The Employee Retirement Income Security Act of 1974 (popularly known as ERISA) added an enormous amount of complexity to an already complex body of law containing rules that must be followed by those who design, sell, and service “qualified” pension and profit sharing plans. If those rules are not followed, the result may not only mean loss of the tax benefits to which qualified plans are entitled, but it also could mean substantial tax penalties and civil or criminal liability.

It should be obvious, then, that anyone who is not well-trained, experienced, and currently informed in the pension field should not attempt solo sales of pension or profit sharing plans. It should be equally obvious that in the space allotted here to cover pension and profit sharing plans only a limited picture is possible. Many important rules (such as those relating to funding standards and to administrative and reporting requirements) are, of necessity, omitted.

In general, what is necessary to know in order to get a working knowledge of pension and profit sharing plans are (1) the nature of “qualified” pension or profit sharing plans and the basic differences between them; (2) how these plans work; (3) who will benefit from them and how; and (4) some of the basic tax considerations.

A “qualified” pension plan is a retirement plan for employees (including self-employed persons treated as employees) that meets certain requirements set forth in the Internal Revenue Code. If a plan meets these requirements, then certain substantial tax advantages follow. Prior approval by the IRS is not mandatory, but the readers are advised to be sure the plan does qualify.

The principal tax advantages of a qualified plan are as follows: (1) the employer can take a current business expense deduction for its contributions to the plan even though the employees are not currently taxed on these contributions; (2) an employee pays no tax until benefits are distributed regardless of whether he or she has a forfeitable or nonforfeitable right to these contributions (except for the cost of current death protection afforded by life insurance in the plan); and (3) the interest earnings on the contributions accumulated for the benefit of the employees are not taxed during the accumulation period.

No employer is too small to be faced, sooner or later, with the problem of what to do about aged employees who should no longer be kept on the payroll. In the absence of advance planning, there seems to be no acceptable solution. To dismiss a long-time loyal employee on his or her 65th birthday with a gold watch and a pat on the back is inhumane, ruinous to company morale, and probably a violation of age discrimination laws. To keep the employee on the payroll at a reduced salary and in a less responsible position is demeaning to the employee and is inefficient for the employer. To retire employees on an informal pay-as-you-go basis is as financially irresponsible as making no provision in advance for replacement of depreciated machinery, equipment, and buildings.

The underlying purpose of a pension plan is to enable an employer to solve this problem in a businesslike way, and on the best possible terms. To the employer who objects to considering a pension plan because it calls for too much of an obligation, the only answer is that a pension plan is not an obligation at all; rather, it is one of the best ways possible to discharge an obligation. The obligation is the retirement of aged employees.

While a solution to the so-called “super-annuated employee” problem should be the primary motive for the establishment of most pension plans, do not overlook the fact that sole proprietors, self-employed professionals, partners, and stockholder-employees of corporations also may qualify as employees for retirement plan purposes. If these individuals, who must make the decision on an employee plan, are made aware of the extent to which they can personally benefit from such a plan, the sale can be that much easier.

Who needs to be included in a pension plan in order for it to meet qualification requirements? Generally, a plan will meet the “coverage” requirements if it covers 70 percent of all employees with at least two years of service. But no discrimination in favor of highly compensated employees is permitted. In addition, a plan generally cannot exclude an employee on account of age if he or she is at least twenty-one years old and has had at least one year of service.

How are costs and benefits determined? The cost is determined, of course, by the number of participants and by the formula of contributions or benefits selected by the employer. The employer may choose from among the following types of plans.

Uniform benefit plans. This type of benefit provides a flat dollar amount per month for every covered employee who has worked the required number of years.

Flat percentage of pay. Participants receive a pension of some percentage of their average or final annual earnings. Sometimes there is a reduction for years of service less than a certain number.

Unit benefits plans. These plans recognize length of service by providing a unit of pension for each year of employment. An employee earns an annuity of some small percentage of his or her average or final earnings (usually 1 percent-2 percent) for each year of service.

These first three types of plans in this listing are classified as “defined benefit” plans. This means that each participant's retirement benefit is either fixed or determinable by some formula usually relating to his or her length of service or pay or both; the amount of the contribution, then, is a function of the retirement benefit; that is, whatever amount is required to be contributed annually to accumulate a sufficient fund to pay the retirement benefit promised determines the amount of the contribution.

A fourth type of plan, a money purchase plan, is classified as a “defined contribution” plan. In this type of plan, the amount of the contribution is either fixed or determined by a formula, such as a fixed percentage of the participant's pay. The amount of the retirement benefit is a function of the contribution, i.e., the size of the retirement benefit is determined by whatever the accumulated contributions and their investment earnings amount to at retirement age.

A target benefit plan is a fifth type of qualified pension plan. In a target benefit plan, a retirement benefit is first assumed for each participant as if the plan were a defined benefit plan. But this assumption is made only for the purpose of determining the amount to be contributed each year on behalf of each participant. The plan does not promise to pay the assumed benefit at retirement; rather, the promise is to pay whatever benefit the accumulated contributions and earnings (or losses) will buy, as if the plan were a defined contribution plan.

Do employees share the cost of a pension plan? They may or they may not, depending on whether the employer selects a contributory or a non-contributory plan. If a contributory plan is selected, employee contributions are normally a percentage of their earnings—usually 2 to 6 percent.

The law imposes limitations on benefits and contributions under qualified retirement plans. The limitation with respect to defined contribution plans (money purchase pension plans, profit sharing plans, and target benefit plans) is that contributions and “other additions” with respect to any participant for a plan year, which together constitute an “annual addition,” may not exceed the lesser of a set dollar amount or 25 percent of compensation. The set dollar amount is $30,000. The term “annual additions” means the sum for any year of: (1) employer contributions, (2) the participant's contributions, and (3) any forfeitures added to the participant's account.

The limitation with respect to defined benefit pension plans is that the annual benefit payable to any participant may not be greater than the lesser of a set dollar amount or 100 percent of the participant's average compensation for his or her high three consecutive calendar years. The set dollar amount is $90,000, indexed each year for inflation. The limit for 1999 is $130,000.

How is a pension plan funded? In order to get a deduction for contributions, the employer must set up a trust for the employees. Once a proper contribution is made, it becomes the property of the employees (through their rights in the trust) and it can generally not revert to the employer.

There are six main types of funding that can be discussed here.

Deferred group annuities. The group annuity is best suited to financing a “unit benefit” formula. Every year each employee earns a credit based on some small percentage, usually 1 percent-2 percent of his or her year's earnings. A single premium deferred annuity is then purchased for him or her equal to this credit. Upon retirement, his or her income will be the sum of these small single premium annuities.

Deposit administration group annuities. Under a deposit administration contract, the employer contributions are held by the insurance company in an undivided fund at a guaranteed rate of interest. The fund is increased by rate credits or dividends arising from interest earnings in excess of the guarantees and from savings in anticipated expenses and mortality assumptions. As participants retire, the full purchase price of an immediate annuity is withdrawn from the general fund.

Individual retirement income policies held in trust. A trust is created by the employer. The trust purchases individual retirement income policies on the lives of eligible employees. The amount of retirement benefit is based on one of several formulas regularly used in such plans and is described in the trust instrument. Each unit of the policy normally provides insurance equal to 100 times the monthly pension. This type of funding is particularly appropriate for small plans, especially those that include self-employed individuals.

Group permanent insurance. Group permanent insurance is an adaptation of the individual retirement income form of larger groups. A master contract is issued and certificates are distributed to participants; no trust is necessary. Since this is a form of group life coverage, it is subject to state laws as to minimum number of lives. As in the case of an individual policy plan, the insurance coverage is customarily 100 times the planned monthly pension. The amount of pension may be based upon any of the usual pension formulas.

Self-administration trusts. Under a self-administered trust, an actuary qualified under regulations issued by the Departments of Labor and Treasury estimates costs in much the same manner as an insurance company estimates premiums. From time to time, he tests his estimates against the actual experiences of the plan. Contributions recommended by the actuary are made to a composite trust fund. They are invested by the trustee as directed by the trust instrument and in accord with state and federal law. Pensions are paid from the trust fund as they accrue. Funds are often used to purchase single premium immediate annuities for retiring employees.

Combination plans. There are various funding methods that combine features of those previously described. But the combination plan most frequently used, and growing in popularity, is the one that combines the purchase of individual whole life contracts with a self-administered trust fund or a deposit administration fund. The whole life contract is purchased to provide an annuity funding vehicle at retirement. The contract provides that at retirement it may be exchanged for a retirement income contract upon payment of a lump sum to make up the difference in cash value. This additional sum needed comes from the accumulation in the auxiliary self-administered trust fund or deposit administration fund.

What happens if an employee covered under a qualified plan leaves his or her job before retirement? To what extent, if any, does he or she continue to have any rights in the plan? The answer depends upon the extent to which, at the time employment is terminated, the employee is “vested” in any of the benefits.

When a plan participant becomes vested in a retirement benefit, it means he or she acquires a nonforfeitable right to a percentage of the accrued retirement benefit. This means that if that person lives to retirement age, he or she will be entitled to a retirement benefit based upon the value of this accrued benefit, whether he or she continues with the same employer to retirement age or whether that person permanently quits after becoming either partially or wholly vested.

The law setting forth the qualification rules contains minimum vesting standards that a qualified plan (including a profit sharing plan, discussed later) must meet. First, a plan must provide full and immediate vesting in benefits derived from employee contributions. With respect to employer contributions, a plan generally must meet one of two alternative standards: One is a graded vesting standard requiring that an employee who has completed at least three years of service must have a nonforfeitable right to at least the following percentages of his or her accrued benefit: 20 percent after three years of service, 40 percent after four years of service, 60 percent after five years of service, 80 percent after six years of service, and 100 percent after seven years of service. The other requires 100 percent vesting after five years of service. The IRS may require a more rapid rate of vesting where there is a pattern of abuse (e.g., such as dismissing employees to prevent vesting). A plan must also provide for 100 percent vesting at normal retirement age.

If a plan provides that a terminating employee with a vested interest in the plan is to receive an immediate lump sum distribution of cash or property equal to the present value of the accrued retirement benefit, the employee may defer taxation on the distribution if the money or property (reduced by the sum of employee contributions) is rolled over to an individual retirement plan or another qualified plan. Generally, distributions received after 1992 from qualified retirement plans are subject to a mandatory income tax withholding rate of 20 percent unless the transfer is handled by means of a direct rollover, i.e., the rollover is accomplished by means of a trustee-to-trustee transfer. An individual may still defer taxation on a distribution that is rolled over within sixty days, but the employer must withhold 20 percent of the amount of the distribution.

As the name implies, a profit sharing plan is a plan to enable employees or their beneficiaries to share in the profits of the employer's business.

A profit sharing plan is one that meets the requirements of the Internal Revenue Code. Under a profit sharing plan, a portion of the employer's profit is contributed to an employees' trust, allocated among the employees according to a formula, and accumulated for the participants. Although most companies' contributions to qualified profit sharing plans come from current or accumulated profits, contributions may be made even if a company has no profits. Distribution is permitted only after a fixed number of years, the attainment of a stated age, or the occurrence of some event such as disability, retirement, death, or severance of employment. Distributions must generally begin before the later of April 1 of the tax year after (i) the year in which the participant attains the age of 70 ½ ,or (ii) the year the participant retires.

Generally, the same rules relating to employee coverage, vesting, and non-discrimination that apply to pension plans also apply to profit sharing plans.

Although pension and profit sharing plans have many similar characteristics and attributes, they are quite dissimilar in many significant ways and have different purposes.

As previously explained, the underlying purpose of a pension plan is to enable an employer to handle the problem of retiring employees in a humane and businesslike way. Although a deferred profit sharing plan can, and usually does, do a good job of providing for employee retirement, the primary purpose of a profit sharing plan is to encourage superior work and loyalty on the part of employees by sharing with them part of the fruits of their efforts. Because of this difference in purpose, the rules regarding the employer's contributions are different.

In essence, a pension plan must provide for the payment of a definitely determinable benefit (whether of a defined benefit or a defined contribution nature). A profit sharing plan, on the other hand, must provide a definite, predetermined formula for allocating contributions and trust earnings among participants, but is not subject to an annual funding requirement. Thus, profit sharing plans provide the maximum contribution flexibility from the employer's viewpoint since contributions can be skipped from time to time and the contribution amounts varied.

The amount an employer may contribute each year to a qualified profit sharing trust is limited by the same set dollar amount/25 percent rule applicable to money purchase pension plans; however, the maximum contribution the employer may deduct on its income tax return is limited to 15 percent of the payroll of the participants.

How are profit sharing contributions allocated among employees? The plan must provide a definite predetermined formula for dividing the profits to be shared among eligible members. As with contribution formulas, allocation formulas may take many forms.

The simplest formula is one that divides the employer's contribution according to the compensation of the participants. (In other words, each participant's share is in the ratio of his or her compensation to the total compensation of all the participants.) It also is possible to give some weight to age and/or length of service although care must be taken to prevent discriminatory allocation when it is done.

A profit sharing plan may provide for the purchase of life insurance on the lives of participants out of their allocated shares. The purchase may be mandatory or at the option of each participant.

If the plan permits life insurance to be purchased only with funds that have accumulated in the plan for some minimum period of time not less than two years, there is no restriction on the kind or amount of life insurance that may be purchased. When life insurance is purchased with funds that have not been accumulated for the period required by the plan for deferment of distributions (must be at least two years), and if the kind of insurance purchased is ordinary life, the aggregate premiums for life insurance in the case of each participant must be less than one-half the aggregate of the contributions allocated to him at any particular time.

Whenever life insurance is purchased on the life of a participant for the benefit of the beneficiary, the participant is currently taxed on the portion of the premium equal to the value of the net life insurance protection afforded by the policy in the year for which the premium is paid.

A combination plan for the investment of contributions, such as that discussed in connection with pension plans, is an ideal arrangement. Customarily, one-quarter to one-third of each participant's share of a given year's contribution is used to purchase ordinary life insurance on the life of the participant and the remaining amount is invested elsewhere. (A premium investment of something substantially less than 50 percent of the total contribution allows a desirable margin of safety.) Life insurance so purchased will do two important things: (1) guarantee that, should the employee die prematurely, the heirs will receive a substantial portion of the plan benefit that would have been available had the employee lived to retirement age; and (2) furnish a vehicle by which the employee's share at the retirement age may be converted to a life annuity.

A 401(k) plan is a profit sharing plan under which employees may elect to have the employer either make contributions to the plan on their behalf or pay that amount to the employee as cash compensation (that is, a cash or deferred arrangement). The amount of any before-tax contributions made by the employer at the employee's election (i.e., elective deferrals) is limited to $7,000, as indexed each year for inflation. The elective deferral limit for 1999 is $10,000.

A participant in a qualified cash or deferred arrangement will not have to include in income any employer contribution to the plan merely because the employee could have elected to receive this amount in cash instead.

Salary reduction agreements that meet the requirements of Section 401(k) will qualify as cash or deferred arrangements. Failure to satisfy the requirements can result in the present inclusion of employer contributions in the taxable income of employees on whose behalf the contributions are made, or in plan disqualification.

Pension and profit sharing plans are not for big business only.

To a closed corporation stockholder-employee in a high income tax bracket, participation in a qualified plan can be an unusually attractive investment. For example, if the employee is in a 31 percent income tax bracket, an additional $5,000 taken as a salary raise or as dividends on that person's stock nets the individual only $3,450 for investment and the income from the invested $3,450 is also subject to taxation (or to the lower earnings of tax exempt investments). But when the same $5,000 is contributed to the employee's account in a qualified plan, the entire $5,000 is available to earn investment income and neither the $5,000 nor the earnings made from its investment are subject to tax; only as the funds are distributed, after retirement, is there a tax liability, and then only at the taxpayer's income tax bracket at that time, when it is usually lower than before retirement.

When life insurance is included in a qualified plan, the participants have the unusual privilege of getting the benefits of life insurance that is paid for, in most part, with tax-free dollars. It is virtually the equivalent of getting an income tax deduction for life insurance premiums. There are few persons for whom this does not have a strong appeal.

Often, of even stronger appeal to closed corporation shareholder-employees is the realization that the proceeds of insurance on the life of a plan participant, payable under a qualified plan to a named beneficiary (not to or for the insured's estate), may be excluded from the insured participant's gross estate for federal estate tax purposes.

By all means, tell business-owner clients how a qualified pension or profit sharing plan can help them. At least, tell them enough to make them want to know more. If possible, get the following data from them: (1) employee census data, showing the number of employees, their dates of birth, sex, length of employment, position, and rate of pay; (2) a financial history of the company, showing its earnings record for, say, the past ten years; and (3) Complete information about other plans the company may have.

This information is necessary to enable anyone to give the client advice and to help in setting up a plan that will be custom tailored to the client's individual needs.