11.2 Types of Retirement Plans

• Library: A Lawyer's Guide to Estate Planning: Fundamentals for the Legal Practitioner (ABA) (2018 Ed.)

11.2 Types of Retirement Plans¹

11.21 Pension Plans

A pension plan, which in the tax law is termed a defined benefit plan,²is a retirement plan that provides the participant with a fixed benefit. For example, participants may receive an annual retirement benefit equal to 60% of the participant's average annual salary based on the five consecutive years of the highest salary. The annual benefit cannot exceed the lesser of $220,000 per year in 2018, or 100% of the three consecutive years of the highest salary.³ The benefit cap is indexed annually for cost-of-living increases. The maximum benefit is payable at Social Security retirement age and is actuarially reduced for an earlier retirement.⁴

Planning Pointer 1

A pension plan is ideally suited for a small business when the owner earns a large salary and is older than most of the other employees because the contributions to a pension plan are not limited in amount. The employer simply contributes annually the actuarially determined amount needed to fund each employee's fixed retirement benefit. Thus, the bulk of the contributions is credited to the owner.

Caution: A disadvantage of a pension plan is that the employer's contribution needed to fund the retirement benefits is required each year, irrespective of the profitability of the business.

11.22 Profit-Sharing Plans

A profit-sharing plan, which in the tax law is one of several types of plans termed defined contribution plans,⁵ is a plan in which the employer's contribution to the plan is fixed. The benefit to be received by a participant is not fixed. For example, each year after the employer has reviewed year-end profits, a dollar amount is contributed to the plan that is then earmarked to each participant's account on a pro rata basis. Another approach is for the employer to annually contribute a fixed percentage of salary to each participant's account in the plan. The contribution limit is the lesser of 100% of the participant's compensation (not exceeding $275,000 in 2018 as adjusted yearly for inflation) or $55,000.⁶ The employer's income tax deduction is limited to 25% of total compensation, thus limiting the usage of the 100% maximum percentage.⁷

Unlike a pension plan, the participant's retirement benefit in a profit-sharing plan is uncertain. It is simply the amount contributed to his or her account plus the growth from the investment of those contributions. Another difference is that annual contributions are not required to be made to a profit-sharing plan. Thus, in years in which profitability is poor, only a small—or even no—contribution may be made.

Planning Pointer 2

A profit-sharing plan is ideally suited for young, well-paid business owners because they have many years for contributions to be made and for investment growth. For example, a contribution of $10,000 annually for a 25-year-old at 8% growth yields nearly $2.5 million at 65 years of age.

11.23 Money-Purchase Plans

A money-purchase plan is a defined contribution plan; however, the employer's contribution is fixed at a percentage of the participant's salary. Thus, it becomes a hybrid of a pension and a profit-sharing plan. Just as in a pension plan, the employer must make annual contributions, but as in a profit-sharing plan, the participant's benefit is uncertain because it depends on the investment experience. For example, in a money-purchase plan the employer sets an ongoing contribution commitment at a fixed percentage of salary, such as 10% of annual salary. The contribution limit for a money-purchase plan is the lesser of 25% of compensation or $55,000.

Caution: Because a money-purchase plan sets a fixed and ongoing financial commitment for the employer, future profitability of the business will have no effect on the requirement to fund the annual commitment to the plan. Only an established business with a lengthy history of profitability should consider this type of plan.

Planning Pointer 3

A money-purchase plan is simpler and less costly to implement and administer than a traditional pension plan, yet it assures the employees of a fixed commitment to the future from the business. Just as with a profit-sharing plan, a young, highly paid business owner will reap the greatest benefit from this plan.

11.24 401(k) Plans

There are two types of 401(k) plans: (1) a cash or deferred plan and (2) a salary reduction plan. In the cash or deferred plan, the employer's contribution may be received in cash by the employee and income tax paid on it, or the employee may elect to defer paying income tax on the contribution by having it credited to his or her 401(k) account.⁸ The salary reduction plan allows an...