This article is the first in a three-part series. Part two is here and part three will be available soon.
Typically, most benefits managers think of defined contribution plans as being synonymous with 401(k)-type plans. However, employers may want to consider other types of defined contribution plans, including profit sharing plans, money purchase plans, and target benefit plans.
These alternatives to salary-deferral plans can offer alternative ways of structuring deferred compensation and allow employers a greater number of options when designing a benefits package.
There are important differences between these types of plans. Critically, the last two — money purchase and target benefit plans — have mandatory contributions while the former, profit sharing or profit sharing with a salary deferral option, have discretionary contributions.
What is a profit sharing plan?
Treasury Regulation section 1.401-1(b)(1)(ii)defines a profit sharing plan as a plan established and maintained by an employer to provide for the participation in its profits by its employees or their beneficiaries. The plan must provide a definite predetermined formula for allocating the contributions made to the plan among the participants and for distributing the funds accumulated under the plan after a fixed number of years, the attainment of a stated age, or upon the prior occurrence of some event such as layoff, illness, disability, retirement, death, or severance of employment.
The term "plan" implies a program that is permanent rather than temporary. Although the employer may reserve the right to change or terminate the plan or discontinue contributions to it, the abandonment of the plan for any reason other than business necessity within a few years after it has taken effect will be evidence that the plan from its inception was not a bona fide program for the exclusive benefit of employees in general. To be a profit-sharing plan, there must be recurring and substantial contributions out of profits for the employees.
This definition identifies several conditions that are necessary to maintain a valid profit sharing plan:
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Employees must have the opportunity to share in the employer's profits.
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The plan must be intended to be permanent.
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The contributions must be recurring and substantial.
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The plan document must provide for distributions to employees at times specified in the plan.
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The plan document must provide a nondiscriminatory method for allocation of the contributions.
Although the original concept and basis for profit sharing plans was for employees to share in profits, that was changed by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). Section 1011(A)(j)(2) of TAMRA eliminated the need for contributions to be based on profits and allowed for the adoption of profit sharing plans by tax-exempt organizations. As a result of that change, a "profit sharing" plan is really a discretionary defined contribution plan.
After the contribution is determined, the plan must provide a method of allocating that contribution to the eligible employees. The traditional method is based solely on each participant's compensation. More recent developments in profit sharing plan design add the participant's age and service to the variables. Contributions are limited to the lesser of 25 percent of the employee's compensation or a dollar limit. For 2014, eligible compensation is limited to $260,000 and the dollar limit is capped at $52,000.
Because a profit sharing plan, like all other defined contribution plans, is an individual account plan, section 411(b)(3)(C) of the Internal Revenue Code mandates periodic (at least annual) valuations of assets to determine each participant's accrued benefit, i.e., the value of the individual account balances. In most cases, this is a simple matter unless the plan holds assets that are not easily valued, e.g., real estate, limited partnership shares, or collectibles. These assets should be valued by an outside appraiser, and appropriate documents in support of the appraisal should be kept on file with the plan documents.
Typically the assets in a profit sharing plan are pooled and reported to participants on a balance-forward basis. Each employee's opening balance, gains or losses, and contribution is reported when year-end participant statements are provided. In a plan that provides for self-directed investments, e.g. 401(k) plans, the employee's accounts are not pooled but maintained individually so values are available daily.
What is a money purchase plan?
As part of the general classification of defined contribution plans, in which the contribution rather than the retirement benefit is defined, the contributions to profit sharing plans are discretionary. This classification includes money purchase and target benefit plans (even though they are sometimes lumped together with "pension" plans). The main difference between these plan types and profit sharing plans is the requirement that contributions to money purchase and target benefit plans are mandatory. If the required contribution to a money purchase or target benefit plan is not made when due, there is an excise tax to the extent minimum funding standards are not satisfied.
Minimum funding standards define the minimum contribution required to satisfy benefits provided for in a money purchase or target benefit plan. According to section 412(c)(10)(B) of the Internal Revenue Code, contributions to all "pension" plans (money purchase, target benefit, and defined benefit) must be made by eight and one-half months after the end of the plan year to meet the minimum funding standards. If the contribution is not made, an excise tax is imposed equal to 10 percent of the funding deficiency. If the deficiency is not corrected, the Internal Revenue Service (IRS) has the authority to impose an additional 100 percent excise tax.
All "pension" plans, including money purchase and target benefit plans, must provide for "definitely determinable benefits" for its employees in order to be considered a qualified plan under the Internal Revenue Code. Treasury Regulation section 1.401-1 specifies that in order to be definitely determinable, the benefits must be provided to the employees through fixed (mandatory) contributions that are determined without reference to profits.
Definitely determinable benefits can be loosely defined as the ability of an outside party to read the plan document and determine the contribution or benefit for the employee given the employee's compensation for the period. The determination of the benefit in a defined benefit pension plan or the contribution in a defined contribution pension plan is not subject to discretionary control.
Consistent with the purpose of pension plans, withdrawals may not be taken before death, disability, attainment of normal retirement age, termination of employment, or termination of the plan. Several Revenue Rulings have held that if the plan allowed for distributions during active employment but before retirement, the benefits would no longer be definitely determinable.
In a money purchase plan, the deductible limit for the plan sponsor is 25 percent of total compensation when compensation is limited to $260,000 for any one employee (for 2014), and the contribution is limited to $52,000 (for 2014).
Example 1. Following is an example of a simple money purchase plan that provides for a contribution of 25 percent of compensation. Harold and John are owners of the company. All others are employees.
Salary | Contribution | % of Total Contribution | |
Harold | $ 260,000 | $ 52,000 | 44.83% |
John | 100,000 | 25,000 | 21.55% |
Subtotal | $ 360,000 | $ 77,000 | 66.38% |
Nancy | $ 25,000 | $ 6,250 | 5.39% |
Max | 35,000 | 8,750 | 7.54% |
Louis | 28,000 | 7,000 | 6.03% |
Randy | 18,000 | 4,500 | 3.88% |
Jesse | 50,000 | 12,500 | 10.78% |
Subtotal | $ 156,000 | $ 39,000 | 33.62% |
Total | $ 516,000 | $ 116,000 | 100.00% |
A basic money purchase plan does not maximize the benefits for the owners of the company. Because a contribution of 25 percent of compensation exceeds the maximum allowable annual addition (currently the lesser of 100 percent of compensation or $52,000) for Harold, his contribution is capped at $52,000, the dollar limit.
Example 2. In a money purchase plan with a contribution formula of 20 percent rather than 25 percent Harold receives the same contribution; however, all other employee contributions are reduced.
Salary | Contribution | % of Total Contribution | |
Harold | $ 260,000 | $ 52,000 | 50.39% |
John | 100,000 | 20,000 | 19.38% |
Subtotal | $ 360,000 | $ 72,000 | 69.77% |
Nancy | $ 25,000 | 5,000 | 4.84% |
Max | 35,000 | 7,000 | 6.78% |
Louis | 28,000 | 5,600 | 5.43% |
Randy | 18,000 | 3,600 | 3.49% |
Jesse | 50,000 | 10,000 | 9.69% |
Subtotal | $ 156,000 | 31,200 | 30.23% |
Total | $ 516,000 | 103,200 | 100.00% |
By changing the contribution formula, Harold still has $52,000 allocated to his account but the total contribution for rank-and-file employees goes down by $7,800 ($39,000 – $31,200); however, John's contribution also goes down by $5,000.
In the plan shown in Example 2, forfeitures (the nonvested portion of terminated employees' accounts) should be used to reduce contributions even though the plan may allow forfeitures to be reallocated to the remaining participants. If the forfeitures are reallocated, Harold cannot share in those forfeitures because he is already at the maximum annual addition of $52,000.
What is a target benefit plan?
In profit sharing plans and money purchase plans, the contributions are all allocated based on compensation. If two other variables — the age of the participant and length of service — were added, the result would be a target benefit plan, which is a hybrid plan.
It begins as a defined benefit plan, i.e., the plan defines the resulting retirement benefit in the form of monthly retirement income.
After the contributions are calculated, there is no change to those contributions other than as a result of changes in compensation.
To understand how target benefit plans work, consider a parallel financial calculation that is used regularly:
Example. April would like to save for a larger house. She determines that he can handle a monthly mortgage payment of $1,500.
To do that, based on the price range of the house she can afford, she would have to put down a deposit of $50,000.
April is hoping to accumulate the down payment in five years through an investment in mutual funds that she projects will appreciate by 10 percent annually after taxes.
April has decided that if the mutual fund does not perform as expected, she will adjust her annual deposit so that at the end of the five-year period she will have the $50,000. Here is the result of April's plan:
End the Year | Deposit | End-of-Year Appreciation | Expected Balance | End-of-Year Balance |
1 | $ 8,190 | $ 819 | $ 9,009 | $ 9,009 |
2 | $ 8,190 | $ 1,300 | $ 18,499 | $ 18,919 |
3 | $ 8,610 | $ 2,100 | $ 29,209 | $ 29,820 |
4 | $ 8,801 | $ 4,560 | $ 42,570 | $ 41,811 |
5 | $ 7,431 | $ 50,001 | $ 50,000 |