Named for the section of the IRS tax code that defines them, 401(k) plans are the most popular
type of retirement plan today. A 401(k) plan is a type of defined contribution plan, typically
a profit sharing plan, which contains a cash or deferred arrangement which allows plan participants
to elect to defer a portion of compensation and have it contributed to the plan on their behalf,
typically through payroll withholding. These contributions can be made on either on a pre-tax
(“traditional”) or after-tax (“Roth”) basis depending on the options offered in the plan.
Employees are able to make contributions to their own retirement savings accounts through recurring
payroll deductions. The employee typically selects which of the investment choices in the plan best
suits his or her needs, risk tolerance, and objectives. This control puts the employee in the
driver’s seat instead of taking a passive role as in most other types of retirement plans.
In addition to employee contributions, the employer may contribute to the plan by matching all, or
a portion, of the elective deferrals or by making non- elective, or profit sharing, contributions
to all eligible participants. The employer contributions qualify for tax favored treatment if
certain non-discrimination rules are met.
In a traditional 401(k) plan, all contributions—both employee and employer—and the associated earnings on
investments continue to grow “tax free” until the employee decides to withdraw money from the plan
(typically at age 59½ or later). Conversely, all contributions to a Roth 401(k) are made on
an after-tax basis. These Roth 401(k) contributions and the earnings on them are not taxed at all
upon a qualified distribution from the plan.
Because of the attributes described above, 401(k) plans have become a very popular employee benefit
and can directly improve employee hiring and retention.
A profit sharing plan is a type of defined contribution plan and is perhaps the most flexible plan type
for employers. The plan can be designed so that it does not dictate nor require the sponsoring
employer to make any specific contribution to the plan each year. As a result, a profit sharing
plan can be a good plan design for employers who do not enjoy steady profits year-to-year. And,
like all qualified defined contribution plans, the contributions made by the employer to a profit
sharing plan are tax deductible by the employer up to certain limits.
More specifically, the employer’s contribution to a profit sharing plan is not required to be fixed,
nor does it need to be tied to profits. While a plan may have a definite fixed contribution formula, many
profit sharing plans use a discretionary formula the employer determines each year how much
A profit sharing plan can allow discretion in determining the amount of the contribution; however,
the allocation formula must be definitive. Allocations may be defined in a variety of ways:
pro rata to all participants based on compensation, integrated with Social Security, based on
a points system or “cross-tested” (see New Comparability plans) based on participant allocation
groups, just to name a few.
Both for-profit and not-for-profit organizations may adopt profit sharing plans.
A defined benefit plan, also known as a traditional pension plan, is unique in that it promises the
participant a specified monthly benefit at retirement. The cornerstone of the defined benefit plan
is the funding formula which determines how benefits are accrued. Funding formulas can vary widely,
but are often based on factors such as the participant’s salary, age and/or the number of years he or
she has worked for the employer. A participant in a defined benefit plan doesn’t have an individual
account balance, rather they accrue an annuity payable to him/her at the plan’s specified retirement
age (typically 62 or 65).
The annual funding requirement of defined benefit plans is strictly monitored with annual compliance
of adequate funding jointly overseen by the IRS and the DOL. As a result, defined benefit plans
are most suitable for employers whose business yields steady, predictable operating margins in
which to meet the annual funding requirements.
Because a defined benefit plan is required to provide a specified benefit at retirement, larger
proportionate funding can be skewed in favor of older employees with fewer years to work until
retirement. In the right circumstances and with the right demographics, this can be an advantageous
tax planning tool for businesses looking for ways to provide relatively older business owners an
attractive retirement benefit.
New comparability plans, sometimes referred to as “cross-tested” plans, operate like a profit
sharing plan with the added feature that employees are divided into specific groups or classes,
with each group receiving a different percentage or ratio of the total employer contribution. This
unique feature allows for the plan to provide proportionately higher contributions to a certain
group(s) vs. another group and is often used as a means to maximize contributions to owners and
other higher-paid executives while minimizing the contributions to all other employees.
Plan sponsors of a qualified retirement plan are generally not allowed to favor one group of
employees—for example, higher-paid owners or executives. Plan sponsors are typically required
to provide the same contribution rate to all eligible participants (e.g. 5% of pay). However,
new comparability plans can skew contributions in favor of certain employees over others and
satisfy the non-discrimination requirement by comparing the benefit a contribution is projected
to yield at retirement age as opposed to comparing the contribution currently going into the plan.
As a result, a higher contribution rate (as a % of current pay) for an older participant is
comparable to a lower contribution rate for a younger participant. Thus, an older owner or key
employee may be allocated a higher percentage of pay when compared to a younger non-highly
compensated employee without violating the non-discrimination requirement.
This unique feature allows for creative plan design that can deliver powerful retirement
accumulations for business owners and executives in businesses with the right demographic mix.
A cash balance plan is a hybrid between a defined contribution plan and a defined benefit plan.
It is technically a defined benefit plan that looks like a defined contribution plan.
In a cash balance plan, a hypothetical account balance is maintained on behalf of each participant.
On an annual basis, this account is credited with a compensation credit and an interest credit. The
compensation credit can be a flat dollar amount or a percentage of pay and can vary by employee. The
interest credit is often indexed to a widely used measure, such as 30-year U.S. Treasury Securities,
or can be a fixed market rate of interest. The compensation credit and the interest credit are
guaranteed to the employee. Specifically, the amount that the employee will receive from the plan is
defined. If the plan earns more or less than the interest credit, future contributions made by the
employer may be increased or decreased but the participants’ hypothetical account balances are not
On an on-going basis, increases and decreases in the value of the plan’s investments do not directly
affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan
assets are borne solely by the employer. When a participant becomes entitled to receive benefits
under a cash balance plan, the benefits that are received are defined in terms of an account balance.
For employers looking for a tool to maximize contributions and retirement benefits for certain
employees (owners and executives), a cash balance plan combined with a safe harbor 401(k) plan
can be an excellent solution and enable company annual contributions that can exceed $200,000
Employers that are looking for a tool to maximize contributions and retirement benefits for certain
employees (owners and executives), might consider combining a cash balance plan with a 401(k) to enable
individual annual contributions that can exceed $200,000 per year.
Non-qualified plans, on the other hand, do not have the benefit of contributions being treated as
tax-favored or tax deductible. Nor are they governed by ERISA. As a result, non-qualified plans are
generally more flexible and can be designed to meet specialized retirement planning strategies.
Non-qualified plans are often utilized to provide significant retirement savings opportunities or
additional compensation structures for key executives and other select employees. A non-qualified
plan can also be nicely combined with a qualified plan to meet specific business goals.