Chapter 5

The World of Defined Contribution Plans

Introduction

You should already have an awareness that defined contribution plans shield the employer from investment risk. Some plan types provide the employer with the flexibility of discretionary contributions. Others enable the employees to get involved actively in saving for their own retirement. This is a great way to encourage people to understand better and to engage in planning for their future retirement needs. There are also some creative solutions to help small business owners cash out of their business in a tax-favorable way. A financial professional should understand the broad opportunities available under the various plan types and be able to help clients choose which type is best suited to their stated needs.

Learning Goals

•Describe the basic features of a profit-sharing plan and its potential usefulness

•Describe the features and rules that apply to a 401(k) plan

•Identify the difference between a hardship withdrawal and a safe harbor withdrawal

•Understand the compliance tests required within a 401(k) plan

•Describe the rules that pertain to stock bonus plans and employee stock ownership plans (ESOPs)

•Understand how an ESOP loan could be applied

Profit-Sharing Plans

A profit-sharing retirement plan (PSRP) offers a very valuable benefit to both the employee and the employer. The employee receives a retirement contribution from the employer, which is always a good thing. A PSRP is treated like a defined contribution plan in that all investment risk resides with the employee. The employer simply makes a contribution, and the ultimate outcome is up to the participant’s investment selections. The employer will benefit from discretionary contributions.

The board of directors of the company has discretion over whether contributions are made for any given year. The board can allocate a portion of the business’s profits to the employees using a PSRP. However, the company is not required to post a profit to make a contribution. A lack of profits could trigger the temporary suspension of employer contributions. This suspension should not last for multiple years in a row, or the regulators could view the plan as not being active, which could be a problem for reinstating contributions.

Contributions into a profit-sharing plan are based on a level percentage of compensation. The upper limit for contributions into a PSRP is 25 percent of aggregate compensation with a cap of $52,000 (2014 limit). A profit-sharing plan can be integrated with the employee’s Social Security benefits. This feature will be discussed in detail in Chapter 8. We will also discuss later the ability to either “age-weight” or “cross test” a PSRP, which are two techniques for shifting a higher percentage of the company’s contribution to highly compensated employees (HCEs). Both of these techniques can be used legally to discriminate in favor of HCEs. Pay attention later in this book for a detailed discussion on these techniques.

Consider Johnson’s Hobby Warehouse who wants to make a $50,000 contribution to its company’s profit-sharing plan. The company has three employees. Employee A (the business owner) earns $100,000, while employee B earns $60,000, and employee C earns $40,000. In the most basic profit-sharing calculation, employee A will receive an allocation of $25,000 {$50,000/[$100,000/$200,000 (total compensation)]}.

Unlike defined benefit plans, a PSRP permits in-service hardship withdrawals. Hardship does not mean that the participant is dying to go on a trip. This term is reserved for unforeseen financial emergencies. In the case of true hardship, employees can access their retirement savings to help lighten the burden. We will talk in detail about this concept later.

Employees are also eligible to take loans from a profit-sharing plan. They can also take a loan from a 401(k) or a 403(b) plan. For money to be eligible for a hardship withdrawal or a loan, it must meet two tests. First, the employee needs to have at least five years’ tenure with a given company. Second, the money being withdrawn must have been in the account for at least two years. In July of 2014, a long-tenured employee could access money that was contributed as recently as June of 2012, but nothing contributed in between until the two-year window has moved past a given contribution.

The most important benefit of a profit-sharing plan is that the employer has complete flexibility. Remember this benefit! The two biggest arguments against it are that (1) the company cannot provide for a targeted replacement ratio for its retirees, and (2) there is no adjustment for past service.

401(k)

One of the most well-known retirement savings accounts is the 401(k) plan. It is often offered to employees as part of a cafeteria plan (where they get to choose which basket of benefits they want to accept from their employer). It receives such prominence because most employers offer a plan of this type. An employer can elect to contribute to both a profit-sharing plan and a 401(k) if they so choose. But unlike a profit-sharing plan, the 401(k) requires the employee to contribute money out of his or her gross compensation. In most cases, the employee’s contribution is then matched by the company. According to a recent report by the Internal Revenue Service (IRS), matching contributions are offered by 68 percent of employers, and larger employers are more likely than smaller employers to offer a match.1 This same report found that 15 percent of employers either suspended or reduced their matching contributions.

The concept of a match effectively creates a retirement partnership between the employee and the employer. The employer’s contributions can be either fixed or discretionary. The employer might say that they will match an employee’s contributions dollar for dollar up to a maximum of five percent of compensation, but then the employer could also make a discretionary additional contribution if the company’s board so chooses, based upon profit targets or some other internal metric. However, sometimes the company will not match dollar for dollar. Some companies choose to match $0.50 on the dollar (1 dollar from the company for every 2 dollars contributed by the employee), while some choose custom-matching combinations.

Employees are always able to make non-tax-deductible contributions. They might consider doing this if they have already contributed the entire threshold amount of $17,500 (2014 limit). You will learn more about nondeductible contributions later. A typical 401(k) will offer an assortment of various mutual funds, annuity products, and perhaps even the employer’s stock.

Recall the concept of vesting, which is the point when an employee owns the contribution into their account. The employee is always 100 percent (fully) vested in his or her own salary deferrals (contributions) from day one. It is the employer’s contributions that are typically subject to a sliding vesting schedule. For example, an employer might have a policy that employees fully own the employer’s contributions after three years of service have been completed.

We will discuss individual retirement accounts (IRAs) in detail later in this book, but you do need to know that 401(k)s have a substantial advantage over IRAs…a higher contribution limit. A 401(k) offers a contribution limit of $17,500 (2014 limit), while an IRA is much lower at $5,500 (2014 limit). A 401(k) also has the added benefit of an employer’s matching contributions.

A hardship withdrawal is a government-sanctioned way for an employee to withdraw money from the retirement account in the event of an unforeseen emergency. Within a 401(k), employees always have access to hardship withdrawals on the money that was deferred from their gross wages. This access is not limited by the two-year rule, which is imposed on profit-sharing plans. However, the portion of the account that results from the employer’s contributions is not available for hardship withdrawals.

To access a hardship withdrawal, the IRS has mandated that a hardship event must (1) be because of an “immediate and heavy financial need” and (2) be limited to the amount necessary to satisfy that financial need.2 Companies can exercise some discretion in determining what constitutes a hardship event, but the federal government has created a subset of hardship withdrawals that provides a list of events, known as safe harbor events, that MUST be considered a hardship event. The company can be more generous than this list if they wish, as long as they remain within the two IRS guidelines mentioned previously.

Figure 5.1 illustrates visually that safe harbor events are truly a subset of the larger basket of hardship withdrawals. The IRS has provided a list of safe harbor events, which includes medical care for an employee, his or her spouse, or dependents, costs related to the purchase of a principal residence, college tuition and related educational expenses, payments to prevent eviction or foreclosure on a principal residence, funeral expenses, and some home repair expenses. Disability is also a common safe harbor inclusion.

Figure 5.1 Safe harbor vs. hardship withdrawals

Most withdrawals from a retirement account, before age 59½, will result in a 10 percent early withdrawal penalty. Hardship withdrawals are no exception, although there are a few designated safe harbor events that are also 10 percent penalty free. This group of penalty-free withdrawals include needs such as disability, medical expenses that exceed 7.5 percent of adjusted gross income (tax terminology for taxable income), certain payments related to divorce, employment termination after age 55, and a series of substantially equal payments (you will learn about this special feature later). However, 401(k) plans are always permitted to allow employees to take loans from their accounts. We will discuss loans in detail in another chapter, but according to a recent IRA report, only 65 percent of employers have enabled loans within their 401(k) plans.3

It should be mentioned that preretirement withdrawals from retirement savings accounts should be avoided except as an absolute last resort. If the money is not in a participant’s retirement account, then it is not compounding tax-free, and their retirement well-being may be put in jeopardy as a result.

Most 401(k)s offer a series of mutual funds from which participants may choose. Some funds offer education on investment allocation, while others leave the participants to their own fate. Some 401(k)s also offer something called a brokerage window, which is a potential opportunity for diversification if the participants either know what they are doing with investments or they have hired a professional to help them. A brokerage window involves switching some of the participants’ funds out of the constraints of the limited pool of investments offered within the 401(k) and into a brokerage account (perhaps at Charles Schwab or TD Ameritrade) where the participants can purchase stocks or exchange-traded funds (ETFs) with their 401(k) assets.

As we move forward in human history, the 401(k) will likely be an area that experiences changes. Some employers have stopped offering matching incentives. Others, like IBM, have not gone this far, but they have decided to only make a matching contribution once per year.4 This has the negative side effect of participants missing out on several months’ worth of compound growth, and if they change jobs before the annual contribution is made, then they may miss out on the employer’s match altogether.

401(k) Compliance Testing

To prove that they do not unfairly benefit HCEs, 401(k) plans must past a nondiscrimination test called the actual deferral percentage (ADP) test. The ADP is simply the percentage of an employee’s salary, which is deferred [contributed into his or her 401(k) plan].

The first step in conducting the ADP test is to establish the definition of HCEs. They are anyone who own at least 5 percent of the business either in the current or prior year OR someone who earned more than $115,000 in 2013. Anyone who is not an HCE is by default called a nonhighly compensated employee (NHCE).

Each 401(k) plan must pass one of two tests to satisfy nondiscrimination regulation. To conduct both of these tests, a financial professional will need to know the average ADP for the HCEs and the average ADP for the NHCEs. The first test is called the ADP 1.25 test. With the ADP 1.25 test, the average ADP for HCEs cannot exceed 125 percent of the ADP for NHCEs. For example, if NHCEs have an average ADP of 6 percent, then HCEs cannot have an average ADP higher than 7.5 percent (6% × 1.25). Anything higher than 7.5 percent for HCEs would present a violation of nondiscrimination laws. The second test is called the ADP 2.0 test. With the ADP 2.0 test, the threshold is that HCEs must contribute no more than 200 percent of what NHCEs contribute, with the added provision that the difference between the two groups’ average cannot exceed 2 percent. That is a lot to digest! Consider a situation where the average ADP of HCEs is 8 percent while the average ADP of NHCEs is 6 percent. The HCEs’ rate is less than 200 percent above that of the NHCEs, and it is exactly 2 percent away… so they pass the ADP 2.0 test. What if the NHCEs’ average ADP drops down to 5 percent? Then the HCEs are still less than 200 percent above the NHCEs, but they are more than 2 percent different. In this case, the HCEs would be forced to reduce their savings to 7 percent.

Under a rule known as prior year testing, the percentage of average ADP for NHCEs in a given year will determine the allowable percentage rate for HCEs in the next calendar year.

The ADP test is used for 401(k) plans that do not have a matching contribution. If the employer offers matching contributions, then the appropriate test is called the actual contribution percentage (ACP) test. Both the ADP and the ACP tests follow the same logic. The ADP test calculates percentages based on the employee’s contributions only, while the ACP factors both the employee’s and the employer’s contributions.

It seems almost counterintuitive, but opening eligibility to all employees might create an issue in passing the ADP (or ACP) tests. Consider a company that is very generous on eligibility for 401(k) plan participation. If there is a group of NHCEs that are eligible but elect to contribute 0 percent, then that will dramatically lower the average percentage for the NHCE universe, which will result in a lower percentage of allowable contribution for HCEs.

There is one valuable exception to adherence in passing either the ADP 1.25 or the ADP 2.0 test. The company can make what is called a safe harbor contribution to a 401(k) plan. Under a safe harbor contribution, the employer can pick one of two contribution types that would completely eliminate the need for costly annual ADP testing. The first safe harbor choice is for the company to match dollar for dollar all employee contributions up to 4 percent of each employee’s compensation. This is the most popular choice. The second safe harbor choice is for the company to contribute 3 percent of each employee’s compensation whether or not the employees contribute any money themselves. When an employer contributes regardless of whether employees also defer some of their salary, it is called a nonelective contribution.

According to the IRS, 43 percent of all 401(k) plans are organized as safe harbor plans.5 This study also found that smaller employers are more likely to offer a safe harbor contribution than larger employers. This makes sense because the managers of a smaller company are more likely to also be the owners or decision makers of the firm, and they are most interested in providing a safe harbor plan to enable themselves to continue to have a retirement benefit and get around coverage testing requirements.

Why would an employer want to make a safe harbor contribution to a 401(k), which locks them into making a certain contribution? If they do make a safe harbor contribution, then they escape coverage testing (ADP or ACP). An employer might not pass the ADP test, but if they are willing to make at least a 3 percent nonelective contribution, then they could establish a safe harbor plan and be able to make contributions for the management and perhaps the owners if it is a smaller employer.

According to the final Treasury regulation T.D. 9641, an important caveat is that if the employer ever decides to stop making safe harbor contributions and just makes normal 401(k) matching contributions, they have a few hoops to jump through.6 First, all safe harbor contributions due through the cancelation of the safe harbor concept must be made. Second, the plan will now revert to being subject to either the ADP or the ACP test for the full plan year. If an employer who is operating under a plan year from January to December decides to stop making safe harbor contributions in November, then they will be tested for coverage compliance for the entire plan year and not just the remainder of the plan year not yet passed.

Stock Bonus Plans

A stock bonus plan is very similar to a profit-sharing plan in that the employer has discretion over the contributions. However, the contributions do not need to be based on corporate profitability. When the employer does make a contribution, it is either in the form of company stock or in cash, which is then used to purchase company stock. A stock bonus plan can include a 401(k) feature, which allows employees to contribute as well. Distributions from a stock bonus plan will ultimately be in the form of company stock.

Stock bonus plans are somewhat unique in that they require accelerated distributions in retirement. Distributions must begin no later than one year after retirement, OR the time period could be extended to six years if the employee separated from service (changed jobs) prior to retirement.

Unlike 401(k)s, a distribution from a stock bonus plan is not rolled over into an IRA to extend the tax deferral further. Distributions from a stock bonus plan can take two forms. The first is a lump sum distribution. In this case, the employee has a unique tax benefit called the net unrealized appreciation (NUA) rule. This basically means that the employee can take a lump sum distribution of shares out of the stock bonus plan, but do not pay any taxes until he or she eventually sells the shares. When the shares are eventually sold, the employee will receive the more favorable capital gains tax rates! The other distribution option is to receive what is called a series of substantially equal payments over no longer than five years. A series of substantially equal payments will be taxed at the typically higher ordinary income rate.

The NUA rule is a great benefit, but this concept assumes that there is a public market for the company’s stock. What if the company is not publically traded? In this case, the stock bonus plan must come with a required put option feature. This means that the employer must offer to buy the nonpublically traded shares back from the employee at a reasonable valuation. Companies will often purchase insurance to help offset the costs associated with a put option liability.

One of the very important features that is inherent with stock ownership is the standard voting rights. Employees who own shares of stock through a stock bonus plan will retain all voting rights associated with the shares that they own.

The primary advantages of a stock bonus plan are that the employer receives a tax deduction at the tie that shares are contributed to the plan. It also provides the employee a vested interest in the well-being of the company. It is amazing what an ownership interest can do for employee motivation.

There are, however, some challenges that this plan type creates for employees. They now bear the risk of having an undiversified retirement portfolio. Whatever happens to the company’s stock happens to them. Now, both their retirement and their livelihood are dependent upon one company’s prosperity.

Employee Stock Ownership Plan

An ESOP is another form of defined contribution profit-sharing-type plan. This type of plan involves the employer establishing a trust to own shares of the corporation. The shares are then allocated to eligible employees’ individual accounts. The company might fund the trust with shares that it owns (treasury stock), with cash from its balance sheet that will be used to purchase shares or from the proceeds from borrowings that will be used to buy shares. More on ESOP loans in a moment.

Stock bonus plans and ESOPs are both designed to encourage the employees to invest in their employer. These are both defined contribution plans that create more demand for the employer’s stock. These are both tax-deferred savings options, which means that any growth in the account is not taxed until distributed.

ESOPs are certainly used as a motivational tool for employees, but the real benefit comes from the ability to liquidate a departing owner in a tax-favorable way. The ESOP could be used to purchase shares from an owner who is leaving the company.

One funding method that was mentioned is creating an ESOP loan. This is a scenario in which the ESOP will borrow money to purchase shares of stock. The company guarantees the loan, and the ESOP buys shares from a departing owner, from a specific group of investors, or from the open market (secondary market). The company will then hold the shares as collateral against the loan, while they are making loan payments. As loan payments are made, the company will transfer blocks of shares into individual employee accounts.

The ESOP concept and the loan feature, in particular, create a unique tax situation for the company. Any contributions that the company makes into the account are tax deductible. It does not matter if the contributions are cash, stock, or cash for ESOP loan repayment. All inflows into the account are deductible! Recall that profit-sharing-type plans can only deduct up to 25 percent of gross compensation for an employee. ESOPs have a provision that extend the allowable deduction beyond 25 percent if the additional money is used to repay the ESOP loan. This increased deduction is a tremendous tax benefit for the company and its owner(s).

Dividend-paying companies can also pay a dividend on the shares held in trust within the ESOP (not yet distributed to employee accounts). The previously nondeductible dividends are now transformed into being tax deductible! Additionally, if the company is organized as an S corporation (meaning pass-through of profits like a partnership but with benefits of a corporation), then whatever portion of the profits are attributed to ESOP ownership are not taxed in the current year! Those profits are taxed as the employee’s account balance is taxed upon ultimate distribution.

The most significant ESOP tax benefit is called unrecognition of gains. Internal Revenue Code §1042(3) states that the owner who is selling shares to the ESOP can defer paying capital gains tax on their shares if the ESOP owns 30 percent or more of the company and the proceeds from buying out the owner are used by the departing owner to purchase shares of other domestic corporations.7 The replacement securities will then have a basis commensurate with the business that was sold to the ESOP. The departing owners will then pay capital gains taxes on the gain in the business they sold when they eventually sell the new replacement securities. Consider a business owner who sells all of his shares to an ESOP, which, after the sale, owns 35 percent of the company. The departing owner’s basis in the company was $250,000 and he received value of $3,000,000 from the ESOP transaction. Assuming that the departing owner uses the $3,000,000 to purchase the shares of a domestic corporation(s), then the capital gains taxes due on the gain of $2,750,000 will not be due until the replacement company is eventually sold. The replacement domestic company does not need to be a privately held company. It could be shares of a publically traded company like Procter & Gamble or Hershey Foods. This is a distinct benefit because it permits the departing owner to select the timing of taxation, which can help to manage tax brackets.

ESOPs share the requirements of a stock bonus plan with the exception of a diversification rule. ESOPs must be invested primarily in the issuing company’s stock. However, once employees reach age 55 (theoretically 10 years prior to retirement age), they must be given the option for the company to diversify their holdings within their ESOP account. The diversification could be anywhere between 25 and 50 percent of the account depending upon their age.

Unfortunately, ESOPs are not available for partnerships. Another potential caveat applies to privately held companies. Private companies will incur additional expense to maintain an ESOP because they must pay to have the company valued annually and in the event of an ESOP participant leaving the company, they will need to pay the employee cash for the value of the shares. Another concern is the potential dilution effect of new shareholders. If the company issues new shares, then existing shareholders will still own the same number of shares, but with a reduced voting and ownership percentage. The vast majority of companies that offer an ESOP plan are small businesses (S corporations) and the data suggest that those with an ESOP in place perform better financially than their peers who do not have an ESOP in place.8

Discussion Questions

1.An employer approaches you for advice on which type of retirement plan might be best for them. After completing a fact-finding meeting with the employer, you learn that the company has highly unpredictable cash flows. They do not want to assume any investment risk, but they do want the ability to provide retirement value to their employees. The executives also want the ability to take plan loans, should the need arise. They don’t have any interest in accounting for past years of service. The employer simply wants to offer a benefit to retain their most valuable employees. Which type of plan would you recommend to the business owners? Why?

2.A surgeon for a hospital system in rural Kentucky contributes $17,500 in salary deferrals into the 403(b) account at his hospital. This doctor also operates a private medical practice. He is considering establishing a 401(k) within the medical practice to shelter even more money from taxes. How much can this doctor contribute to the new 401(k) plan if it is established?

3.A company has adopted a 401(k) plan. The participants, their respective compensation, and their applicable percentage contributed (including employee and employer match) are as follows:

4.An employee who is covered by a 401(k) plan mentions to you that she is planning on taking a $15,000 hardship withdrawal from her retirement plan to pay for an unforeseen emergency to renovate their kitchen before the holidays. What would you tell her?

5.A closely held company has an original owner who is about to retire. The company has a defined benefit pension plan, which has already served the purpose of providing benefits for the current owner. Assume that the owner does not have any family members interested in the business and that the employees have worked for the company for a long time. The owner considers his employees to be potential buyers of the company.

6.Having heard that you took a class on retirement planning, your cousin approaches you with a question about ESOPs. Your cousin owns a portion of a regional engineering company, and he is planning on selling his interest to the ESOP sponsored by his employer. The ESOP currently owns 52 percent of the company, and your cousin acquired his 10 percent ownership interest 15 years ago for $50,000. The company has done very well, and now that your cousin’s portion of the company has risen to $1,000,000 he feels ready to retire at his current age of 66. What advice would you give him?