Jul 3, 2009

WHO WILL PAY FOR THE PLAN? | Plan Qualification Requirements

Most qualified pension plans are funded entirely by the employer. Pension plans requiring contributions by employees, referred to as contributory plans, were once popular but are currently of diminishing importance. There are two reasons for this. First, employee contributions to a qualified plan other than "salary reductions" (see below) are after-tax contributions—the employee receives no tax deduction or exclusion for the contribution. Also, employee contributions involve administrative complications such as Code Section 401(m).

Many employers believe that retirement plan benefits are appreciated more by employees if the employees themselves contribute (or feel that they are contributing) toward their cost. In most cases, of course, most of an employee's income comes in the form of compensation from the employer, so there is some degree of illusion in this approach. Some employers may also believe that a contributory approach lowers plan costs, but this is not actually true. To the extent that a contributory approach results in the loss of tax benefits (in effect, losing a contribution to the plan by the U.S. Treasury), a contributory plan actually costs the employer more for the same level of benefits. A better justification for contributory plans is that they give the employee some degree of choice in allocating his or her compensation between cash and deferred benefits.

Currently, the most favorable contributory plan design is to use salary reductions in a plan that is permitted to use salary reductions—a Section 401(k) plan, a Section 403(b) plan, a Section 457 plan, or a SIMPLE plan. Qualified pension plans cannot use salary reductions, except for some older plans that were "grandfathered" (permitted to use older law) when current law was enacted. Salary reductions are subject to FICA and FUTA (Social Security and federal unemployment) taxes but not to federal income tax. Thus, the tax benefits of qualified plans are not completely lost to the employee if the salary reduction approach is used.


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