Today's qualified retirement plan marketplace is dominated by 401(k) plans, in which eligible employees may defer a portion of compensation on a pre-tax basis and employers may also contribute through profit sharing or matching contributions. However, for business owners and key executives, combining a 401(k) plan with a traditional Defined Benefit plan may provide increased potential for wealth accumulation and tax savings.
When your firm's objectives include minimizing taxes and maximizing wealth accumulation for owners and key employees, Defined Contribution plans, such as Profit Sharing and 401(k) plans, may fall short.
• The maximum dollar additions to an individual account, from employee and employer sources combined, is $40,000 in 2002;
• 401(k) is limited to 11,000;
• A special discrimination test that applies to 401(k) contributions may result in a taxable distribution to a highly compensated employee of a portion of his/her contribution.
A change in the tax code has provided Defined Benefit Plans with more appeal to firms with key employees nearing retirement age who need to accelerate funding of their retirment plan.
Until the January 2000 plan year, the Internal Revenue Code (IRC) section 415(e) limited contributions to an individual who participated in both a Defined Benefit plan and a Defined Contribution plan maintained by the same employer. Section 415(e) was repealed allowing firms to accelerate their pension plans up to the maximum benefit limit of $160,000 and receive a tax deduction for the cost of funding the plan.
Traditional Defined Benefit Pension plans may provide an excellent vehicle to maximize benefits to owners and key employees. In addition, a number of age-sensitive allocation techniques used in a Defined Benefit pension plan may provide greater allocations to owners and key employees nearing retirement age.
How it works
A Defined Benefit Pension Plan generally provides for distributions to participants in the years after retirement. Retirement benefits are measured by, and based upon, such factors as years of service and compensation. In 2002, the maximum annual benefit is limited to the lesser of $160,000 or an average of the participant's highest three years of compensation. In order to provide the promised benefits, the employer must contribute, or fund, an actuarially calculated amount. One advantage of a Defined Benefit Plan is the ability to contribute amounts that exceed the limit imposed upon Defined Contribution plan participants, i.e., the lesser of 100 percent of compensation or $40,000. This difference may allow for greater tax-deductible contributions.
Defined Benefit Plan values typically start accruing at a low rate during early years of plan participation and increase rapidly as a participant approaches normal retirement age - conversely a Defined Contribution plan's calculation of benefits, tend to accrue more evenly over the participant's working years. Thus, Defined Benefit Plans often benefit older, higher-paid owners and key employees. Likewise, the cost of providing benefits to short-service employees may be lower than the comparative cost in a Defined Contribution plan, though it may also be more expensive to fund a promised benefit for a participant nearing normal retirement age.
Risk and reward
In Defined Benefit Plans, the employer bears the investment risk. The actual rates of return on plan assets may be higher or lower then the actuarial assumptions that form the basis of the funding requirement. If rates of return exceed projected returns, future required employer contributions might decrease. If returns are below expectations, future required contributions might increase. Alternatively, if the employer desires to amend the benefit formula under the plan, additional assets generated through actuarial gains may be utilized to increase benefits under the plan.
A Defined Benefit Plan may be less expensive to fund as compared to a Defined Contribution plan intended to provide similar levels of benefits at normal retirement age because:
• The potential investment gains in excess of expectations may reduce future required contributions
• The cost of providing benefits to younger, short-service employees may be lower.
In addition to providing maximum benefits to key employees, Defined Benefit Plans aim to benefit loyal, longer service employees. They may also be easier to administer than 401(k) plans because they are not subject to the 401(k) discrimination test, do not allow participants' involvement in plan asset investment decisions, and are generally accounted for annually.