which try to "target" benefit amounts at retirement for individual employees. The formulas take into account both the compensation and age of each employee. Older employees receive larger contributions than younger employees in a Target Benefit Plan. This is because older employees are closer to retirement age and have fewer years to accumulate dollars in their account before retirement. With fewer years to accumulate, larger amounts are required each year in order to make the benefits equal.

Target Benefit Plans are mostly obsolete. Since similar contribution amounts can be achieved in a Cross-Tested Plan with discretionary contributions each year, there needs to be a special reason for the employer to commit to the requirements of a Target Benefit Plan.