The Employee Retirement Income Security Act (ERISA) covers two types of pension plans: defined benefit plans and defined contribution plans.
A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service —for example, I percent of average salary for the last 5 years of employment for every year of service with an employer.
A defined contribution plan, on the other hand, does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee’s individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually. These contributions generally are invested on the employee’s behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.
A Simplified Employee Pension Plan (SEP) is a relatively uncomplicated retirement savings vehicles. A SEP allows employees to make contributions on a tax-favored basis to individual retirement accounts (IRAs) owned by the employees. SEPs are subject to minimal reporting and disclosure requirements. Under a SEP, an employee must set up an IRA to accept the employer’s contributions. Employers may no longer set up Salary Reduction SEPs. However, employers are permitted to establish SIMPLE IRA plans with salary reduction contributions. If an employer had a salary reduction SEP, the employer may continue to allow salary reduction contributions to the plan.
A Profit Sharing Plan or Stock Bonus Plan is a defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution. A profit sharing plan or stock bonus plan includes a 401(k) plan.
An Employee Stock Ownership Plan (ESOP) is a form of defined contribution plan in which the investments are primarily in employer stock.
A Money Purchase Pension Plan is a plan that requires fixed annual contributions from the employer to the employee’s individual account. Because a money purchase pension plan requires these regular contributions, the plan is subject to certain funding and other rules.
A 401(k) Plan is a defined contribution plan that is a cash or deferred arrangement. Employees can elect to defer receiving a portion of their salary, which is instead contributed on their behalf, before taxes, to the 401(k) plan. Sometimes the employer may match these contributions. There are special rules governing the operation of a 401(k) plan. For example, there is a dollar limit on the amount an employee may elect to defer each year. An employer must advise employees of any limits that may apply. Employees who participate in 401(k) plans assume responsibility for their retirement income by contributing part of their salary and, in many instances, by directing their own investments.
Safe Harbor Provisions: Every 401k must pass mandated compliance testing every year. The tests compare the participation rates of different classes of employees. Employers can choose to skip the tests and instead make a requisite contribution to their so-called non-highly-compensated employees’ 401k accounts. This is called the safe harbor method of plan administration.
The safe harbor method of plan operation lets 401k plans skip their annual 401k discrimination testing so long as the sponsoring employer meets certain employer 401k contribution requirements designed to ensure broad participation in the company plan and provides 100% immediate vesting of the contributions.
- To qualify a 401k plan as a safe harbor plan, an employer must make matching contributions that fulfill the below requirements or make non-elective contributions equal to 3% of each eligible employees’ compensation.
- Non-elective contributions are made to all eligible employees, regardless of if employees participate in the company 401k plan. Matching contributions, on the other hand, being based upon salary deferral amounts, are made only to active 401k participants’ accounts.
- If the employer chooses to make safe harbor matching contributions, those contributions must meet two requirements: First, each non-highly-compensated employee must receive a dollar-for-dollar match on salary deferrals up to 3% of compensation and a 50¢ to the dollar match on salary deferrals from 3% to 5% of compensation. Second, the rate of any matching contributions being made to highly compensated employees cannot exceed that being made to non-highly compensated employees.
- The employer must provide annual information to employees explaining the 401k plan’s safe harbor provisions and benefits, including that safe harbor contributions cannot be distributed before termination of employment and that they are not eligible for financial hardship withdrawal.
- Employers can decide as late as 30 days before the end of each plan year whether or not to take the safe harbor route. However, if, as its safe harbor contribution, employer wants to make matching contributions rather than the flat 3% of compensation contribution, the employer must define the matching formula well ahead of those 30 days; in fact, any safe harbor matching contribution must be defined and communicated to employees no later than 30 days before the START of the applicable plan year so employees have plenty of time to adjust their contribution rates accordingly.
Employee salary deferrals are immediately 100 percent vested — that is, the money that an employee has put aside through salary deferrals cannot be forfeited. When an employee leaves employment, he/she is entitled to those deferrals, plus any investment gains (or losses) on their deferrals.
In SIMPLE 401(k) plans and Safe Harbor 401(k) plans, all required employer contributions are always 100 percent vested.
In Traditional 401(k) plans, all employee deferrals are 100 percent vested. You can design your plan so that employer contributions become vested over time, according to a vesting schedule.
CONTRIBUTIONS A 40 1(k) can accept the following types of contributions:Elective contributions (sometimes referred to as employee pre-tax contributions or salary deferrals). This type of contribution is made on a pre-tax basis and is immediately 100% vested. This contribution allows participants to save for their retirement.
Catch-up contributions (employee contributions above and beyond the legal limit for elective contributions available to participants who are at least 50 years of age as of the end of the plan year). This type of contribution allows participants who are at least age 50 during the year to make pre-tax salary deferrals over a limit imposed by the law or by the plan on a pre-tax basis.
Employee after-tax contributions may be offered in addition to pre-tax deferrals in a 401(k) plan.
Employer matching contributions (contributions expressed in terms of participants’ deferral amounts) provide an incentive to participants to make pre-tax contributions to the plan. Matching contributions may be made on pre-tax deferrals or employee after-tax contributions and may be discretionary (determined by the employer each year) or the formula may be defined in the plan document.
Employer non-elective contributions (contributions that are typically expressed in terms of participants’ compensation and are often called discretionary employer or profit sharing contributions). This type of contribution may be used to provide performance incentives and/or to share company profits with eligible participants. Non-elective contributions may be discretionary or may be defined in the plan document.
What Are The Types Of Plan Fees And Who Pays For Them? There are a variety of plan fees and expenses that may affect your retirement plan. The following is an overview of some of those fees and expenses and the different ways in which they may be charged. Plan fees and expenses generally fall into three categories:Plan Administration Fees. The day-to-day operation of a plan involves expenses for basic administrative services – such as plan recordkeeping, accounting, legal and trustee services – that are necessary for administering the plan as a whole. In addition, a profit-sharing or 401(k) plan also may offer a host of additional services, such as telephone voice response systems, access to a customer service representative educational seminars, retirement planning software, investment advice, electronic access to plan information, daily valuation, and on-line transactions.
In some instances, the costs of administrative services will be covered by investment fees that are deducted directly from investment returns. In other instances, when the administrative costs are billed separately, they may be borne, in whole or in part, by the employer or charged directly against the assets of the plan. In the case of a 401(k), profit sharing, or other similar plan with individual accounts, administrative fees are either allocated among individual accounts in proportion to each account balance (i.e., participants with larger account balances pay more of the allocated expenses, (a “pro rata” charge)) or passed through as a flat fee against each participant’s account (a “per capita” charge). Generally the more services provided, the higher the fees.
Investment Fees By far the largest component of plan fees and expenses is associated with managing plan investments. Fees for investment management and other related services generally are assessed as a percentage of assets invested. Emp1oyers should pay attention to these fees. They are paid in the form of an indirect charge against the participant’s account or the plan because they are deducted directly from investment returns. Net total return is the return after these fees have been deducted. For this reason, these fees, which are not specifically identified on statements of investments, may not be immediately apparent to employers.
Individual Service Fees. In addition to overall administrative expenses, there may be individual service fees associated with optional features offered under an individual account plan. Individual service fees may be charged separately to the accounts of those who choose to advantage of a particular plan feature. For example, fees may be charged to a participant taking a loan from the plan or for executing participant investment directions.
What fees are associated with the Investment choices in a retirement?
Apart from fees changed for administering the plan itself, there are two basic types of fees that may be charged in connection with plan investments or investment options made available to participants and beneficiaries. These fees, which can be referred to by different terms, include:
Sales charges – (also known asloads on commissions). These are basically transaction costs for buying and selling shares. They may be computed in different ways, depending on particular investment product.
Management fees – (also known as investment advisory fees or account maintenance fees ).These are ongoing charges for managing the assets of the investment fund. They are generally stated as a percentage of the amount of asset invested in the fund. Sometimes management fees may be used to cover administrative expenses. You should know that the level of management fees could vary widely, depending on the investment manager and the nature of the investment product. Investment products that require significant management, research, and monitoring services generally will have higher fees. Be aware that higher investment management fees do not necessarily mean better performance.
