Age-Weighted and Cross-Tested Defined Contribution Plans

1. What is it? • a defined contribution plan allocation that allows higher plan contributions for older plan entrants • the formula for annual employer contributions or allocations to participant accounts is based on AGE as well as compensation level • older plan entrant’s accounts build up quickly • tends to favor owners and key-employees

2. Plan Types cross tested (new comparability plan) • maximizes benefits to highly compensated employees (HCEs) • benefits to non-HCEs are whatever is necessary to meet nondiscrimination regulations

3. Plan Types age-weighted profit sharing plan allocation formula contains actuarial age-weighting factor that gives a higher allocation for older plan entrants target plan pension plan with an age-weighted formula but requires annual contributions

4. When is it indicated? • relatively older business owners and key employees want to • maximize own plan benefits • minimize plan costs 2. employer wants to bring older employees into a defined contribution plan

5. When is it indicated? • want plan that provides adequate retirement benefits to older employees with lower cost and simplicity of a defined contribution plan • when employer terminates existing defined benefit plan and wants to provide approximately the same benefits to most employees • closely held business or professional corporation has older key employees

6. Advantages • can maximize retirement benefits for employees entering plan at older ages • older business owners and key employees may receive a larger portion of plan allocations as compared with other defined contribution plans • provides tax-deferred savings for employees • simple and inexpensive to design, administer, and explain to employees

7. Advantages • plan benefits may be eligible for special 10 year averaging for income tax purposes • individual accounts allow plan participants to benefit from good investment results

8. Disadvantages • annual additions to employee account limited to lesser of 100% compensation or $49,000 (2009); these limits may disadvantage highly compensated or older employees • employees bear investment risk • contributions to age-weighted or cross-tested profit sharing plan must be “substantial and recurring”; target benefit plan contributions must meet minimum funding standards each year

9. Disadvantages • age-weighted profit sharing plans have uncertain benefits; annual contributions not required • target pension plan or cross-tested plan may require annual actuarial services

10. Cross-Tested Plan Design • designed to meet nondiscrimination requirements of IRS Code Section 401(a)(4) on the basis of benefits provided (i.e. is tested as if were defined benefit plan, hence ‘cross-tested’) • cross-testing rules are complex - basically • highly compensated can receive maximum contribution allowed under Section 415 limits • remaining employees given allocation that meets requirements of cross-testing regulations

11. Cross-Tested Plan Design • in general, cross-testing regulations focus on plan’s ultimate benefits to evaluate nondiscrimination • plan must satisfy “gateway” requirement; small businesses usually face minimum allocation of 5% of compensation for nonhighly compensated employees to meet this requirement • when more than one highly compensated employee is in group, plan must be broken into “rate groups” to test for nondiscrimination

12. Disadvantages of Cross-Tested Plans • unstable plan design; age of new hires can necessitate new plan • plan becomes costly or impractical if have • relatively large number of older rank and file employees • relatively young highly compensated employees • must analyze plan design when have new hires, increasing plan costs

13. Disadvantages of Cross-Tested Plans • plan design inhibits hire of older employees • can put employer in danger of violating age discrimination legislation • can deprive company of valuable and experienced employees who have critical skills

14. Fixed-Formula Age-Weighted Plans Age-Weighted Profit Sharing Plan • actuarial formula for allocating employer contributions • allows plan to automatically pass cross-testing requirements • reduces plan complexity and cost • plan is difficult to communicate to employees; younger employees may deem larger contributions to older employees as unfair

15. Fixed-Formula Age-Weighted Plans Age-Weighted Pension (Target Benefit) Plan • similar to profit share plan with fixed formula, but as pension plan must meet annual minimum funding requirements • disadvantages • no guarantee of fund balance at retirement • difficult to communicate to employees • employers must fund annually

16. Tax Implications • employer plan contributions tax deductible • employee contribution tax deferred • annual additions limited to 100% compensation or $49,000 (2009) • must follow rules for qualified plan distributions; premature distributions subject to penalty • special 10 year averaging may be available for some lump-sum distributions

17. Tax Implications • target pension plan is subject to minimum funding rules of IRC Section 412 • some employers may qualify for $500 business tax credit for ‘qualified start up costs’ • plan may allow employees to contribute to ‘deemed IRA’ under plan; such contributions will limit other IRA contributions • plan subject to ERISA reporting and disclosure rules

18. Alternatives defined benefit plans • more benefit security • greater tax deductible employer contributions for older, highly compensated employees • more complex and costly to design and administer money purchase plan • similar to target benefit plan • without age-related contribution feature

19. Alternatives nonqualified deferred compensation plans • can be provided exclusively for executives • employer tax deduction deferred until benefit payments are made individual retirement savings plans • can be alternative or supplement to employer plan • amount of contribution limited

20. True or False? • An age-weighted plan allows for higher contribution levels as percent of compensation for older plan entrants. • A cross-tested plan maximizes benefits to highly compensated employees. • An age-weighted plan can provide approximately the same benefits to employees when their employer switches from a defined benefit plan.

21. True or False? • An age-weighted plan and a target benefit plan must have annual employer contributions. • Cross-tested plans do not need to meet nondiscrimination rules since their structure precludes discrimination. • A cross-tested plan is typically not advantageous when many highly compensated employees are relatively young.

22. Discussion Question Discuss how an age-weighted or cross-tested plan would work for • self-employed • shareholder employees of S corporation