Close_401(k)Gap

How to Close the 401(k) Gap

The Gap

As noted in previous editions of the “Retirement Roadmap” many employers have chosen to discontinue or terminate their traditional pension plans. Increased funding costs and the complexity of reporting and disclosure requirements for these traditional pension plans have doomed them to eventual extinction.

In the aftermath of the demise of the traditional pension plans many companies continue to search for ways to offer additional benefits to their key employees with tax advantaged savings plans. The reality is that given the current contribution limits the traditional salary deferral and match contribution into the executive’s 401(k) account will not allow the executive to accumulate sufficient assets to retire financially secure.

This difference is the 401(k) Gap!

What are employer’s options to close this gap? How can they close the gap for their executives without substantially increasing the benefit cost for their rank and file employees’ We will examine various options in this article.

Deferred Compensation Plans

Employees are permitted to defer for tax purposes a portion of their wages each year provided that the deferred compensation is a part of a written agreement executed between the employee and the employer. IRS rules also require that the written agreement was in place before the employee actually earned the revenue. These plans are commonly know as “Non-Qualified” plans.

Section 409A of the Internal Revenue Code was added in 2004 to provide employers with additional guidance regarding the operation of non-qualified deferred compensation plans. The IRS issued final regulations on Code Section 409A during 2007 and employers must make sure their non-qualified plans are in compliance with these rules changes by December 31, 2007.

The primary advantage of a non-qualified plan is the employer is free to discriminate in designating which employees may participate in the plan. With more flexibility there tends to be a wide variety of plan designs. One common design is to allow key executives to defer compensation in excess of the annual 401(k) salary deferral limit ($15,500 for 2007). There is no set dollar limit for contributions to a non-qualified plan, which is another significant advantage as compared to qualified plans.

In a non-qualified plan the compensation deferred by the employees remains an asset of the employer. This is in contrast to a qualified plan in which contributions are placed in a separate legal trust entity for the exclusive benefit of the participants and beyond the reach of the employer or its’ creditors.

Non-qualified plans have one significant disadvantage for employers. The compensation deferred cannot be deducted by the employer until the employee receives a distribution of the money in the plan.

In addition, since the assets held in the deferred compensation plan are technically an asset of the employer, any taxable income generated by the investments must be reported by the employer. Employers have typically addressed this issue by investing the amounts contributed for deferred compensation plans in some type if insurance product which would shield the employer from tax liability until the amounts are distributed to the employee.

A recent development in this area is the use of Exchanged Traded Funds as an alternative to the insurance investment products. ETFs are generally a very tax efficient investment vehicle that tend to generate minimal tax consequences until the investment is liquidated.

Qualified Plan Solutions

Many employers have followed these two approaches to increasing benefits for the employer’s key executives using a qualified plan.

Cross-Tested Profit Sharing Contribution

The employer’s 401(k) plan may be amended to add an employer funded profit sharing contribution. In order to ensure that key executives can reach the maximum contribution permitted in a defined contribution plan ($45,000 for 2007) the contribution allocation formula may be designed to permit a higher level of contribution to certain classes of employees. A typical approach would be to design a formula which would permit the key executives to reach the maximum contribution amount and a formula for the rank and file contribution to minimize the contribution as much as possible. These types of plans are subject to IRS discrimination and coverage testing rules. These discrimination tests must be completed each year to ensure the plan remains qualified.

Cash Balance Pension Plan

Although traditional pension plans have fallen out of favor with employers many are using a “hybrid” defined benefit plan commonly known as a Cash Balance Pension Plan to increase the tax qualified retirement accounts for their key executives.

Cash Balance Plans are referred to as “hybrid” pension plans because they merge certain aspects of a defined benefit plan with the operational characteristics of a defined contribution plan. Employer contributions to a Cash Balance Plan are based on actuarial estimates designed to accumulate a targeted monthly benefit for the employee upon their retirement. However, unlike a defined benefit pension plan, after the contribution has been actuarially determined the employer’s contribution is placed into an account balance for the employee. This account balance can be tracked by the employee similar to their 401(k) Plan. This account balance ultimately determines the employees’ benefit from the plan.

The key advantage of the Cash Balance Plan is the contribution is not limited to $45,000 defined contribution plan limit. In fact the contributions under the cash balance plan can be made in addition to the $45,000 contribution to the employer’s profit sharing plan.

Since the Cash Balance Plan is a qualified plan it is also subject to the IRS discrimination and coverage rules. IRS regulations permit the Cash Balance Plan to be cross-tested with the employer’s 401(k)/Profit Sharing Plan. Cross-testing both plans will generally result in reducing the funding required for the rank and file employees to the Cash Balance Plan.

Contributions to both of these plan are may be deducted by the employer in the year of the contribution.

Retirement Solutions Advisors has assisted many clients with the design and implementation of each type of plan discussed in this article. If you believe you and your key executives require additional contributions into a retirement plan to ensure financial security for retirement, please feel free to contact Steve Johnson so that we assist you in designing a plan that fits best for your Company. Steve can be reached by phone at (312) 923-8700 Ext 232 and by e-mail at steve.johnson@rsadvisorsllc.com

Welcome William!

William Brennan has joined Retirement Solutions Advisors, LLC in the position of sales and business development. William’s focus will be working directly with prospective clients and advisors to help them understand RSA’s services and identify opportunities for RSA to assist their organizations with improving their retirement benefit plans.

William is a recent Cum Laude graduate of Middlebury College in Vermont. He joins RSA after playing professional soccer with the Rockford Thunder of the American Indoor Soccer League.

William can be reached by phone at 312-923-8700 extension 240 and by e-mail at william.brennan@rsadvisorsllc.com.