Retirement Plan Comparisons
Wondering what the difference is between a 401(k) and a 403(b)? Confused about Safe Harbor 401(k)? And what is prevailing wage? Comparing retirement plans can be complicated, so we’ve rounded up the need-to-know information to get you started. And of course, we’re here to help when you are ready.
It’s great to compare retirement plans. You may also be interested in reading our Guide to Choosing a Retirement Plan, or talking with one of our retirement specialists.
A type of qualified defined contribution plan that permits employees to elect to defer compensation into the plan on a pre-tax (or in the case of Roth contributions, post-tax) basis. An account is maintained for each participant, and the retirement benefit is based on the account value at retirement. The retirement benefit will vary depending on the engagement of both employee and plan sponsor as well as market performance.
- Allows employees to elect to contribute to their retirement via payroll deductions.
- Allows employers to make match or non-elective profit sharing contributions.
- Employer contributions are tax deductible up to 25% of total eligible compensation.
- Allows flexibility with employer contributions, employers may elect to have discretionary or fixed contributions.
- Employee contributions and earnings are tax deferred until distributed at retirement (except in the case of Roth contributions).
- 401(k) plans are an extremely valuable employee benefit. To compete for talent, a 401(k) is expected. Having a plan that only offers employee contributions is better than having no plan at all.
There are two tests that may complicate this plan design:
- Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. In this test you divide the company into two groups – highly compensated employees (owners and non-sibling family, or those earning over $125,000 in 2019), and non-highly compensated employees (everyone who isn’t HCE). The people in the HCE group can defer or receive match contributions an average of 2% more than the average of the people in the NHCE group in most cases (when NHCE average is between 2 and 8%). This restricts the average amount the HCE group is allowed to defer. This test can be corrected with additional employer contributions or a distribution of HCE deferrals and/or match contributions in excess of the acceptable amount.
- Top Heavy test. If more than 60% of the plan assets are in the accounts of the business owner, non-sibling relatives of owners, or certain officers of the business, then the plan is considered “top heavy.” In general, when the plan is top heavy in the prior plan year, the employer must make a minimum contribution of 3% of pay to each of the eligible employees.
- Companies already passing or very close to passing the ADP test.
- Companies trying to benefit targeted HCEs over other HCEs.
- Companies that can’t afford to allow for mandatory safe harbor contributions.
- Owner-only or NHCE-only plans.
- Companies whose primary reason for installing the program is access to a 401(k) for employees.
- Companies whose primary reason for installing the program is to create a qualified trust for prevailing wage contributions.
401(k) Safe Harbor Plan
401(k) Safe Harbor plans are simply 401(k) plans that have adopted the safe harbor provision which provides an automatic “pass” to each of the ADP/ACP and top-heavy tests referenced above. This allows for owners and other HCEs to defer to the annual maximum each year regardless of average employee participation and a guaranteed pass on the ACP test for match formulas considered “safe harbor” (e.g., 100% match on deferrals up to 4% of compensation). Safe harbor plans require mandatory employer contributions each year.
- Allows employees to make contributions to the plan via payroll deduction.
- Allows HCEs to defer up to the 402(g) annual deferral limit each year.
- Allows employers to make match or non-elective profit sharing contributions.
- Employer contributions are tax deductible up to 25% of eligible employee compensation.
- Employee contributions are tax deferred until distributed at retirement (except in the case of Roth contributions).
- Allows access to discretionary employer match and/or profit sharing contributions.
- Mandatory annual safe harbor contributions to the plan. These may be 3% of compensation for each eligible employee (safe harbor non-elective) or as low as 4% of compensation for employees who choose to make 401(k)/Roth deferrals of at least 5% of compensation (safe harbor match).
- Safe harbor contributions must be immediately 100% vested.
- While the top-heavy test is deemed to pass which prevents the requirement of corrective minimum contributions due simply to deferrals, additional profit sharing contributions negate this automatic pass and safe harbor match plans may require additional contributions to employees who choose to not defer.
- New plans with owner and/or HCE interest that expect little to no voluntary employee participation.
- Existing plans with excessive corrective distributions or unaffordable corrective contributions.
- Family businesses.
- Current sponsors of a SIMPLE 401(k) who would appreciate an increase of deferral limits to $19,500 in 2020 from $13,000.
- Plans with a large discrepancy between owner and staff compensation.
- Companies that would like to attract talent with the promise of annual contributions to their retirement account.
A type of plan similar to a 401(k) plan, this plan type is only available to certain entities, including non-profit organizations under IRC 501(c)(3), and public educational and church organizations. The plan permits employees to defer compensation into the plan on a pre-tax (or in the case of Roth contributions, post-tax) basis.
- Allows employees to elect to defer contributions.
- Employer contributions are tax deductible up to 25% of eligible participants compensation.
- Employee contributions are tax deferred until taken out at retirement (except in the case of Roth contributions).
- Salary deferrals are not subject to compliance (ADP) testing.
- Certain plans may not be subject to ERISA.
- There is a Form 5500 filing requirement for 403(b) plans that have employer contributions.
- It is sometimes difficult to round up investment reports from each of the individual accounts to prepare the filing.
- 403(b) plans are either subject to ERISA (retirement plan rules), or not. Church plans covering employees of the church, and plans that have no employer contributions, are typically exempt from ERISA.
- A non-ERISA plan is not subject to testing or filing requirements.
Non-profit entities that will make no employer contribution, but who want the employees to have access to a retirement plan.
Profit Sharing Plan
A defined contribution plan under which the employer may determine, annually, how much will be contributed to the plan. However, regular contributions must be made to the plan to avoid IRS scrutiny. The plan details a formula for allocating to each participant a portion of each annual contribution, though the actual contribution amount may be fixed or discretionary. Profit sharing plans may exist in a trustee-directed, single, pooled trust account or in participant-directed individual accounts or both. Participant deferrals are typically placed in individual accounts. All 401(k) plans are profit sharing plans but not all profit sharing plans contain 401(k) or match contribution provisions.
- No additional payroll procedures to implement if no 401(k) provision.
- Gives employers simplicity in plan design and discretion over annual contributions.
- Provides benefits to a mix of rank-and-file employees and owner/managers.
- Contributions and earnings generally are taxed upon distribution.
- Retirement plans funded only with profit sharing contributions can be an expensive way to get the maximum annual contribution to targeted employees.
- It can be frustrating for employees if they are not allowed access to payroll deferrals through a 401(k).
- Companies simply looking for the tax advantages of a retirement plan without the burden or liability of additional payroll processes as a result of a 401(k) provision.
- Companies with a SEP looking for more flexibility with eligibility and distribution requirements and/or increased HCE favorability with contribution allocations.
- Owner or family-only companies.
- Companies who would like to attract talent with the promise of annual contributions to their retirement account.
Cash Balance Plan
A cash balance plan is a defined benefit plan with defined contribution characteristics. Similar to defined benefit plans, a cash balance plan promises to pay employees a certain amount of income at retirement via mandatory annual contributions. The risk of investment lies with the employer, and the plan is likely subject to Pension Benefit Guaranty Corporation (PBGC) oversight and fees. Like defined contribution plans, participant “accounts” are represented as dollar amounts so the benefit is easy to understand and there is a direct relationship between the contributions made currently and the promised benefit at retirement.
- Cash balance plans provide the advantages of a pension plan, but they are much easier to explain to employees. While benefits are still provided as they would be under a defined benefit plan, the cash balance participant has a “hypothetical account” which is equal to the “pay credits” and “interest credits” they have earned over their participation in the plan. This contribution formula also allows the employer greater predictability for the contribution, making it an extremely valuable tax planning tool.
- Contributions may be vested over a 3-year period from the inception of the plan.
- Deductibility of a defined benefit plan combined with the accessibility and effectiveness of a defined contribution plan.
- Contributions are required every year for at least three years (five is preferred) and, while providing a large benefit to a select few, may be very large.
- 40% of employees working at least 20 hours per week or salaried must be covered by the plan.
- If the investment portfolio does not return the rate defined for the “interest credit” then the contribution may have to be increased to make up for the shortfall; similarly, any rate of return that exceeds the prescribed amount results in a reduced contribution, thus tax deduction for that year.
- Actuarial calculations are required annually to determine the pay credit, interest credit, and additional portfolio adjustment contributions required.
- Changes to the company’s demographics may impact the funding formulas. Speak with your administrator before the end of the first quarter of the plan year to discuss what important amendments should be adopted to avoid unintentional contributions to terminated staff or failure to meet minimum coverage requirements of new staff.
- For cash balance to provide larger contributions to targeted employees, they must be combined with 401(k) profit sharing plans (called “combo” plans). This will require two separate documents, a series of compliance tests, and filing requirements so costs roughly the same as two plans to administer.
- PBGC premiums run about $83 per person in 2020 and are due 9 ½ months after the start of each plan year (10/15 for calendar plans). Professional services companies such as architects, engineers, attorneys, and doctors with less than 25 participants are exempt from PBGC.
- Considering the setup fees, TPA fees, actuarial fees, and PBGC premiums it had better be worth the increased tax deduction considering the new costs. When it works, it works.
- Small- to medium-sized companies that are looking to make significant contributions toward retirement for business owners and/or key employees in their mid-forties or older. In many instances, when paired with a 401(k) profit sharing plan, targeted individuals can get contributions of $100,000–$260,000 per year while contributions to employees may be as low as 5% of pay per year.
- Partners or owners who desire to contribute more than $50,000 a year to their retirement accounts.
- Companies that have demonstrated consistent profit patterns. Because a cash balance plan is a pension plan with required annual contributions, consistent cash flow and profit is very important.
- Partners or owners over 45 years of age who want to accelerate their pension savings. The older the participant, the faster they can accelerate their savings.
Defined Benefit Plan
A defined benefit plan promises to pay employees a certain amount of income at retirement. Contributions are made by the employer on a pre-tax basis and are intended to grow so there will be adequate funding at retirement. Employer contributions are based on a benefit formula stated in the plan that must be calculated by an actuary. In a defined benefit plan, the risk of the investment lies with the employer, as no matter how much the employer contributes, a participant is still guaranteed a specific retirement benefit. Defined Benefit plans are also subject to PBGC oversight and fees in most cases (see Cash Balance plans above for more information.
- The annual contributions are often significantly higher than with defined contribution plans, like 401(k) plans. Since contributions to qualified retirement plans are tax deductible, a defined benefit plan can prove to be a good tax-planning tool.
- Increased employer contributions compared to a defined contribution plan.
- Defined benefit plans require the services of an actuary to determine the contributions required each year.
- Contributions to the plan are required every year. A minimum number of employees must be funded, so a company needs to budget carefully and plan at least five years ahead. The rate of return that the portfolio provides is defined in the plan document. If the portfolio fails to return that rate, then additional contributions may be required to make up for the shortfall. Conversely, if the portfolio return exceeds the assumed plan rate, then contributions may be reduced resulting in possible tax planning challenges.
- Small successful companies with predictable cash flow, and few employees who are not owner or family.
- Owner-only companies where the owner is older than age 45 with predictable cash flow who want to contribute more than $60,000 to their retirement.
A defined contribution plan that invests primarily in company stock. An ESOP provides liquidity for shareholders that isn’t available for most non-publicly traded companies. It can be structured to provide a tax-advantaged transition of shares from a selling shareholder to the employees of the company.
- Employer tax deduction on contributions of cash or stock to the plan.
- May be used to acquire shares from selling/retiring shareholder.
- Employees become owners of the company through the plan.
- Employees recognize that they benefit directly from the success of the company.
- Plan trustees vote shares held by the plan, with certain exceptions, so there is no loss of control.
- S-Corporations that are 100% ESOP owned will have no corporate income tax since the shares are owned by a tax-exempt trust.
- Shares purchased with a loan guaranteed by the corporation will have an impact on the company’s balance sheet.
- Stock must be valued by an independent appraiser at each transaction, and annually.
- The plan invested primarily in company stock, so success of the plan depends heavily on the success of the business.
- Employees who terminate service may be able to request a distribution in the form of shares.
- Most terminated employees will ask to sell their shares back to the plan or to the company resulting in a need for liquidity within the plan.
- A business owner planning for retirement in the next five to ten years. He or she can continue to manage the company even after selling shares to the ESOP.
- If 30% or more of the shares are sold to the ESOP, the selling shareholder may be able to exchange company stock for a portfolio of publicly traded stocks. The §1042 exchange provides favorable tax treatment on the sale of stock.
- Companies whose employees are interested in an ownership stake in the company.
- Companies who have determined it is a preferred method of ownership transition.
An employee benefit plan that allows pre-tax contributions to fund benefits such as insurance premiums, dependent care, and/or uninsured medical expense reimbursement.
- Premium only plans allow for the employees to pay their expenses on a pre-tax basis.
- Dependent care expenses of up to $5,000 per year can be paid with pre-tax funds.
- Medical expenses that are not covered by insurance can be paid on a pre-tax basis. This is great for expenses like chiropractic, dental work, and large co-pays.
- Employer saves employment taxes on cafeteria plan contributions.
- Reduces workers’ compensation premiums.
- Dependent care and reimbursement accounts are use-it-or-lose-it. If the employee fails to remit reimbursement requests during the year or within the first 2½ months of the following year, funds are forfeited and remain in the company’s cafeteria plan account.
- Compliance testing is required. Contributions from key employees cannot represent more than 25% of the total premiums or total reimbursement contributions. For dependent care, the contributions from the key employees cannot exceed 50% of the total dependent care expenses.
- Companies that pass some of the insurance premium expense to their employees can at least offer a tax-favored way for the employee to pay those premiums.
- Insurance coverage for dependents can be paid with pre-tax dollars.
- If employees have a lot of out-of-pocket medical expenses, or dependent care expenses the plan can provide some relief.
A 457(b) plan may be adopted by §501(c)(3) non-profit entities. A 457(b) is often paired with a 403(b) or 401(k) where the executive director or management team is restricted from making maximum contributions to the existing plan. The 457(b) plan may be funded by the employee or the employer or both.
- Allows employees to elect to defer contributions via payroll deduction.
- May provide a benefit to certain highly compensated employees of tax-exempt, non-government agencies.
- These are considered “top hat” plans as eligibility is restricted to a select few employees of the company. There is an initial disclosure that must be submitted to the Department of Labor, but no other filings are required.
- A plan document is required for the 457(b) plan. Any changes to the group of employees eligible for the plan must be changed through plan amendment.
- 457(b) plan assets are considered assets of the employer, not of the individual for whom the contributions are made. Accounts may be set up on behalf of the employees, but are subject to creditors of the employer unless the plan is set up through a rabbi trust.
Non-profit entities whose executive director or management team is looking to increase contributions above and beyond what is available to them through the 401(k) or 403(b) plan sponsored by the employer.
In a rollover business startups (ROBS) plan, rollover money is used to buy stock for a business venture, startup or existing. With an individual account, the individual may elect to invest up to 100% of their account in the form of employer stock. By rolling cash into the plan, then using that cash to buy company stock, the cash is freed up to help with business expenses.
- Provides an opportunity for entrepreneurs to use their retirement savings to invest in themselves.
- Avoids immediate taxation on retirement plan funds.
- Provides funding for the new company, regardless of your credit rating or any other factors.
- There is no debt to repay or interest payments to make.
- Afford to re-invest more profits back into the company.
- Plan is available to C-corps only.
- If the business fails, your retirement savings are at risk.
- While the IRS has concluded that ROBS are not abusive tax avoidance transactions per se, they can be disqualified if they are not properly administered.
- Available stock must be offered to all eligible plan participants.
- Annual independent valuation of company must be performed.
C-corporations looking for more capital to fund their business ventures whose board is comfortable with making company stock available to all members of the retirement plan.
Many companies will choose to satisfy some or all of the prevailing wage law requirements by contributing that amount to a benefit plan (like a profit sharing plan) on behalf of the employee, rather than paying it to the employee in cash. If the contractor pays the fringe as compensation, the payment is subject to FICA and other payroll taxes. However, by contributing the fringe to a benefit plan, it is not subject to taxes.
- Savings in payroll taxes.
- Lowered workers’ compensation premiums (since the fringe benefits are not considered part of the payroll).
- Flexibility for company to deduct contributions to a tax-deferred plan for key employees with little or no contribution required for other employees.
- Can be combined with a 401(k) plan to allow both field and staff employees to reduce personal income taxes by contributing a portion of their gross paycheck on a pre-tax basis to a retirement plan with tax-deferred earnings.
- Some employers with existing safe harbor 401(k) profit sharing plans may want to consider utilizing the prevailing wage fringe to offset the required safe harbor contribution.
- Special consideration needs to be given to such plan design features as eligibility requirements, service crediting method, vesting, timing of contributions and the treatment of forfeitures.
Any open-shop contractor that intends to continue to pursue public works projects and is looking to bring their labor rate down by reducing their taxable liability.
Thanks for taking the time to compare retirement plans. Ready to take the next step? Talk to one of our retirement plan specialists and you’ll be on your way to retiring with confidence.