ERISA: Corporate Retirement Plan Standards

The Employee Retirement Income Security Act of 1974 (ERISA) established standards that corporate retirement plans must adhere to in order to receive favorable tax considerations. If a corporate retirement plan meets the criteria set forth by ERISA, the plan is a qualified plan and the employer may deduct contributions to the plan as a business expense. Vesting, eligibility, and discrimination are the core issues addressed by ERISA.

Vesting Provisions

Vesting refers to the amount of time required to pass before the plan participant achieves a non-forfeitable right to benefits under the plan. Employees are always 100% vested in their own contributions to the plan. Under ERISA rules, the most restrictive vesting schedules are graded and cliff vesting. Graded vesting requires a portion of the company contribution to vest annually, with the employee being fully vested no later than the end of the sixth year. If the employer chooses to restrict vesting of company contributions to 0% for the first two years, the company contribution must be 100% vested at the end of year 3, known as cliff vesting.

Eligibility

Under ERISA rules, all employees who meet the following criteria are eligible to participate in a corporate-sponsored retirement plan:

• At least 21 years of age
• Employed by the organization for at least one year
• Work at least 1,000 hours per year (full time)

Discrimination

It is common for an employer to match employee contributions up to a certain percentage of salary. ERISA requires the percentage be the same for all employees regardless of salary, job level, tenure, etc. If a plan favors certain highly compensated employees (i.e., an executive has the ability to take personal loans from the plan) it will lose its qualified status. This is a violation of exclusive benefit rules known as a “top heavy plan.”

ERISA also requires a qualified plan document to be in writing. The plan must be funded, with assets in the plan segregated from other corporate assets. Participants in the plan must receive statements at least annually and have the right to name a beneficiary.

Defined Benefit vs. Defined Contribution

Corporate retirement plans can be structured as either defined benefit or defined contribution plans. A defined benefit plan will provide a specific benefit at retirement. The benefit is determined using a formula typically involving age at retirement, compensation level, and years of service. A defined benefit plan tends to favor older employees because a larger amount may be contributed for those nearing retirement.

Defined contribution plans are more prevalent and easier to administer. The benefit that will ultimately be received by the plan participant is unknown; it depends on the investment return of the funds in the plan. With a defined contribution plan, the IRS restricts allowable contributions to certain amounts. While there is a “catch-up” provision that allows people over 50 to contribute more to a qualified plan, if a person exceeds the maximum allowable contribution, a 6% per year penalty will be assessed on the excess contribution.

Types of Qualified Plans

401(k):

• A 401(k) is the most common type of qualified defined contribution plan. Employees may allocate a portion of their salaries to this plan, and contributions are excluded from their income for federal income tax purposes (Contributions to qualified plans have no affect on the employees’ Social Security tax liability). Contributions and earnings grow tax deferred until withdrawn. Withdrawals from a 401(k) plan are taxed as ordinary income and may be subject to an additional 10% federal tax penalty if withdrawn prior to age 59½.

Roth 401(k):

• Roth 401(k) plans became available January 1, 2006. Roth 401(k) plans must be funded with after-tax contributions but allow tax-free withdrawals, provided that the account owner is at least age 59½.

Profit Sharing/Money Purchase Plans:

• Profit sharing plans are popular with companies in cyclical industries because they do not require a fixed contribution. The company can increase, decrease, or even skip a contribution as long as the contributions are “substantial and recurring."

• With a money purchase plan, the employer contributes a fixed percentage of the employee’s salary regardless of the company’s profitability. The company must make contributions or pay a penalty.

SIMPLE (Savings Incentive Match Plan for Employees):

• A SIMPLE plan is an IRA established and maintained by the employee, but to which the employer may contribute. SIMPLEs are only available to small employers (100 or fewer employees). A SIMPLE plan eliminates the administrative work and costs associated with other plans. A participant in a SIMPLE plan will “simply” open an IRA account at the brokerage firm of their choice; the employer will make appropriate salary deductions and deposit them, along with any match the company may make, into the employee’s IRA.

SEP (Simplified Employee Pension Plan):

• An SEP is also an IRA established and maintained by the employee, but the employer may contribute to it. With high contribution limits and immediate vesting, SEPs are generally appropriate for small, family-owned businesses looking to fund a retirement plan with company profits, lowering the tax liability of the company.

Keogh (HR-10):

• Keoghs are intended for self-employed persons and owners of unincorporated businesses, such as lawyers or doctors. If the owner of a Keogh has any employees, the plan is then subject to ERISA eligibility rules.

Lesson Summary

The Employee Retirement Income Security Act of 1974 (ERISA) established standards for corporate retirement plans to qualify for tax benefits:

• A qualified plan allows employers to deduct contributions as a business expense
• Core issues of ERISA include vesting, eligibility, and discrimination

Vesting Provisions:

• Vesting determines when a participant gains a non-forfeitable right
• Employees are 100% vested in their contributions
• Options include graded vesting and cliff vesting

Eligibility:

• Employees are eligible if they meet age, tenure, and work hour requirements

Discrimination:

• ERISA requires an equal percentage of salary matching for all employees
• Top-heavy plans can lead to loss of qualified status

Defined Benefit vs. Defined Contribution:

• Defined Benefit provides specific retirement benefits
• Defined Contribution depends on plan investments

Types of Qualified Plans:

• 401(k), Roth 401(k), Profit Sharing/Money Purchase Plans, SIMPLE, SEP
• Keogh plans are for self-employed individuals

Chapter Vocabulary