401(k) PROFIT SHARING SOLUTIONS

401(k) PROFIT SHARING SOLUTIONS

Most small business owners are concerned about retirement, both for themselves and for their employees. The question isn t whether to implement a retirement plan. The two most important issues are what type of plan you should start with and what are the considerations for choosing the right plan. A profit sharing plan is often a good place for a small business to start. There are two basic categories of qualified retirement plans available: defined benefit and defined contribution plans. Profit sharing plans are a type of defined contribution plan. Profit Sharing Plans Profit sharing plans offer both design flexibility and discretion in making contributions. Company contributions are determined by the plan sponsor and can be allocated in a number of ways. If the company makes little or no profit in a given year, no contribution is required, although low profits don t restrict the contribution level. A profit sharing plan can include an option allowing the company to make contributions even if the company has no profit. Profit sharing contributions are allocated to employees based on compensation. An employer s maximum deduction is limited to 25% of the annual compensation paid to eligible employees. (The individual participant limits applied to all defined contribution plans are the lesser of 100% of compensation or $49,000.)

There are three different types of profit sharing plans: traditional, age-weighted and new comparability. The difference between these plans is the contribution allocation formulas. The following sections will discuss these three types of plans and show comparative charts. Traditional Profit Sharing Plan A traditional profit sharing plan follows the salary ratio method. The salary ratio method is designed to allocate employer contributions to all participants on a uniform basis. For example, if one employee receives a 10% of pay contribution, all eligible employees would be allocated 10% of compensation as their share of the contribution. A profit sharing plan with a salary ratio formula is similar to a Simplified Employee Pension (SEP) plan, but may be more attractive than a SEP plan in situations where an employer (a) does not wish to cover certain part-time employees, (b) wants to make employer contributions subject to a vesting schedule or (c) wants more control over the assets. Age-Weighted The age-weighted method allocates contributions based on both the age and compensation of eligible employees. It is similar to a defined benefit pension plan, only with discretionary contributions. Since the participant s age, or length of time until retirement, is factored into the allocation formula, older participants receive a larger proportionate share of the contribution. This can be advantageous in situations where the key employees are significantly older than the other employees. Although this type of plan is available to any size company, age-weighted plans are designed to be top-heavy and are especially well-suited for small businesses and professional practices. In certain situations, an age-weighted plan design works extremely well, but some employees with the same salaries may receive different allocations, based on age. In addition, an older nonprincipal employee may receive a larger share than a younger principal. 2

New Comparability The new comparability, or cross-tested, allocation method allows the employer to divide the employees into different classifications for purposes of allocating the contribution. If nondiscrimination requirements are met, a larger share of the company s contribution may be made on behalf of those employees to whom the employer wishes to provide a more significant benefit. Nondiscrimination testing, like an age-weighted plan, is based on projected benefits at retirement, similar to a defined benefit plan. If the aggregated age of the preferred class is higher than the other classes, the allocation of current dollars can be skewed proportionately toward the older group. This type of plan involves complicated calculations and may require actuarial consulting, but it is still less expensive and more flexible than a defined benefit plan. This plan may be appropriate in a situation where a business wants to favor older or highly paid participants. These plans may establish several class designations of employees, such as placing principals in the first group, officers in the second group and all other employees in the third group. Eligible Employee Age W-2 Compensation Traditional Profit Sharing Plan Age-Weighted New Comparability Officer 1 57 $245,000 $24,500 $36,285 $27,318 Officer 2 48 $245,000 $24,500 $17,412 $27,318 Employee 1 50 $40,000 $4,000 $3,347 $1,496 Employee 2 35 $30,000 $3,000 $738 $1,122 Employee 3 25 $20,000 $2,000 $218 $748 Totals $580,000 $58,000 $58,000 $58,000 This chart is an example of the available allocation methods in a profit sharing plan using a 10% contribution. Eligible Employee Age W-2 Compensation Traditional Profit Sharing Plan Age-Weighted New Comparability Officer 1 57 $245,000 $49,000 $49,000 $49,000 Officer 2 48 $245,000 $49,000 $23,514 $49,000 Employee 1 50 $40,000 $8,000 $4,519 $2,000 Employee 2 35 $30,000 $6,000 $997 $1,500 Employee 3 25 $20,000 $4,000 $294 $1,000 Totals $580,000 $116,000 $78,324 $102,500 This chart is an example of the available allocation methods in a profit sharing plan designed to maximize contributions for the oldest owner. 3

Consider a 401(k) Plan for Your Company, Your Employees and Yourself Your company s success depends on quality employees. And attracting and retaining them often takes more than a competitive salary or a satisfying environment. Workers today expect added benefits, including the means to save for retirement through alternatives such as a 401(k) plan. As a business owner, you likely already recognize the importance of offering and receiving such a benefit. After all, establishing a 401(k) plan can provide both you and your employees the means for a secure retirement, while also helping you gain tax advantages for your business and ultimately affecting your company s bottom line. However, deciding which 401(k) arrangement is best for your organization and then maintaining the plan can be a challenge. That s where we can help. Our goal is to listen to you to determine the best approach for your business, then search our database of 401(k) providers to find a plan that meets your company s unique needs. Since Raymond James has no proprietary inhouse 401(k) products, we offer truly objective advice. Ours is an approach that is unique in the industry... one that focuses on you and your business rather than a specific retirement alternative. But our commitment to you doesn t stop there. We not only assist in evaluating options, but work with you to coordinate the different components of the 401(k) process on an ongoing basis. And we believe that establishing a 401(k) plan for your company also means creating longterm relationships with your employees providing assistance in understanding investing and coordinating their 401(k) allocations with all other assets into complete financial plans. The next few pages give an overview of 401(k) plans and the decisions that must be made to ensure an effective program for your company. Please take the time to read through the information, then we will work together to create a plan tailored to your needs. About 401(k) Plans A 401(k) is a profit sharing retirement plan that allows employees to make elective salary deferrals while avoiding current taxes on that portion of their income. Most employers, including nonprofit organizations but excluding government entities, can offer a 401(k) plan to their employees. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) allowed employees to add qualified Roth contributions to a 401(k) plan starting January 1, 2006. The Roth 401(k) contributions only apply to the employees elective salary deferrals. There are several common factors that an employer should consider when evaluating whether a 401(k) plan is right for a company: 4

Eligibility Requirements Employees who are at least age 21 and who have completed one year of service are generally eligible to participate. Certain employees, such as those covered by a collective bargaining agreement, may be legally excluded. Funding the 401(k) A 401(k) plan can be funded from one or more of the following sources: Employee elective salary deferral All 401(k) plans permit employees to voluntarily contribute, or defer, a portion of their salaries to the plan, either pretax or after-tax Roth contributions. Matching employer contribution As an incentive to participate, many employers match a portion of each participant s elective salary deferral. This discretionary matching contribution is tax deductible for the company. An employer may not make the matching contribution in the form of an after-tax Roth contribution. Employer profit sharing contribution Employers may also make a discretionary contribution to all eligible employees, regardless of whether the employee makes an elective salary deferral. The employer profit sharing contribution must be pretax and not an after-tax Roth contribution. Individual Contribution Limits The maximum 401(k) deferral for 2009 is the lesser of 100% or $16,500 of each employee s eligible payroll. Plan documents may limit salary deferrals to less than 100%. Employer Contribution Limits The employer s contribution limit is 25% of each employee s eligible payroll. While an employee can exceed 25%, total contributions from the three funding sources listed above cannot surpass the $49,000 maximum. Nondiscrimination Requirements 401(k) plans may not discriminate in favor of highly compensated employees (HCEs) employees who own 5% or more of the company or who earn a minimum of $110,000. Each plan is subject to an annual nondiscrimination test, commonly referred to as the Actual Deferral Percentage (ADP) test, that is intended to prevent the plan from benefiting only the HCE group. In essence, the amount that an HCE may defer is controlled by the deferral rate of the non-highly compensated employee (NHCE) group. 5

In addition, every 401(k) plan has a number of different components that must be coordinated to ensure the most effective benefit for your employees. Actual Deferral Percentage (ADP) Test This chart illustrates the highest deferral percentage available to the HCE group, as an average, if the ADP for the NHCE group is at a specific level. Highly compensated employees include: 1. Employees with 5% or more ownership stake and 2. Any employee who earns $110,000* or more. *Indexed figures for 2009 HCE 2% 4% 5% 6% 7% 8% 9% 10% 11.25% 12.5% NHCE 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Investment Alternatives With most 401(k) plans, participants can choose investments from among a variety of alternatives. An effective plan should allow employees to move freely among available funds to create the best asset allocation for their needs. Recordkeeping Allocating contributions and earnings among different investment alternatives, calculating vesting amounts, and generating participant statements are usually referred to as participant-level accounting. These functions are critical to keep the plan running smoothly. Plan Administration Regulatory functions, such as plan qualification, nondiscrimination testing, reporting to the IRS and disclosure to employees, must be performed on an annual basis. In addition, participant-level information must be incorporated into plan-level accounting as part of IRS reporting. Employee Communication From the long-range perspective of creating the means for employees to accumulate assets for retirement, this is the most important component of the 401(k) plan structure. It is critical for employees to have a basic understanding of the concepts of investing and how their plan works. Trustee Selection Unlike a traditional pension plan, an outside trustee mainly performs custodial functions in a participant-directed 401(k) plan such as distributions and the related reporting functions but assumes no fiduciary liability. 6

Structuring Your Plan While there are many factors that influence 401(k) decisions, choosing a structure is often determined by the maintenance and fees involved. The three basic structures are: Single Source This arrangement is a full-service package that provides single-source responsibility as well as a single source of fees for all functions. Frequently referred to as a bundled plan, this format has the fewest components and is the simplest to maintain. Multiple Source This is also a packaged arrangement, but adds a third-party administration firm that can be electronically linked to the mutual fund family or insurance company that provides the investment alternatives. The recordkeeping functions, plan administration and investments must interface for the plan to run efficiently. While this arrangement is more complex than the single-source option and fees are charged separately from multiple sources, it provides additional flexibility that may be critical to meeting the objectives of the plan. 7

Unbundled In this arrangement, many components operate independently, and no single source is responsible for the process as a whole. As such, while this option offers total investment flexibility, it has the greatest potential for operational breakdowns and poor service. In addition, the unbundled approach may require more day-to-day employer involvement. While your individual needs will dictate which type of plan is right for your company, most employers tend to select the single- or multiple-source arrangements to reduce management responsibility, as well as likelihood of problems with the different parts of uncoordinated plans. In addition to the general structure of your plan, there are also two investment arrangements to choose from: Single Mutual Fund Family Providing investment choices from a single company typically offers the lowest overall cost since all functions are controlled by one entity. Choosing a fund family with investment alternatives across different asset classes can deliver a cost-effective retirement plan structure while minimizing your fiduciary liability. Multiple Fund Managers This format, which is usually provided either through an insurance company or an alliance arrangement with an independent plan administration firm, employs investment managers from different fund families with the idea that this selection process may potentially result in superior long-term performance. Insurance companies offer group annuity packages specifically designed for qualified retirement plans, although they typically do not contain an insurance component. A sophisticated recordkeeping system guarantees same-day execution of trades across fund family lines. In addition to the internal fund expenses, the insurance company imposes an asset charge for maintaining the plan and generating the participant-level accounting. The trading platform alliances, in which an independent plan administration firm is linked to a transfer agent trading platform that processes trades across fund family lines, may allow a wider selection of fund choices, but can also be more complex. In addition, the overall accountability is divided among several sources, which can lead to communication problems. The cost of linking the unrelated funds is structured differently than the group annuity format, but the result is still a higher overall cost than a single mutual fund family approach. W hen comparing single-fund and multiple-fund alternatives, you should examine both costs and expectations. Consider whether the performance potential that a broader selection of investment managers may offer warrants the additional expense of having access to these funds, or if the participants are better off with fewer choices and lower expenses. 8

The Safe-Harbor 401(k) Plan Alternative Because of the complexities of traditional 401(k) plans, some business owners especially those with fewer employees may choose to explore options better suited to their needs. In the past, this often meant choosing to offer no retirement plan at all. However, newer alternatives can replace or supplement more conventional plans, reduce administration efforts and costs involved, and/or provide added benefits for business owners. A Safe Harbor 401(k) plan is similar to a traditional 401(k). However, its key benefit is that low employee participation does not keep the business owner from achieving the maximum pretax payroll deferral limit. This is because a Safe Harbor 401(k) allows you to avoid nondiscrimination, ADP and ACP testing. However, the company must be willing to make contributions on behalf of its employees. There are two options: A dollar-for-dollar match for the 3% of compensation and $0.50 per dollar on the next 2%. If an employee contributes 5% of his or her salary to a Safe Harbor 401(k), the employer match obligation is 4%. A 3% of compensation nonelective contribution to all employees eligible to contribute to the Safe Harbor 401(k). Each will receive the 3% regardless of plan participation. The company can also make additional contributions, up to 25% of eligible compensation per eligible employee (reduced by its match or nonelective contribution). Safe Harbor Contribution (3% Nonelective Option) Eligible Employee W-2 Compensation Pre-Tax Payroll Deferral 1 3% Safe Harbor Employer Contribution 2 Additional Profit Sharing Contributions 3 Total Employer Contributions 1 Owner $245,000 $16,500 $7,350 $25,150 $49,000 Employee 1 $40,000 $4,000 $1,200 $4,106 $9,306 Employee 2 $30,000 $1,200 $900 $3,080 $5,180 Employee 3 $20,000 $0 $600 $2,053 $2,653 Totals $335,000 $21,700 $10,050 $34,389 $66,139 1 If any participant is age 50 or older, an additional $5,500 may be contributed through catch-up payroll deductions. This illustration assumes that no employees qualify for the catch-up contribution. 2 Owner satisfies Safe Harbor and top-heavy requirements by making a 3% fully vested contribution to all participants, including both contributing and noncontributing employees, as well as himself/herself. 3 Owner makes an additional 10.3% contribution to all participants, subject to a vesting schedule, to achieve the maximum contribution of $49,000 for himself/herself. 9

Safe Harbor Contribution (4% Matching Option) Eligible Employee W-2 Compensation Pre-Tax Payroll Deferral 1 4% Safe Harbor Employer Contribution 2 Additional Profit Sharing Contributions 3 Total Employer Contributions 1 Owner $245,000 $16,500 $9,800 $22,700 $49,000 Employee 1 $40,000 $4,000 $1,600 $3,706 $9,306 Employee 2 $30,000 $1,200 $1,200 $2,780 $5,180 Employee 3 $20,000 $0 $0 $1,853 $1,853 Totals $335,000 $21,700 $12,600 $31,039 $65,339 1 If any participant is age 50 or older, an additional $5,500 may be contributed through catch-up payroll deductions. This illustration assumes that no employees qualify for the catch-up contribution. 2 Owner satisfies Safe Harbor and top-heavy requirements by making a 4% fully vested contribution to all participants, including both contributing and noncontributing employees, as well as himself/herself. 3 Owner makes an additional 9.3% contribution to all participants, subject to a vesting schedule, to achieve the maximum contribution of $49,000 for himself/herself. 10

The charts below illustrate how the addition of a Safe-Harbor 401(k) to a traditional, ageweighted or new comparability profit sharing plan permits the business owner(s) to fully contribute up to the IRS limit while reducing the amount the employer must contribute on behalf of plan participants. The first chart illustrates the three types of profit sharing plans with only employer contributions. The second chart adds a Safe-Harbor 401(k) with the matching option, taking advantage of an employee salary deferral contribution and limiting the total employer contribution to the plan. Enhanced Profit Sharing Contribution Eligible Employee Age Class W-2 Compensation Traditional Profit Sharing Plan Age-Weighted New Comparability Owner 1 57 1 $245,000 $49,000 $49,000 $49,000 Owner 2 48 1 $245,000 $49,000 $23,514 $49,000 Subtotals $490,000 $98,000 $72,514 $98,000 Class two 50 2 $40,000 $8,000 $4,519 $2,000 Class two 35 2 $30,000 $6,000 $997 $1,500 Class two 25 2 $20,000 $4,000 $294 $1,000 Subtotals $90,000 $18,000 $5,810 $4,500 Totals $580,000 $116,000 $78,324 $102,500 Enhanced 401(k) Contribution Eligible Employee Age Class W-2 Compensation Salary Deferral Match (4%) Catch-up Traditional Profit Sharing Plan Age-Weighted New Comparability Owner 1 57 1 $245,000 $16,500 $9,800 $5,500 $22,700 $22,700 $22,700 Owner 2 48 1 $245,000 $16,500 $9,800 N/A $22,700 $10,893 $22,700 Subtotals $490,000 $33,000 $19,600 $5,500 $45,400 $33,593 $45,400 Class two 50 2 $40,000 $4,000 $1,600 N/A $3,706 $2,094 $1,234 Class two 35 2 $30,000 $1,200 $1,200 N/A $2,780 $462 $926 Class two 25 2 $20,000 $0 $0 N/A $1,853 $136 $617 Subtotals $90,000 $5,200 $2,800 N/A $8,339 $2,692 $2,777 Totals $580,000 $38,200 $22,400 $5,500 $53,739 $36,285 $48,177 11

Frequently Asked Questions About Profit Sharing Plans Q. Can a profit sharing plan be combined with a 401(k) plan? A. A 401(k) plan is simply a profit sharing plan with a provision allowing employee salary deferrals. Most 401(k) plans provide employer matching contributions based on the participant s contribution, with an additional option for a profit sharing allocation. Although most 401(k) plans use a salary ratio formula for profit sharing plan allocations, any of the other formulas could be used. Q. What are the costs of implementing and maintaining a profit sharing plan? A. Cost can vary significantly depending on the design complexity of the plan, the number of employees and the structure of the investment portfolio. Q. Can an IRA be rolled into a profit sharing plan? A. Yes. An IRA can be rolled into a profit sharing plan as long as the profit sharing plan permits such a rollover. Q. Do all employees have to be included in a plan? A. Certain employees may be excluded, but strict coverage rules are enforced to prevent the plan from discriminating in favor of highly compensated employees. Q. What is the difference between a profit sharing plan and a SEP plan? A. The profit sharing plan allows vesting schedules, while SEP plans require 100% immediate vesting. A profit sharing plan can require employees to work at least 1,000 hours to share in the contribution, but a SEP plan covers all eligible employees, regardless of hours worked. Q. What are the administrative requirements? A. All profit sharing plans are subject to IRS reporting requirements. This includes keeping the plan up to date with new laws, performing nondiscrimination tests, filing a Form 5500 return each year, and providing benefit statements and other plan information to participants at least annually. Self-employed persons with no employees are not required to file returns until the plan has $250,000 in assets. It is recommended that a professional pension plan administrator be retained to perform these annual reporting functions. C hoosing an appropriate retirement plan is an important decision for small business owners. For more information on 401(k) plans and other retirement plan alternatives for your business, please contact us today. We look forward to helping you create an effective retirement benefit for your company, your employees and yourself. 12

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