SECTION 403(B) TAX-DEFERRED ANNUITY PLANS

The 403(b) plan is another specialized plan that is available to some employers as an alternative or supplement to a qualified plan. The 403(b) plan was provided as a result of Congress's concern that employees of tax-exempt organizations might not have adequate qualified plan coverage. Tax-exempt employers may have relatively little money available for employee benefits, and the tax deductibility of a qualified plan does not act as an incentive because the tax-exempt employer pays no federal income taxes. As a result, Congress enacted Code Section 403(b), which, within limits, allows employees of certain tax-exempt organizations to have money set aside for them by salary reductions or direct employer contributions in a tax-deferred plan somewhat similar to a qualified plan.

Section 403(b) plans are an important consideration in designing the benefit program for any tax-exempt employer. However, today many tax-exempt employers have regular qualified plans for their employees, with the Section 403(b) plan being made available as a supplemental retirement or savings program. Tax-exempt, but not government, employers can adopt 401(k) plans as well as 403(b) plans, so such employers may be in a position to choose between the two approaches for salary savings. For most tax-exempts, the 403(b) plan is somewhat more advantageous than a 401(k) plan.

Section 403(b) plans are sometimes referred to as tax-deferred annuity (TDA) plans or tax-sheltered annuities, but because these terms also can refer to annuities not covered under Section 403(b), the term Section 403(b) plans will be used here to avoid confusion.

Eligible Employers

Employees of the following two types of organizations are eligible to adopt Section 403(b) plans:

1. A tax-exempt employer described in Code Section 501(c)(3)—an employer "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes, or to foster national or international amateur sport competition ... or for the prevention of cruelty to children or animals." Section 501(c)(3) also requires that the organization benefit the public rather than a private shareholder or individual and that the organization refrain from political campaigning or propaganda to influence legislation.

2. An educational organization with a regular faculty and curriculum and a resident student body that is operated by a state or municipal agency—in other words, a public school or college. This is the only type of government employer that can adopt a 403(b) plan.

Thus, Section 403(b) plans are available to a wide range of familiar nonprofit institutions such as churches, private and public schools and colleges, hospitals, and charitable organizations.

To participate in a Section 403(b) plan of an eligible employer, the participant must be a full- or part-time employee. This is significant because tax-exempt organizations often have ties with persons who are independent contractors rather than employees. For example, many physicians on a hospital staff technically are not employees but rather independent contractors. A person is an employee when the employer exercises control or has the right to control the person's activities as to what is done and when, where, and how it is done. The question of employee status also affects federal income tax withholding, employment taxes (Social Security and federal unemployment), and participation in other fringe benefit plans of the employer. If the employer wishes to cover a person under a Section 403(b) plan, it must at least treat that person consistently as an employee for all these purposes.

To be eligible for a Section 403(b) plan, a public school employee must perform services related directly to the educational mission. The employee can be a clerical or custodial employee, as well as a teacher or principal; a political officeholder is eligible only if the person has educational training or experience.

Coverage and Participation Tests

Section 403(b) plans to which the employer makes contributions are subject to relatively complicated nondiscrimination requirements. Employer matching contributions are also subject to the tests described in the discussion of savings and thrift plans. However, if the plan is funded entirely through employee salary reductions, as many plans are, these requirements do not apply. There is a simpler nondiscrimination requirement for salary reductions, however: if the plan permits salary reductions for any employee, then it must permit salary reductions of more than $200 for any other employee, except for those covered under a Section 457 plan or Section 401(k) plan or under another 403(b) plan. Certain part-time and student employees can be excluded.

A Section 403(b) plan (except for a church-related, public school, or public college plan) is covered under the age and service provisions of ERISA Section 202, which are the same as the analogous age and service code provisions for qualified plans. Thus, if a Section 403(b) plan uses age or service eligibility, these can be no greater than age 21 and one year of service. However, age and service requirements are rarely used in Section 403(b) plans.

The Limits on the Employee's Annual Contributions

Determining the maximum amount that can be contributed for an employee under a 403(b) plan is quite complicated. There are at least three steps in the computation, and if the plan is based on employee salary reductions, as most plans are, there are five basic steps summarized following.

1. The 403(b) annual exclusion allowance. The starting point in the computation is a provision unique to 403(b) plans, the annual exclusion allowance. The formula for the annual exclusion allowance for an employee is

   • 20 percent of the participant's includable compensation from the employer multiplied by

   • the employee's total years of service for the employer, minus

   • amounts contributed to the plan in prior years that were excluded from the employee's income.

   Includable compensation in general is gross compensation including salary reductions. For example, if a participant has a salary of $30,000 and elects a salary reduction of $5,000 to the 403(b) plan, his includable compensation for purposes of this formula is $30,000, even though his taxable compensation is only $25,000.

   The third item—the amount subtracted from the 20 percent times years of service amount—must include contributions by the employer to regular qualified plans on behalf of the employee. If the qualified plan is a defined-benefit plan, the amount deemed to be contributed for the employee is to be determined under recognized actuarial principles or under a formula provided in the regulations.

2. The Section 415 annual additions limit. The determination of the maximum 403(b) contribution for higher-income employees is complicated by the fact that although a Section 403(b) plan is not a qualified plan, the Section 415 limitation for defined-contribution plans applies. Thus, the annual addition to any participant's account cannot exceed the lesser of 25 percent of compensation or $30,000, even if the exclusion allowance would produce a higher figure.

   
   

   Doctor Staph is an employee of the Tibia Hospital and has annual compensation of $200,000 this year. She has four prior years of service for Tibia Hospital, during which the hospital has contributed $5,000 to her account in a Section 403(b) plan. No amounts have been contributed to any qualified plan on her behalf. Her exclusion allowance for the Section 403(b) plan this year is 20 percent of her includable compensations of $200,000 times her five years of service, or a total of $200,000, less contributions for prior years of $5,000, or $195,000. However, since this exceeds the applicable Section 415 limit of $30,000 is the most that can be contributed to the Section 403(b) plan for Doctor Staph this year.

   If the participant has more than one employer, all Section 403(b) plans of all employers must be combined for purposes of the Section 415 limit. However, if the employee participates in a regular qualified plan or plans as well as the Section 403(b) plan, it usually is not necessary to combine the qualified plans and the 403(b) plan for purposes of the Section 415 limit [Section 415(g) and Regulations Section 1.415-8].

   
   

3. Section 415 catch-up alternatives. The third step relates to a special feature in applying the Section 415 limit to a 403(b) plan. The Section 415 limit (25 percent/$30,000) may not be exceeded in any year, while the regular exclusion allowance is increased by prior service. This works a hardship on long-service employees who have had relatively low Section 403(b) contributions in prior years. Under the regular exclusion allowance, their prior service would otherwise permit large contributions to catch up for past years. For employees of educational institutions, hospitals, and home-health service agencies—but not other employers—the Code contains catch-up alternatives to the regular Section 415 limitation that are aimed at long-service employees. Under the catch-up alternatives, the 25 percent of compensation limit under Section 415 is not always applied, thus permitting Section 403(b) contributions in excess of 25 percent of the current year's compensation. However, in no event can the $30,000 limitation be exceeded, even under the catch-up alternatives.

4. Salary reduction limitation. The fourth step in determining the maximum 403(b) contribution applies to salary reduction plans. For such plans, there is a limit of $9,500 on annual salary reductions for each participant. This limit applies to the total (for each employee) of Section 403(b) salary reductions, SIMPLEs, and 401(k) salary reductions under plans of all the employee's employers. The $9,500 is indexed for cost-of-living increases (2000: $10,500). The $9,500 limit does not apply to direct employer contributions to the participant's account; thus, the total can be more than $9,500, as long as the exclusion allowance and the Section 415 limit are not exceeded.

   The amount contributed to the plan by a salary reduction will not be subject to income taxes if the salary-reduction election is made properly. For these amounts to avoid taxation, the salary reductions must be made under the same rules discussed in connection with 401(k) plans concerning the timing of the election. As with 401(k) salary reductions, although the amounts are not currently subject to income tax to the participant, they are subject to Social Security and federal unemployment (FICA and FUTA) taxes.

5. Salary reduction catch-up. As a final step in the process of determining the maximum 403(b) annual contribution, there is a further catch-up provision to raise the $9,500 salary reduction limit for employees having at least 15 years of service with the employer. The catch-up limit [Code Section 402(g)] allows additional salary reductions above the $9,500 limit (as indexed) equal to the least of

   • $3,000;

   • $15,000 less prior catch-up contributions; or

   • $5,000 times the employee's years of service with the employer, less all prior salary reductions with that employer.

Types of Investments for 403(b) Plans

Section 403(b) plan funds must be invested in either

• annuity contracts purchased by the employer from an insurance company or

• mutual fund shares held in custodial accounts [referred to as 403(b)(7) accounts].

Many different types of annuities may be used for Section 403(b) plans. Thus, the annuities can be individual or group contracts, level or flexible premium annuities, and fixed dollar or variable annuities. Face-amount certificates providing a fixed maturity value and a schedule of redemptions are also permitted. In addition, the annuity contract may provide incidental amounts of life insurance for the employee; however, the value of such insurance is taxable to the employee each year under the PS 58 table. The annuity contracts can provide the employee a choice of broad types of investment strategy—for example, a choice between investment in a fixed-income fund and an equity-type fund. However, if the contract gives the employee specific powers to direct the investments of the fund, the IRS will regard the employee as in control of the account for tax purposes and the employee will be currently taxed on the fund's investment income.

Annuity contracts used in Section 403(b) plans must be nontransferable. This means that they cannot be sold or assigned as collateral to any person other than the insurance company issuing the contract. However, the employee is permitted to designate a beneficiary for death benefits or survivorship annuities. Because similar restrictions apply to annuities transferred to participants from qualified plans, most insurance companies use the same standard provisions for both types of annuity contracts.

Mutual fund accounts [403(b)(7) accounts] are used in 403(b) plans much as they are in 401(k) plans, and can give participants the opportunity to allocate their accounts according to their own investment strategies by providing a family of funds with different investment approaches.

Distributions and Loans from Section 403(b) Plans

Distributions from Section 403(b) plans are subject to rules similar to those applicable to qualified 401(k) plans; however, there are differences in detail. Withdrawal restrictions are quite complicated. In general, withdrawals are not permitted from 403(b)(7) custodial accounts (mutual funds) or from any salary-reduction 403(b) account except for withdrawals after age 59½, or upon death, disability, separation from service, or financial hardship. These withdrawal restrictions technically do not apply to annuity-type 403(b) accounts funded by direct employer contributions rather than salary reductions. However, this "loophole" is of limited usefulness because all early withdrawals are subject to the 10 percent early distribution penalty of Code Section 72(t). This penalty applies to most distributions prior to age 59½ from qualified plans, IRAs, and Section 403(b) plans. The penalty applies even to distributions that are permitted; for example, many hardship distributions from Section 403(b) plans will be subject to the penalty.

Other qualified plan distribution rules also apply to Section 403(b) plans. Distributions must begin by April 1 of the calendar year following the attainment of age 70½ or actual retirement, if later. The minimum annual distribution thereafter is a level amount spread over the participant's life expectancy or over the joint life expectancies of the participant and beneficiary.

Loans

Section 403(b) plans with either annuity or mutual-fund accounts may permit loans on the same basis as regular qualified plans. Because of the restrictions on Section 403(b) distributions, plan loan provisions are particularly important to employees and should be considered in any Section 403(b) plan.

Taxation of Section 403(b) Plans

A Section 403(b) plan provides the same general tax advantages as a qualified plan. Thus, plan contributions within the limits of the exclusion allowance are not currently taxable to the employee. Investment earnings on plan funds are also not currently taxable.

However, the taxation of distributions from Section 403(b) plans is some-what less favorable than for qualified plans. The full amount of any distribution from a Section 403(b) plan, whether during employment or at termination of service, is fully taxable as ordinary income to the participant, except for any cost basis the participant has in the distribution. A cost basis could result if the employee paid tax previously on any amount contributed to the plan or reported PS 58 costs if the plan provides incidental life insurance. There are no averaging or capital-gain provisions for the taxable amount of a distribution from a Section 403(b) plan. The bad tax effect of having all of the income taxable in a single year can be alleviated only by having a periodic form of payout from the plan. A periodic distribution from a Section 403(b) plan is taxed under the annuity rules the same as an annuity from a qualified plan.

Death benefits are also subject to somewhat less favorable income tax treatment than death benefits from qualified plans. The averaging and capital gain provisions are not available to the beneficiary. Section 403(b) death benefits are included in the gross estate of the deceased participant for federal estate tax purposes. However, if they are paid to a spouse, they escape estate taxation under the unlimited marital deduction. In other cases, there may be no estate tax because the tax applies only to relatively large estates (those over about $600,000, subject to increase to $1,000,000 by 2007).

Regulatory and Administrative Aspects

A Section 403(b) plan is considered a pension plan, rather than a welfare benefit plan, for purposes of the reporting and disclosure provisions. The reporting and disclosure requirements applicable are similar to those applicable to qualified plans. However, as with qualified plans, Section 403(b) plans of government units and churches that have not elected to come under ERISA are exempt from these requirements, unless mutual funds rather than annuity contracts are used for funding. If a Section 403(b) plan is purely of the salary reduction type and does not include any direct employer contributions, the reporting and disclosure and other regulatory requirements are greatly reduced.

SIMPLEs | 401(k) and Other Salary Savings Plans

In an attempt to increase coverage of employer-sponsored plans, Congress has provided certain simplified arrangements that are not qualified plans but provide employers and employees some of the same benefits as qualified plans. One such arrangement, structured as a salary savings plan somewhat similar to a 401(k) plan, is the SIMPLEs (savings incentive match plans for employees). SIMPLEs are employer-sponsored plans under which plan contributions are made to the participating employees' IRA's. SIMPLEs also can be part of a 401(k) plan, but this arrangement is somewhat more complicated than a SIMPLE/IRA. Tax-deferred contribution levels are generally significantly higher than the $2,000/$4,000 deductible limit for individual IRAs. SIMPLEs feature employee salary reduction contributions (elective deferrals) coupled with employer matching contributions.

SIMPLEs are easy to adopt and generally simple to administer, while providing employees with the tax-deferred retirement savings benefits of a qualified plan. However, qualified plans potentially can provide higher contribution levels. An employee's salary reductions under a SIMPLE can be no greater than $6,000 annually.

Eligible Employers

Any employer may adopt a SIMPLE if it meets the following requirements:

• The employer has 100 or fewer employees.

• The employer does not maintain a qualified plan, 403(b) plan, or SEP except for a collectively bargained plan.

Advantages and Disadvantages

SIMPLEs can be adopted by completing a simple IRS form (Form 5304-SIMPLE or 5305-SIMPLE) rather than by the complex procedure required for qualified plans. Benefits of a SIMPLE/IRA are totally portable by employees because funding consists entirely of IRAs for each employee and employees are always 100 percent vested in their benefits. Employees own and control their accounts, even after they terminate employment with the original employer. Individual IRA accounts allow participants to benefit from good investment results, as well as run the risk of bad results. As with a 401(k) plan, a SIMPLE can be funded in part through salary reductions by employees.

However, SIMPLEs have some disadvantages. As with profit-sharing or salary savings plans in general, employees cannot rely on a SIMPLE to provide an adequate retirement benefit. First, benefits are not significant unless the employee makes significant regular salary reduction contributions. Such regular contributions are not a requirement of the plan. Furthermore, employees who enter the plan at older ages have only a limited number of years remaining prior to retirement to build up their SIMPLE accounts. Also, annual contributions generally are restricted to lesser amounts than would be available in a qualified plan. SIMPLE contributions are limited by the maximum $6,000 (as indexed; 2000: $6,000) salary reduction permitted for each participant (plus the employer's matching contribution). This contrasts with the $9,500 (as indexed; 2000: $10,500) annual salary reduction permitted for 401(k) or 403(b) plans. Distributions from SIMPLEs/IRAs are not eligible for the 5-year (or 10-year) averaging provisions available for certain qualified plan distributions. (Five-year averaging is repealed for years after 1999, but 10-year averaging is available even after 1999.)

Design Features of SIMPLEs

The following are the most significant Internal Revenue Code requirements for SIMPLEs (Section 408(p):

• The employer must have 100 or fewer employees (only employees with at least $5,000 in compensation for the prior year are counted) on any day in the year.

• The employer may not sponsor another qualified plan, 403(b) plan, or SEP under which service is accrued or contributions made for the same year the SIMPLE is in effect, except for a plan covering exclusively collective bargaining employees.

• Contributions may be made to each employee's IRA or to the employee's 401(k) account. In effect, there are thus two types of SIMPLEs—those that include the 401(k) requirements and those funded through IRAs. SIMPLEs meeting the 401(k) requirements are rarely adopted and will not be discussed further here.

• Employees who earned at least $5,000 from the employer in the preceding two years and are reasonably expected to earn at least $5,000 in the current year can contribute (through salary reductions) up to $6,000 (as indexed; 2000: $6,000) annually.

• The employer is required to make a contribution equal to either

  1. a dollar-for-dollar matching contribution up to 3 percent of the employee's contribution (the employer can elect a lower percentage, not less than 1 percent, in not more than two out of the past five years) or

  2. 2 percent of compensation for all eligible employees earning at least $5,000 (whether or not they elect salary reductions).

In a SIMPLE/IRA plan, each participating employee maintains an IRA. Employer contributions are made directly to the employee's IRA, as are any employee salary reduction contributions. Employer contributions and employee salary reductions, with the limits discussed above, are not included in the employee's taxable income.

Direct employer contributions to a SIMPLE are not subject to Social Security (FICA) or federal unemployment (FUTA) taxes. However, as with 401(k) plans, employee salary reduction contributions are subject to FICA and FUTA. The impact of state payroll taxes depends on the particular state's laws. Both salary reductions and employer contributions may be exempt from state payroll taxes in some states.

Distributions to employees from a SIMPLE/IRA plan are treated as distributions from an IRA. All the restrictions on IRA distributions apply and the distributions are taxed the same.

Installation of a SIMPLE

Installation of a SIMPLE can be very easy. The employer merely completes IRS Form 5304-SIMPLE or Form 5305-SIMPLE. Form 5305-SIMPLE provides for a "designated financial institution" for participant investments, while Form 5304-SIMPLE does not have this provision, which some plan sponsors and participants may find restrictive. Under a SIMPLE, salary reduction elections must be made by employees during a 60-day period prior to January 1 of the year for which the elections are made. The form does not have to be sent to the IRS or other government agency.

The reporting and disclosure requirements for SIMPLEs are simplified if the employer uses Form 5304-SIMPLE or 5305-SIMPLE. The annual report form (5500 series) need not be filed if these forms are used. In other cases, reporting and disclosure requirements are similar to those for a qualified profit-sharing plan.

SECTION 401(K) PLANS (CASH OR DEFERRED PLANS)

A qualified cash or deferred profit-sharing plan, usually referred to as a 401(k) plan because the special rules for these plans are found in Code Section 401(k), is a qualified profit-sharing or stock bonus plan that incorporates an option for participants to put money into the plan or receive it as taxable cash compensation. In other words, a 401(k) plan differs from a regular profit-sharing plan in that employees can participate in deciding how much of their compensation is deferred. Amounts contributed to the plan are not federal income taxable to participants until they are withdrawn; this is a significant advantage over contributions to a savings plan, which are taxable to the employee before contribution to the plan. However, 401(k) amounts for which the employee can elect to receive either cash or a plan contribution—elective deferrals—are subject to an annual limit of $9,500, indexed for inflation (2000 figure is $10,500).

A 401(k) plan can be an independent plan or the 401(k) feature can be included with a regular profit-sharing, savings, or stock bonus plan of the employer. The plan can be designed in a number of ways to combine both employer and employee contributions, or the entire plan can be funded through salary reductions by employees.

Eligible Employers

Section 401(k) plans can be adopted only by private employers, including tax-exempt organizations. They are not available to government employers. Government employers may be eligible to adopt Section 403(b) or Section 457 plans to provide results somewhat similar to 401(k) plans.

Advantages and Disadvantages

Section 401(k) plans are currently very attractive to employees. First, they have the basic attraction of all qualified plans—they provide a tax-deferred savings medium. But 401(k) plans have an additional advantage by giving employees an opportunity to choose the amount of deferral according to their individual need for savings. From the employee's viewpoint, a 401(k) plan appears much like an individual IRA, but with additional advantages: The 401(k) plan has higher contribution limits than an IRA, in certain cases it provides special averaging on qualifying lump-sum withdrawals, and the withdrawal provisions during employment are slightly less restrictive.

From the employer's viewpoint, 401(k) plans are favorable because the entire plan can be funded through salary reductions by employees. Thus, the plan provides no direct additional compensation costs to the employer. Because of the popularity of the plan with employees, partly due to good publicity for these plans in the media, the employer can obtain employee goodwill with this type of plan at a relatively low cost. There are also some actual dollar savings in using the 401(k) type of design, because salary reductions by employees may reduce employer expense for workers' compensation and unemployment compensation insurance by reducing the payroll subject to those taxes.

The 401(k) type of design has some disadvantages, but in reviewing these it is important always to ask disadvantages to whom and disadvantages compared with what? First of all, the $9,500 (indexed) annual limit on elective deferrals is lower than that for other types of qualified plan contributions. However, as a practical matter, this limit primarily affects highly compensated employees. Another disadvantage is that a 401(k) plan is a qualified plan and as such is much more complicated than simply leaving savings up to individual employees, either through individual IRAs or otherwise. Also, the 401(k) plan is a qualified profit-sharing plan, not a pension plan, so the employer's deduction is limited to 15 percent of the covered payroll. That is, the total of the employer contribution and nontaxable employee salary reductions cannot exceed 15 percent of covered payroll. Generally speaking, integration of a 401(k) formula with Social Security is not possible, but the 401(k) nondiscrimination rules nevertheless permit significant discrimination in favor of higher-paid employees. Section 401(k) plans are more difficult to administer than regular qualified plans because of the additional rules (discussed later) that must be satisfied. Deferral amounts must be 100 percent vested; thus, there is no opportunity for the employer to save on plan costs by making use of employee forfeitures on Section 401(k) deferral amounts. Finally, distributions to employees prior to termination of employment are more restrictive than for a regular qualified plan. However, these restrictions are more liberal than those for an IRA.

Employer Matching Contributions

Under this approach, participating employees can elect salary reductions, with the employer making a matching contribution to the plan. The employer share can be dollar-for-dollar, or some specified fraction of the employee's contribution. Matching can be limited to a specified percentage of each employee's compensation. For example, a plan might provide that an employee can elect salary reductions up to 6 percent of compensation, with the employer contributing an additional 1 percent of compensation for each 2 percent of employee salary reduction.

A significant advantage to this approach is that employer matching encourages plan participation by lower-paid employees. This helps to meet the qualification tests for 401(k) plans—the actual deferral percentage tests discussed later.

Employer Profit-Sharing Contributions

The plan also may provide for additional employer contributions not related to salary reductions by employees. These contributions can be completely discretionary or subject to a formula, as in the case of a regular profit-sharing plan. These contributions can be allocated in any manner permitted in a profit-sharing plan, including a simple uniform percentage of the participant's compensation as well as integration with Social Security or an age-weighted or cross-tested approach.

Employee After-Tax Contributions

The plan may permit employees to make additional after-tax contributions to the plan—that is, contributions not subject to the elective deferral rules and subject to income tax. These contributions are treated like employee contributions to a thrift or savings plan, discussed earlier.

Coverage Requirements

Because a 401(k) plan is a qualified profit-sharing plan, it must meet all the eligibility and coverage requirements discussed earlier for qualified plans in general. However, substantial additional participation by lower-paid employees may indirectly be required to meet the actual deferral percentage requirements applicable under Section 401(k) as discussed below.

Vesting of Employee Accounts

Vesting requirements in a 401(k) plan may depend on the source or identity of the plan contributions.

• Nontaxable employee salary reductions or elective deferrals made under a Section 401(k) cash or deferral option must be immediately 100 percent vested.

• Any after-tax employee contributions must be 100 percent immediately vested, as in qualified savings or thrift plans, discussed earlier.

• Employer contributions to the plan must meet the usual vesting rules for qualified plans. That is, the plan must have a vesting schedule for employer contributions that at least meets one of the ERISA minimum vesting standards (five-year vesting or three- to seven-year vesting).

$9,500 Limit on Elective Deferrals

Code Section 402(g) imposes a $9,500 annual limit on elective deferrals for each plan participant. The limit is imposed on the total of elective deferrals under all 401(k) plans, Section 403(b) tax-deferred annuity plans, and SIMPLEs covering the participant. The plan may not permit elective deferral contributions in excess of this limit. The $9,500 limit is adjusted for cost-of-living changes (2000: $10,500).

Designing a Plan To Meet the ADP Tests

Obviously, it is critical to design the 401(k) plan so that the ADP tests are met; otherwise the plan will fail to qualify and all tax benefits will be lost. Fortunately, it is not as difficult as plan designers once believed and disqualifications are rare. Some of the methods used to ensure compliance are as follows:

• Mandatory deferral. For example, an employer contributes 5 percent of compensation for all employees that must be deferred and allows an additional 2 percent under a cash or deferral option. This plan will always meet the second ADP test.

• Limiting deferral by the higher paid. This approach involves administrative problems. The highly compensated group must be identified and deferral must be monitored, with a mechanism to stop deferrals at an appropriate point during the year if necessary. Alternatively, excess deferrals for highly compensated employees can be computed at the end of the year and corrective distributions, including interest earnings, made to affected employees. Such corrective distributions are income-taxable to the recipients and must be made within 2½ months after the end of the plan year to avoid an additional penalty tax. Instead of cash distributions if the plan permits after-tax contributions, these excess amounts can be retained in the plan and recharacterized as after-tax contributions within 2½ months after the plan year. Related matching contributions can be forfeited and generally cannot be distributed.

• Counting on the popularity of the 401(k) approach. In actual practice, many companies find that participation by lower-paid employees is substantial. It is not unusual for 75 percent of all employees of an organization to participate in the plan. This may eliminate the problem without any special mechanisms coming into effect.

Because of the ADP tests, not every employer is suitable for a 401(k) plan. Because substantial participation by lower-paid employees is necessary, pay levels must be reasonably high in the organization, at least high enough so that some amount of retirement saving is possible by most of the employees.

Distribution Restrictions

Account balances attributable to amounts subject to the cash or deferral election—the 401(k) amounts—are subject to special distribution restrictions. These amounts may not be distributed earlier than on retirement, death, disability, separation from service, hardship, age 59½, or termination of the plan. Also, as with any qualified plan distribution, the 10 percent early withdrawal penalty applies. Amounts attributable to matching and profit-sharing contributions can generally be withdrawn according to the rules for profit-sharing plans discussed earlier.

The income taxation of distributions from 401(k) plans, including both 401(k) and non-401(k) amounts in the plan, follows the usual rules for qualified plan distributions. The qualified plan rules relating to loans and plan distributions.

Social Security and Employment Taxes

Section 401(k) plans are an exception to the general rule that contributions by an employer to a qualified plan are free of federal employment taxes (Social Security [FICA] and unemployment tax (FUTA)). The popularity of 401(k) plans when first introduced caused such a noticeable reduction in federal employment tax revenues that Congress made special rules for 401(k) plans. Under current law, 401(k) amounts subject to an employee election to defer instead of receiving cash (elective deferrals) are subject to FICA and FUTA, whether these are contributed through salary reduction or employer bonuses. FICA and FUTA do not apply to non-401(k) amounts—matching or profit-sharing contributions made by the employer to the plan that are not subject to elective deferrals.

In general, state unemployment compensation and workers' compensation payments are not required for either employer contributions or salary reductions in a 401(k) plan.

SALARY SAVINGS PLANS IN GENERAL

A salary savings plan, as it is called here (there is no single accepted term for these plans), is a plan under which employees are given a choice, or election, to receive a part of their compensation in cash or to contribute it to a qualified plan or similar arrangement under which the amount contributed to the plan is not subject to income taxation in the year in which it is contributed. Instead, income tax on the contributions and investment earnings on those contributions is deferred until actual withdrawals are made by the employee. Amounts contributed by the employee under such an arrangement are sometimes referred to as elective deferrals.

In the last decade, such plans have become extremely popular with employers and employees as a result of the trends, as well as specific advantages of the salary savings approach such as the following:

• No annual funding commitment for the employer except to the extent that the plan requires a matching or formula contribution

• Initial cost to the employer is minimized because elective deferral amounts come out of existing cash payroll

• No long-term liability for employer

• Benefits have high portability to employee—fast vesting, annual or more frequent account valuation, easy for employee to understand how much has accumulated

• Employee has option to save at desired level (or not to save at all)

• Apparent administrative simplicity (although complex plans with directed investment may be as costly to administer as a defined benefit plan)

Many salary savings plans make use of directed investment provisions (where the employee chooses the investments for his or her account, usually among a family of mutual funds), so that the employee's choices regarding savings programs are further enhanced.

The trend toward this type of qualified benefit is not without its disadvantages. Overall, the movement from the traditional pension plan to profit-sharing and salary savings approaches, however inevitable, probably results in a reduction in potential retirement income for employees, although employees who change jobs frequently (an increasing category of employees) may do better with the newer types of arrangement, as long as they do not dissipate their account accumulations before retirement. Many mobile workers, however, tend to spend distributions from profit-sharing or salary savings plans when they change jobs, particularly if the distribution is relatively small. Another emerging problem, in the case of plans using directed investment provisions, is that employees tend not to make good investment allocations in their plan accounts and, overall, may earn less on their money than if the employer chose the investments. Employees who do well with salary savings plans tend to be people who would save wisely and well for retirement even without the plan, thus raising questions as to the social utility of these plans. These problems, along with already well-known demographic problems with Social Security, threaten to haunt American society in the early 21st century as the baby boomers retire. Some time soon, we will have to better address, both individually and as a society, the issue of retirement income adequacy.

Among the general public, the best-known salary savings plan is the 401(k) plan, which is basically a qualified profit-sharing plan with an elective deferral feature. In addition, there are several other plan types (SIMPLEs, 403(b) tax-deferred annuity plans, and Section 457 plans) that, although not qualified plans, provide elective deferrals and have much the same income tax and other consequences for the participants. These plans are discussed together because of their practical similarity, but the student must be careful to note that they all have different rules and all are different from qualified plans.

Employee Stock Ownership Plan (ESOP)

The ESOP is a stock bonus plan with an important additional feature: If certain requirements are met, the plan can be used by the employer company as a means of raising funds on a tax-favored basis. The funds can be used for any corporate purposes, which can include acquiring the assets or stock of another company.

In effect, an ESOP allows an employer to indirectly borrow money from a bank and repay the loan with fully deductible repayment amounts. The repayment amounts are deductible in full because they are structured as contributions to an ESOP; normally, only the interest portion of a loan repayment would be tax deductible.

This bit of tax magic (see Figure1) is accomplished by first having the plan trustee borrow money from a bank or other lender. The borrowed money is then used to purchase a block of employer stock from the employer. Shares of this stock also will subsequently be allocated to participants' accounts in the ESOP as plan contributions are made. The employer makes periodic plan contributions to the ESOP and obtains a tax deduction for them. These plan contributions are designed to be enough to enable the plan trustee to gradually repay the loan to the bank. The net result is that the employer immediately receives the full proceeds of the bank loan and in effect pays off the loan through tax-deductible contributions to the plan on behalf of plan participants.

Figure1

Because the ESOP normally has no financial status independent of the employer, the employer usually must guarantee the loan to the bank. If the plan gives collateral for the loan, the collateral may consist only of qualifying employer securities.

Contribution Formulas and Accounts

An ESOP's contribution allocation formula may not be integrated with Social Security because plan allocations must be based on total compensation. In other respects, contribution formulas and participants' accounts are handled in the same manner as for the stock bonus plan described earlier.

Deductibility of Contributions

The rules for contribution deductibility for an ESOP are somewhat different from those for a stock bonus plan or profit-sharing plan. If employer contributions to the ESOP are applied to the repayment of a loan, amounts applied by the plan to repay the loan principal are deductible by the employer up to a limit of 25 percent of compensation of employees covered under the plan. Amounts used to repay interest are deductible without any percentage limit.

Plan Distributions

The distribution rules, voting rights, and taxation considerations regarding ESOP distributions are the same as those discussed earlier in connection with stock bonus plans.

Diversification Requirement

To reduce investment risks, participants in ESOPs who have reached age 55 with ten years of service are entitled to an annual election requiring the employer to diversify investment in the participant's account. The plan must offer at least three investment options, other than employer stock, to the participant for diversification purposes.

Creating a Market for Closely Held Stock

In small companies, it is often important for shareholders to find a market for their stock for financial and estate planning purposes. Many types of plans have been designed to enable the use of company funds for purchasing stock, such as stock redemption and corporate-owned life insurance plans. An ESOP or stock bonus plan can also be helpful for this purpose. The shareholder can sell stock to the plan during lifetime or at death, generally with favorable tax results. These techniques involve various complexities and must be designed with some care.

Stock Bonus Plan

The stock bonus plan is the older of the two types of qualified plans that invest primarily in employer securities. Under the regulations, a stock bonus plan is a qualified defined-contribution plan similar to a profit-sharing plan, except that the employer's contributions are not necessarily dependent on profits; benefits are distributable in the stock of the employer company.

Typically, the plan contribution formula is based on employee compensation. Employer contributions to the plan may be made in cash or directly in the form of employer securities, newly issued or otherwise. Shares of stock are allocated to participants' accounts under a formula that must meet the same nondiscrimination requirements as the allocation formula in a profit-sharing plan. Some stock bonus plans also provide for after-tax employee contributions or salary reductions. (A salary reduction stock plan is sometimes referred to as a KSOP.)

The value of each participant's account in a stock bonus plan is stated in terms of a certain number of shares of employer stock. The value of the account varies with the value of the underlying employer stock. Dividends on the shares can be used to increase participants' accounts, or cash dividends can be paid through the plan directly to participants as currently taxable income, in which case the employer gets a tax deduction.

Plan Distributions

Distributions from both stock bonus plans and ESOPs are generally subject to the same restrictions applicable to distributions from any qualified plan. Thus, distributions prior to age 59½, death, disability, or retirement are subject to a 10 percent penalty, with some exceptions. However, for a stock bonus plan or ESOP, there is no requirement of providing a joint and survivor annuity or other spousal death benefit.

Because an employee retains the investment risk in the employer company until the stock is distributed, a deferred distribution to a terminated employee would not be appropriate, so payouts from stock bonus plans or ESOPs have a special earlier beginning date than that for other qualified plans. Distributions from a stock bonus plan or ESOP must occur no later than one year after the end of the fifth plan year after the employee's separation from service or no later than one year after retirement, disability, or death.

In general, the plan must distribute benefits in the form of employer stock. However, the participant can be given the option of receiving cash of equal value, subject to a right to receive employer stock. If the participant receives stock that is not traded on an established market, the participant has a right to require that the employer repurchase the securities under a fair valuation formula. This is referred to as the "put" requirement. If an employee exercises the put option on distribution—that is, sells the securities back to the plan—the participant must be paid over no more than five years, and during that time the plan must provide adequate security for the payment.

Voting Rights

If the employer company is closely held, plan participants must be given the right to vote with respect to stock held for them in the plan on corporate issues requiring more than a majority of the outstanding common shares. If the employer stock is publicly traded, participants must be permitted to vote on all issues.

Taxation of Employees

In addition to the usual tax advantages for qualified plans, an additional employee tax benefit provided by the Code for a plan holding employer stock is the deferral of taxation of unrealized appreciation. When the plan makes a lump-sum distribution including employer stock, the unrealized appreciation of the stock—that is, the difference between the value of the stock when contributed to or purchased by the trust and its value when distributed to the employee—is not taxable to the employee at the time of the distribution to the extent that it (1) represents nondeductible employee contributions or (2) represents employer contributions, and the participant's entire account is distributed within one taxable year as a result of death, the attainment of age 59½, or the employee's separation from the service of the employer.

This means that the taxable amount of a lump-sum distribution from a stock bonus plan does not include unrealized appreciation of employer securities if the recipient is entitled to the special tax treatment for lump-sum distributions in general. The unrealized appreciation is taxable only when the employee or other recipient sells the securities at a later date. The unrealized appreciation amount is taxable as a capital gain when the stock is sold.

Deductibility of Contributions

As indicated above, the employer can deduct a contribution to a stock bonus plan in the form of employer securities as well as cash. Deductions for contributions can be taken even if there are no current or accumulated profits. The deduction limit is the same as that for a profit-sharing plan—15 percent of covered payroll.

USING EMPLOYER STOCK IN QUALIFIED PLANS

For a number of years, the Internal Revenue Code has included special provisions for qualified plans that invest primarily in employer securities. Congress wants to encourage these plans on the premise that it is desirable to give employees some ownership interest in the company for which they work. The most important special benefit is the leveraging technique for ESOPs, described below, that allows the employer to use the ESOP as a means of financing corporate growth. There are also provisions that encourage the use of a stock plan to help create a market for employer stock.

There are two types of qualified plans that invest primarily in employer securities, the traditional stock bonus plan and the employee stock ownership plan (ESOP). In addition, a regular profit-sharing plan may invest in employer stock without limit, and profit-sharing plans are sometimes used, formally or informally, for this purpose. Qualified pension plans may not invest more than 10 percent of their assets in employer stock, so pension plans are not very useful as employer stock plans.

Advantages of Investing in Employer Stock

There are certain employer and employee advantages to any plan that invests in employer stock, including a regular profit-sharing plan, a stock bonus plan, or an ESOP.

• A market can be created for employer stock. This has many planning implications and is discussed in detail below.

• The employer can obtain a deduction for noncash (that is, employer stock) contributions to the plan.

• Employees receive an ownership interest in the company, which may act as a performance incentive.

• As described below, unrealized appreciation of stock is not taxed to the employee at the time of distribution.

SAVINGS PLANS | Profit-Sharing and Similar Plans

Almost any qualified plan can have a provision for employee contributions to supplement the plan fund or benefit. A plan that is designed particularly to exploit the possibility of employee contributions is often referred to as a savings plan or thrift plan. The term savings plan will be used here to describe a plan featuring employee after-tax contributions.

Design of Savings Plans

A savings plan is a defined-contribution plan so that employees can have separate accounts. Usually, qualified savings plans are designed as profit-sharing plans (rather than money-purchase pension plans) because only a profit-sharing plan permits account withdrawals during employment, and this is an important feature of the plan if the plan is to be described to employees as a savings medium. Thus, a savings plan can generally be described as a contributory profit-sharing plan.

The typical savings plan features employee contributions matched by the employer. Plan participation is voluntary; employees elect to contribute a chosen percentage of their compensation up to a maximum percentage specified in the plan. The employer then makes a matching contribution to the plan. The matching may be dollar for dollar, or the employer may put in some multiple or submultiple of the employee contribution rate. For example, typically a plan might permit an employee to contribute annually any whole percentage of compensation from 1 to 6 percent. The plan might then provide that the employer contributes at the rate of half the chosen employee percentage; thus, if the employee elects to contribute 4 percent of compensation, the employer would contribute an additional 2 percent.

If the plan's maximum contribution level is too high, there is a possibility of discrimination because only higher-paid employees could be in a position to contribute to the plan, and only they would receive full employer matching contributions. To prevent this type of discrimination, there is a specific numerical test applicable to after-tax employee contributions. Under this test [Code Section 401(m)], a plan is not deemed discriminatory for a plan year if, for highly compensated employees, the total of employee contributions (both matched and voluntary) plus employer matching contributions does not exceed certain numerical limits similar to those applicable to Section 401(k) plans. Administration of the Section 401(m) limits can be complex and costly.

Apart from the features relating to employee contributions, savings plans generally follow the rules for profit-sharing plans described earlier. In designing a savings plan, emphasis is usually put on features relating to the objective of providing a savings medium for employees. Thus, a savings plan usually has generous provisions for vesting, employee withdrawal of funds, plan loans, and investment flexibility.

Advantages and Disadvantages of Savings Plans

Savings plans have been very popular in the past and continue to be so, despite the advent of other types of plans, such as Section 401(k) plans, that provide greater tax leverage. Some older savings plans have been converted to add a 401(k) feature while retaining the provision for additional after-tax contributions by employees. Like all qualified plans, a savings plan provides a tax-deferred savings medium because earnings in the plan fund are not taxable until the employee's account is distributed.

A savings plan usually does not maximize the potential tax deduction available for plan contributions, because it involves after-tax contributions by the employee—contributions that are not deducted or excluded for federal income or Social Security tax purposes. A greater degree of tax deductibility can be provided with other types of plans, such as regular profit-sharing plans or Section 401(k) plans. However, some of these plans may require a greater employer outlay for the plan itself (although not necessarily for the overall compensation package). These other plans may also entail greater restrictions on the funds, which may make them a less attractive savings medium from the employee's standpoint.

Deduction of Employer Contributions

Under Code Section 404(a)(3), the maximum amount that an employer can deduct for contributions to a profit-sharing plan is 15 percent of the compensation paid or accrued during the taxable year to all employees who participate in the profit-sharing plan. This is an employer deduction limit based on compensation of all covered employees; it is not a rule stating that allocations to individual participants' accounts are limited to 15 percent of their compensation. The limitation on annual additions to individual accounts, the Section 415 limit, is discussed below.

An employer can contribute to a profit-sharing or a stock bonus plan in excess of the 15 percent limit, but the excess is not deductible and is subject to a 10 percent penalty under Section 4972. The excess amount can be carried over to a future year and deducted then, but deductions in the future year for current contributions plus carryovers are still subject to the 15 percent of payroll limit.

Combined Profit-Sharing and other Plans

If an employer has both a defined-benefit plan and a profit-sharing or other defined-contribution plan covering a common group of employees, the total contribution for both plans cannot exceed 25 percent of compensation of the common group of employees. However, if a greater contribution is necessary to satisfy the minimum funding standard for the defined-benefit plan, the employer will always be able to make and deduct this contribution.

Section 415 Limits

The Section 415 limits that apply to profit-sharing plans are those applicable to all defined-contribution plans. The annual addition to any participant's account cannot exceed the lesser of 25 percent of the participant's compensation or $30,000 (as indexed for inflation). For a profit-sharing plan, the annual addition includes the participant's share of any forfeitures as well as employer and employee contributions. This means that when forfeitures are allocated to a participant's account, the amount of employer contributions that can be allocated may be reduced. The Section 415 limits usually affect only highly compensated employees covered under the plan.

Investment Earnings and Account Balances

As a defined-contribution plan, a profit-sharing plan must provide separate accounts for each participant. However, unless the plan contains a provision permitting participants to direct investments (discussed below), the plan trustee or other funding agents will generally pool all participants' accounts for investment purposes. The plan must then provide a mechanism for allocating investment gains or losses to each participant. Most methods for doing this effectively allocate such gains and losses in proportion to the participant's account balance.

IRS revenue rulings require accounts of all participants to be valued in a uniform and consistent manner at least once each year, unless all plan assets are immediately invested in individual annuity or retirement contracts meeting certain requirements. The plan usually will specify a valuation date or dates on which valuation occurs. Investment earnings, gains, and losses are allocated to participants' accounts as of this date.

Participant-Directed Investments

Under ERISA Section 404c, any "individual account" plan (such as a profit-sharing, stock bonus, or money-purchase pension plan) can include a provision allowing the participant to direct the trustee or other funding agent as to the investment of the participant's account.

If the plan administrator provides a broad range of investment choices—so that the participant's choice has real meaning—then the trustee and other plan fiduciaries are not subject to fiduciary responsibility for the investment decision.^[1] A plan can technically allow unlimited choice of investments, but this increases the plan's administrative burdens. Often, a family of mutual funds is offered as an investment option to increase the administrative feasibility of participant direction. At least three investment alternatives must be included.

Investment direction gives the participant a considerable degree of control over the funds in his or her account. It is frequently used in profit-sharing plans, particularly those for closely held businesses where the controlling employees have by far the largest accounts. On the other hand, to the extent that participant direction of investments removes the security provided by the fiduciary rules, such a provision is at odds with a plan objective of providing retirement security, and it would not be appropriate if this were a major objective of the plan for a particular employee group.

To prevent certain abuses associated with participant-directed investments, the Code provides that an investment by a participant-directed qualified plan account in a collectible will be treated as if the amount invested were distributed to the participant as taxable income to the participant. A collectible is defined in Code Section 408(m) as a work of art, rug or antique, metal or gem, stamp or coin (excluding certain federal and state-issued coins), alcoholic beverage, or any other tangible personal property designated as a collectible by the IRS.

Withdrawals during Employment and Loan Provisions

The incentive (rather than retirement security) focus of profit-sharing plans tends to dictate that participants be given the opportunity to control or benefit from their accounts even before retirement or termination of employment. There are various ways to do this. One such provision is a participant-directed account, as discussed above. Another is a special feature permitted in profit-sharing plans but not in pension plans—a provision for account withdrawals from the plan during employment.

The regulations require that employer contributions under a profit-sharing plan must be accumulated for at least two years before they can be withdrawn by participants.^[2] However, in some revenue rulings, the IRS has permitted a plan provision allowing employees with at least 60 months of participation to withdraw employer contributions, including those made within the previous two years. Also, revenue rulings have permitted a plan provision for withdrawal in the case of "hardship," including contributions made within the previous two years. Hardship must be sufficiently defined in the plan and the definitions must be consistently applied. All these limitations apply only to amounts attributable to employer contributions to the plan. If the plan permits employee contributions, the employee contributions can be withdrawn at any time without restriction.

In considering the design of withdrawal provisions, it is important to keep in mind that the taxation and early-withdrawal penalty rules act as disincentives for participants to withdraw plan funds. These rules indirectly reduce the advantages of using a qualified plan as a medium for preretirement savings.

Many plan designers prefer to have a prohibition or at least restrictions on withdrawals from the employer-contributed portion of the account. This is because favorable investment results sometimes depend on having a pool of investment money that is relatively large and not subject to the additional liquidity requirements imposed by the possibility of participant withdrawals. Some typical restrictions found in profit-sharing plans include a requirement that the participant demonstrate a need for the money coming within a list of authorized needs either set out in the plan or promulgated by the plan administrator and applied consistently. Such needs might include educational expenses for children, home purchase or remodeling, sickness or disability, and so forth. Another method of restricting plan withdrawals is to provide a penalty on a participant who withdraws amounts from the plan (in addition to the 10 percent federal penalty tax, which also applies). A plan penalty might include suspension of participation for a period of time, such as six months after the withdrawal. The plan penalty cannot, however, deprive a participant of any previously vested benefit.

Loan provisions are appropriate for profit-sharing plans. Again, however, a generous loan provision in a plan may have the effect of reducing the amount of funds available for other plan investments.

Incidental Benefits

The regulations permit profit-sharing plans to provide as an incidental benefit life, accident, or health insurance for the participant and the participant's family. Incidental life insurance is the only one that is commonly provided. If employer contributions are used to provide insurance, the incidental benefit limitations must be met.

If the plan provides incidental whole life insurance, the usual test is that aggregate premiums for each participant must be less than 50 percent of the aggregate of employer contributions allocated to the participant's account. If the plan purchases term insurance or accident and health insurance, the aggregate premiums must be less than 25 percent of the employer contributions allocated to the participant's account. The current IRS position is that universal life premiums also must meet the 25 percent limit. Note that these tests apply to the aggregate—that is, the total contributions made for all years at any given time. If either of these limits is exceeded, the plan could be disqualified. However, insurance premiums paid with employer-contributed funds that have accumulated for at least two years are not subject to these limitations.

If the employee dies before normal retirement age, the plan can provide that the face amount of the policies plus the balance credited to the participant's account in the profit-sharing plan can be distributed to the survivors without the life insurance violating the incidental benefit requirement. This can be done even though the amount of life insurance might be more than 100 times the account balance expressed as an expected monthly pension.

If life insurance is provided by the plan, the term insurance cost is currently taxable to the employee or the insurer's term insurance rates. Accident and health insurance provided by an employer under the plan might not be taxable because of the exclusion provided for employer-provided health insurance. However, there usually is no particular benefit in providing accident and health insurance under a profit-sharing plan. It is usually provided in a separate plan not connected with the profit-sharing plan.

QUALIFIED PROFIT-SHARING PLANS

The basic profit-sharing plan is a defined-contribution plan in which employer contributions are typically based in some manner on the employer's profits, although there is no actual requirement for the employer to have profits in order to contribute to the plan. Even a nonprofit organization may have a "profit-sharing" plan. The general characteristics are as follows:

• The employer contribution may be specified as a percentage of annual profits each year or, for even more flexibility, the plan may provide that the employer determines the amount to be contributed on an annual basis, with the option of contributing nothing even in years in which there are profits or, conversely, making contributions in unprofitable years.

• The plan must have a nondiscriminatory formula for allocating the employer contribution to the accounts of employees.

• Because the plan is a defined-contribution plan, the benefit from it consists of the amount in each employee's account, usually distributed as a lump sum at retirement or termination of employment.

• The plan may permit employee withdrawals or loans during employment.

• Eligibility and vesting are usually liberal because of the incentive nature of the plan.

• Forfeitures from employees who terminate employment are usually reallocated to the accounts of remaining participants, thus making the plan particularly attractive to long-service employees.

• The main price for the advantages of the design is that the employer's annual deduction for contributions to the plan is limited to 15 percent of the payroll of employees covered under the plan.

Eligibility and Vesting

Profit-sharing plans are typically designed with relatively liberal eligibility and vesting provisions, compared with pension plans. This is because the employer generally wishes the incentive objective of the plans to operate for short-term as well as long-term employees, and also because the simplicity of administering a profit-sharing plan makes it less necessary to exclude short-term employees to reduce plan administrative costs. Thus, many profit-sharing plans permit employees to enter the plan immediately upon becoming employed, or after a short waiting period—for example, until the next date on which the plan assets are valued. A great variety of vesting provisions are used, and they are typically tailored to the employer's specific needs.

As a qualified plan, a profit-sharing plan is subject to the restrictions on eligibility and vesting provisions. In summary, a minimum age requirement greater than 21 is not permitted, nor can a waiting period for entry be longer than one year, or up to 1½ years if entry is based on plan entry dates. Under the age discrimination law, no maximum age for entry can be prescribed (and contributions must continue for as long as the employee continues to work).

A profit-sharing plan is more likely to discriminate in favor of highly compensated employees as a result of high employee turnover and the use of forfeitures, as discussed below. Therefore, the IRS may require the more stringent three- to seven-year vesting schedule in new profit-sharing plans. Most profit-sharing plans use a vesting schedule that is at least as generous as this schedule. Even more stringent vesting is required if the plan is top-heavy.

Employer Contribution Provision

There is great flexibility in designing an employer contribution provision for a profit-sharing plan. The contribution provision can be either discretionary or of the formula type.

With the discretionary provision, the company's board of directors determines each year what amount will be contributed. It is not necessary for the company actually to have current or accumulated profits. Many employers will wish to contribute the maximum deductible amount each year, but a lesser amount can be contributed.

Although employers are permitted to omit contributions under a discretionary provision, the IRS requires that contributions be "substantial and recurring." If too many years go by without contributions, the IRS is likely to find that the plan has been terminated, with the consequences (basically 100 percent vesting for all plan participants and distribution under a specified payment schedule). No specific guidelines are given by the IRS as to how many years of omitted contributions are permitted, so the decision to skip a profit-sharing contribution must always be made with some caution.

With a formula contribution provision, a specified amount must be contributed to the plan whenever there are profits. Typically, the amount is expressed as a percentage of profits determined under generally accepted accounting principles. There are no specific IRS restrictions on the type of formula, so flexibility is possible. For example, the plan might provide for a contribution of 7 percent of all current profits in excess of $50,000, possibly with a limitation on the amount deductible for the year. There is also considerable freedom in defining the term profit in the plan. For example, profit before taxes or after taxes can be used, with before-tax profits being the most common. Profit as defined in the plan can also include capital gains and losses or accumulated profits from prior years. Even an employer that is organized under state law as a "nonprofit" corporation can have a profit-sharing plan funded from a suitably defined surplus account.

The advantage of the formula approach is that it is more attractive to employees than the discretionary approach and more definitely serves the incentive purpose of the plan. However, if a formula approach is adopted, the employer must remember that the formula amount must always be contributed to the plan; the formula constitutes a continuing legal and financial obligation for the business as long as the plan remains in effect. It is possible to draft formulas that take into account possible adverse financial contingencies. Without such provisions, the formula may have to be amended in the future in the event of financial difficulty.

Allocations to Employee Accounts

The plan's contribution provision determines the total amount contributed to the plan for all employees. The plan must also have a formula under which appropriate portions of this total contribution are allocated to the individual accounts of employees. Here there is less flexibility because the allocation provision must meet nondiscrimination requirements. The law provides that contributions must be allocated under a definite formula that does not discriminate in favor of highly compensated employees. Any formula that meets these requirements can be acceptable, but most formulas allocate to participants on the basis of their compensation, compared with the compensation of all participants. That is, after the total employer contribution is determined, the amount allocatable to a given participant is

If compensation is used in the allocation formula, the plan must define compensation in a way that does not discriminate. Compensation might include only base pay or might be total compensation including bonuses or overtime. Only the first $150,000 (as indexed for inflation) of each employee's compensation can be taken into account in the plan formula.

Service is another factor often used in the formula for allocating employer contributions. However, since highly compensated employees are likely to have long service, the IRS will probably require a showing that any service-based formula will not produce discrimination.

Age-Based Allocation Formula and Cross-Testing

Under IRS regulations, it is possible for a profit-sharing plan's allocation formula to take the participant's age at plan entry into account. That is, the plan can provide a greater allocation percentage of compensation to a participant who entered the plan at, say, age 55 than to a participant who entered at age 25. The purpose of this allocation method is to provide the late entrant with a more adequate benefit at retirement, given the fact that the late entrant has fewer years to accumulate plan contributions. Compared with a target plan, the age-based profit-sharing plan has the additional advantage that the employer is not "locked-in" to an annual contribution obligation, which may make this approach attractive to smaller or less stable businesses.

Age-based profit-sharing allocation formulas and target plans are examples of a method of discrimination testing known as cross-testing. A cross-tested defined-contribution plan is tested for discrimination in favor of the highly compensated as if it were a defined-benefit plan. That is, projected benefits at retirement age are determined for all participants in the defined-contribution plan (by assuming that the current level of contributions to each participant's account continues each year until that participant's retirement age). These projected benefits, as a percentage of each participant's compensation, are then tested for discrimination. If lower-paid employees are generally younger than highly compensated employees, cross-testing may allow relatively low contribution levels (percentages of compensation) for the lower-paid employees because the contributions for the younger employees are projected over a longer period of time than those for the older employees. Cross-tested plans are often used by smaller businesses to provide substantial contributions for highly compensated employees, with relatively low costs for coverage of other employees.

Forfeitures

A forfeiture is an unvested amount remaining in a participant's account when the participant terminates employment without being fully vested under the plan's vesting schedule. Thus, forfeitures can occur in any defined-contribution plan that does not have 100 percent immediate vesting. Forfeitures can be reallocated to accounts of other participants or used to reduce future employer contributions. In a profit-sharing plan, forfeitures are usually reallocated to participants to provide an additional incentive for continuing service.

Forfeitures must be allocated in a nondiscriminatory manner. In most plans, forfeiture allocations are made in the same manner as allocations of employer contributions—on the basis of compensation or a combination of compensation and service. The IRS usually will not accept a forfeiture allocation provision based on account balances of remaining participants because such a provision may provide substantial discrimination.

Analysis of profit-sharing plans of smaller employers that have existed for a number of years generally shows that by far the largest account balances are those for highly compensated participants. This is because the combination of higher compensation, longer service (and therefore more years in the plan), and low turnover among the highly compensated group eventually produces a great disparity in account balances. This phenomenon is, in fact, one of the reasons why closely held businesses adopt profit-sharing plans. As such, they are not deemed to be discriminatory. However, if a plan contains any features designed to multiply this inherent discrimination (such as forfeiture allocation based on account balance), the IRS generally will not approve it.

CURRENT QUALIFIED PLAN TRENDS | Profit-Sharing and Similar Plans

Although only the traditional types of pension plans involve an employer commitment to adequate retirement income for employees, trends in management, the economy, and the workforce have produced a gradual erosion in qualified pension plan coverage and a movement toward "nonretirement" plans—that is, defined-contribution plans that provide a form of savings and incentive benefits for employees without a specific funding commitment by the employer. The reasons for this trend include the following:

Figure 1: Pension Coverage

• Competition and cost pressures to minimize wage and benefit costs

• Increasing acquisition, dissolution, and reorganization of business enterprises discourage employer long-term commitment to employees

• Decline in collective bargaining; labor unions have traditionally favored the defined-benefit plan

• Increased mobility in the workforce; the 40-year career with one employer has become a rarity

• Employers are using more part-time employees, leased employees, and independent contractors who would generally receive little benefit from a traditional pension plan

• Increase in families with two wage earners; traditional pension plans tend to duplicate benefits in such cases

We will discuss the following:

• Qualified profit-sharing plans

• Savings or thrift plans

• Employer stock plans (stock bonus plans and ESOPs)

Increasingly, the trend in qualified planning is toward salary savings plans such as 401(k) plans, which are primarily funded through employee salary reductions that are contributed to the plan. These plans are typically combined with the traditional employer-funded profit-sharing plans, or with those in which employer contributions match the employee salary reductions. First, to fully understand how salary savings plans work, the basic profit-sharing plan and its variants