Defined Benefit 401ks set to make their debut

 

Small business owners have plenty of options to choose from when it comes to a qualified retirement plan for the company. It can range from a Savings Incentive Match Plan for Employees (SIMPLE) to a Simplified Employee Pension (SEP) to a 401(k). But now there’s a new kid on the block.
 
Strategy: Consider the defined benefit 401(k) plan (called the “DB/401(k)” for short) for small business clients. This hybrid plan combines some of the advantages of a traditional pension plan with a regular 401(k).
 
Why haven’t you heard more about the DB/401(k)? The authority for this new plan, which becomes available on Jan. 1, 2010, was buried deep within the massive Pension Protection Act of 2006. But interest in DB/401(k)s is expected to heat up during the coming year.
 
Background information: With a defined benefit plan, such as a traditional pension plan, contributions are based on salary, age and years of service. The company sets aside actuarially determined contributions on behalf of the employees each year. For 2009, the contributions can’t fund an annual retirement benefit exceeding $195,000.
 
Because employers must pay the entire tab for pension plans, these plans have waned in popularity in recent years. Conversely, more employers have switched to defined contribution plans such as 401(k) plans, which are funded largely or totally with employees’ money.
 
With a 401(k) plan, employees can elect to defer part of their salary, up to an annual dollar limit. For 2009, the employee elective deferred (salary reduction) limit is $16,500 ($22,000 if age 50 or older).
 
The elective deferrals may be combined with matching contributions from the employer up to the annual limit for defined contribution plans. The limit for defined contribution plan contributions for 2009 is $49,000 ($54,500 if age 50 or older). All qualified plans must meet nondiscrimination rules ensuring that highly compensated employees (HCEs) aren’t unduly favored, but the testing requirements for 401(k)s can be particularly onerous. To ease the burden, special “safe-harbor” rules have been established. Also, some 401(k) plans use an automatic enrollment feature designed to increase plan participation among non-HCEs (see Requirements for automatic enrollment 401(k)s below).
 
New option: Enter the DB/401(k). It is available for the 2010 plan year to employers with at least two employees and no more than 500 employees.
 
The DB/401(k) combines a defined benefit plan based on final average pay with a safe-harbor 401(k). Two requirements:
 
1. The defined benefit part of the plan must provide a benefit equal to 1% of the final average pay times years of service up to a maximum of 20% of final pay. (A more complex structure is required if a cash balance plan is used instead of a final average pay plan.)
 
2. The 401(k) part of the plan requires automatic enrollment with an employee deferral of 4% of compensation. Matching contributions for HCEs can’t exceed the matching contribution rate for non- HCEs. Employees must be immediately vested in their 401(k) accounts.
 
Advisory: If these requirements are met, the company has to file only one document for the plan and one Form 5500, Annual Return/Report of Employee Benefit Plan, each year. Best of all, employers don’t have to undergo the rigorous testing procedures for 401(k)s. Simply make the allowable contributions, file the paperwork and you’re set.
 
Requirements for automatic-enrollment 401(k)s
 
Elective Deferrals By Employees      Employer Contributions
Automatic deferral must equal between 3% and 10% of compensation with:
• At least 3% in the first year of participation
• At least 4% in the second year of participation
• At least 5% in the third year of participation
• At least 6%, but not more than 10%, in any subsequent year of participation
 
100% vesting after no more than two years under either of the following two options:
 
Option 1: Matching contributions for nonhighly compensated employees (non-HCEs)* must equal 100% of elective deferrals up to 1% of compensation + 50% of elective deferrals of more than 1% up to 6% of compensation.
 
Option 2: Automatic employer contribution must equal 3% of compensation.
 
*Matching contribution rate for highly compensated employees (HCEs) can’t exceed matching contribution
rate for automatically enrolled non-HCEs.
 
Reprinted with permission from The Tax Strategist, October 2009. For continuing advice on this and numerous other tax strategies, go to www.TaxStrategist.net. Receive 2 FREE Bonus reports and a 40% discount on The Tax Strategist when you use Promo Code WN0013.

Small business owners have plenty of options to choose from when it comes to a qualified retirement plan for the company. It can range from a Savings Incentive Match Plan for Employees (SIMPLE) to a Simplified Employee Pension (SEP) to a 401(k). But now there’s a new kid on the block.

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