Accumulating enough savings for a comfortable retirement is important to many working Americans. Just as important is ensuring that retirement funds are managed and distributed fairly and responsibly. Among its many goals, ERISA seeks to protect funds that private-sector employees accumulate in their retirement plans as they work.[1] Although offering such plans is optional, an employer who does so must comply with certain minimum standards.
In this module, we’ll discuss the different types of retirement plans ERISA covers and the associated requirements.
Required Information in a Retirement Plan
ERISA seeks to ensure that plan participants are informed about their rights and benefits, as well as the plan’s performance. Therefore, when an employer offers a retirement benefits plan, it must provide employees with details on the following:[2]
- When an employee must be allowed to become a participant. Generally, an employee who is at least twenty-one years old must be allowed to participate in a qualified retirement plan after having been employed at the company for a year. An employer cannot set a maximum age for participation. Once the employee meets the eligibility requirement, she must be given the opportunity to join at the start of the next plan year or within 6 months, whichever is sooner.
- How long an employee must work before she has a vested interest in her benefits. Depending on the plan, an employee may have an immediate right to keep her retirement benefits or her employer’s contribution might vest incrementally over time.
- How long an employee can be away from her job before it may affect her benefits. An employee who leaves her job and is later rehired may be able to count her previous time with the employer toward vesting requirements. If an employee returns within five years, the plan usually must preserve the service credit that the employee had accumulated during the prior stretch of employment.
- Whether a spouse has a right to any benefits in the event of the participant’s death. Defined benefit plans usually include survivor’s benefits for a participant’s spouse unless the couple mutually decides otherwise. Generally, under defined contribution plans, a surviving spouse is automatically entitled to the retirement funds if the participant dies before receiving them. A participant may select a different beneficiary with the spouse’s written consent.
Types of Retirement Plans
Let’s look at two types of retirement plans: defined benefit plans and defined contribution plans.
Defined Benefit Plans
Under a defined benefit plan, the amount a participant will receive in retirement is determined in advance using a specified formula. We traditionally refer to such plans as pensions.[3] Typically, an employer funds the plan and invests the funds on behalf of employees—though some plans do include employee contributions as well. The employer bears the investment risk. Employees who satisfy eligibility requirements usually receive a set monthly amount at retirement.[4]
Under a traditional pension plan, as long as the employee works for his employer for a threshold number of years, he’s eligible for benefits when he reaches retirement age. The benefits are determined by a formula that considers the worker’s salary and years of service with the company.
One advantage of such a traditional plan is that an employee does not have to contribute earnings to the plan. However, the employee typically can’t invest additional funds, make investment choices or take the plan to another employer.[5] If an employee does leave, she can typically choose between receiving a lifetime annuity or a lump-sum payout based on the value accrued at the time.
A cash-balance plan, a second type of defined benefit plan, has some characteristics in common with defined contribution plans. The employee doesn’t contribute funds or make any investment choices. Under this plan, a worker receives a credit each year that is equal to a percentage of their salary (commonly 5 percent) plus a set interest rate. Employees can often opt to take a lump sum and roll it into an individual retirement account.[6]
Defined Contribution Plans
With a defined contribution plan, the amount paid into the plan is predetermined, but the amount the employee will receive in retirement is not fixed. Instead, this amount is based on factors such as the performance of the plan’s investments. It does not promise a specific payout.[7] The employer, the employee or both contribute to the retirement fund. For example, an employee might contribute six percent of his salary each pay period, and the employer might match 50 percent of that (three percent of the worker’s salary).[8]
The employee is responsible for choosing how much to contribute to his account on a pretax basis and how contributions are invested.[9] The balance in workers’ accounts is based on employee and employer contributions, investment gains or losses and fees charged to the accounts.[10]
The most popular defined contribution plan is a 401(k) plan. Such a plan allows an employee to contribute to the account from her paychecks, with “pre-tax” money, which means that contributions are tax deductible.[11] Under traditional 401(k) plans, eligible employees can make pre-tax deferrals through payroll deductions, and employers can make contributions on behalf of all participants or based on the amount that workers contribute. For example, an employer may decide to contribute one percent of each participant’s salary or match 50 percent up to the first six percent that an employee contributes, or some combination of these.
To attain maximum tax benefits, 401(k) plans must pass a “nondiscrimination” test, which means that they cannot favor executives or discriminate against low-wage earners.[12] All plan participants must be treated equally.[13] To ensure that plan sponsors abide by the rules, they have to conduct annual tests to preserve their tax benefits. Nondiscrimination tests compare benefits for highly compensated or key employees to the average benefits provided to rank-and-file workers. If there is too much of a gap between the benefits offered to the different groups of employees, the employer must either reduce the benefits offered to highly compensated or key employees or increase the benefits offered to other workers.[14]
There are different types of nondiscrimination tests that may apply, depending on the benefits plan. As an example, a minimum coverage test will verify that there are enough non-highly compensated workers receiving benefits compared to highly compensated workers.[15] A top heavy determination test looks at the total account balances for key employees versus the total balances for non-key employees.[16] If a plan is top heavy, non-key employees must receive faster vesting and certain minimum benefits.[17]
However, the Tax Code provides a “safe harbor” that allows plans to avoid nondiscrimination tests if they meet certain statutory requirements. The requirements for a safe harbor 401(k) plan include notice requirements, that employer contributions must vest immediately and certain across-the-board employer matching of contributions rules.[18]
SIMPLE 401(k) plans are available to certain small businesses and, like safe harbor 401(k) plans, aren’t subject to the nondiscrimination tests that apply to traditional 401(k) plans. Like an employer that offers a safe harbor plan, an employer offering a SIMPLE 401(k) plan must make contributions that fully vest immediately.
Under automatic enrollment 401(k) plans, employers may elect to automatically deduct a fixed percentage from employees’ wages to put into 401(k) accounts. An employee may opt out or elect to contribute a different percentage.
Under simplified employee retirement plans (known as SEP IRAs), employees own individual retirement accounts, and employers make contributions on a tax-favored basis.[19] If certain conditions are met, the employer may not be subject to ERISA’s reporting and disclosure mandates that are required for most retirement plans.[20] SEP IRAs can also be used by self-employed business owners as a more flexible vehicle than a traditional IRA.
Finally, profit sharing plans, or stock bonus plans, give employers discretion to determine how much to contribute to the plan each year—usually out of company profits.[21] If an employer doesn’t have a profit, it doesn’t have to contribute, so this type of plan may be attractive to small businesses. The employer’s contributions can be made in cash or company stock.
Participation and Vesting
Employers have leeway to set eligibility requirements and vesting schedules for their employees, as long as they meet ERISA’s minimum standards.[22] For example, even though employees must usually be allowed to participate if they are at least 21-years-old and have worked for the company for at least one year, an employer may allow younger workers or those who have been with the company for a shorter period to participate in a retirement plan.[23]
The term “vesting” refers to the time it takes for an employee to have a nonforfeitable right to an employer’s contributions.[24] One of ERISA’s goals is to prevent an employer from arbitrarily firing an employee right before he retires to avoid paying his retirement benefits. The law thus establishes vesting requirements,[25] which vary by plan type.
For employer contributions to most defined benefit plans, an employer can require employees to work for five years and then fully vest, referred to as cliff vesting. Employers can also choose to have an incremental vesting schedule, called a graduated vesting plan, that requires workers to reach seven years of service before fully vesting. However, the graduated vesting plan must allow for at least 20 percent vesting after 3 years, 40 percent after 4 years, 60 percent after 5 years, and 80 percent after 6 years of service.
Plans may provide different schedules as long as they are more generous than these minimum standards. For a cash-balance plan, employer contributions must vest after three years.[26]
The vesting requirements for defined contribution plans can differ in some ways. For example, under a traditional 401(k), employers can provide for their matching contributions to vest in one of two ways. Under the cliff vesting option, employer contributions fully vest after an employee completes three years of service. Under a graduated vesting option, employer contributions must be 20 percent vested after two years, 40 percent after three years, 60 percent after four years, 80 percent after five years and 100 percent after six years.[27]
Automatic enrollment 401(k) plans that require employer contributions must vest after two years, though plans with optional matching contributions may follow the cliff or graduated vesting options for those contributions. Required employer contributions under SIMPLE 401(k) and safe harbor 401(k) plans must vest immediately.[28]
Employers may choose a more-generous vesting option, but once an employer’s contribution is vested, the employee has the right to receive those funds even if he leaves his employer before retirement.[29] Employees are always immediately vested in any contributions they make to their own retirement plan, though they may have to pay a penalty if they access those funds before they reach a certain age.
Limits on Contributions and Withdrawals
Employers and employees alike should be aware of benefit and contribution limits under the various retirement plans. For example, under a defined benefit plan in 2018, annual contributions for a participant could not exceed $220,000.[30] This dollar amount is adjusted based on cost of living each year and increased by $5,000 from 2017.[31]
Defined contribution plans are also subject to limitations. For example, employees could contribute only $18,500 per year on a tax-deferred basis in 2018. Participants who are at least 50-years-old, however, could contribute an additional $6,000 on a tax-deferred basis, an allowance known as a “catch-up contributions.”[32]
Even after an employee’s interest vests, a participant may face penalties under tax law for withdrawing funds from a qualified retirement plan before reaching a certain age. Generally, withdrawals before age 59½ are known as “early” or “premature” distributions. A person must pay an additional 10% early withdrawal tax unless an exception applies.[33]
There are several exceptions to the tax penalty on early withdrawals. The following are just some of the exceptions that prevent penalties from being applied to early distributions:[34]
- The distribution was made to the employee’s estate or beneficiary after her death;
- The distribution was made because the employee is totally and permanently disabled and is unable to continue working;
- The withdrawal was made to cover qualified post-secondary education expenses. For this exception to apply, the qualified higher education expenses must be for the employee or her spouse, children or grandchildren.[35] Qualified higher education expenses include tuition, fees, books, supplies and equipment, as well as room and board if the student is enrolled at least half time in a degree program.; and
- A withdrawal was made to cover tax-deductible medical expenses. To qualify, the employee needs to have medical expenses that exceed 10% of her adjusted gross income, or 7.5% if she or her spouse is aged 65 or older.[36]
Nonqualified Plans
Qualified retirement plans must meet ERISA’s standards, but employers may also offer nonqualified plans to employees.[37] These plans are generally offered to executives and highly compensated employees who cannot qualify based on income or contribution levels or who would cause the plans to fail nondiscrimination tests. Nonqualified plans do not have to adhere to eligibility, participation, documentation and vesting requirements that ERISA-qualified plans must meet.[38] Furthermore, nonqualified plans are not subject to the nondiscrimination and top-heavy testing that qualified plans must pass.[39]
Although an employer will receive an immediate tax deduction for contributions to qualified plans, its contributions to nonqualified plans are not deductible until the employee withdraws the money and is taxed on the income.[40] Conversely, employees do not have to pay income taxes on the contributions to nonqualified plans until they take distributions.[41]
Conclusion
Although traditional pension plans were once popular, the percentage of U.S. workers in the private sector who are covered by defined benefit plans has been steadily declining over the past 25 years.[42] In 1990, about 35 percent of private-sector workers were covered by such plans. By 2011, only 18 percent participated in defined benefit plans.[43]
Defined contribution plans, particularly 401(k) plans, have increased in popularity starting in the 1980s.[44] Today, 401(k) plans hold more than $4.8 trillion in assets.[45] There is a great deal of debate on whether defined contribution plans adequately replace defined benefit plans. Regardless, defined contribution plans continue to be popular sources of retirement savings for many American workers today.[46]
In our next module, we’ll look at the application of ERISA to health insurance plans and other employer-sponsored benefits related to the health and welfare of employees.
[1] “RetirementPlans and ERISA FAQs – What is ERISA?”
[2] Id.
[3] “What is the Difference Between a Defined Benefit Plan and a Defined Contribution Plan?” Time, http://time.com/money/collection-post/2791222/difference-between-defined-benefit-plan-and-defined-contribution-plan/
[4] Id.
[5] “Ultimate Guide to Retirement – What are the Disadvantages of a Defined Benefit Plan?” CNN Money,
https://money.cnn.com/retirement/guide/pensions_basics.moneymag/index10.htm?iid=EL
[6] Id.; “What is the Difference Between a Defined Benefit Plan and a Defined Contribution Plan?” Time, http://time.com/money/collection-post/2791222/difference-between-defined-benefit-plan-and-defined-contribution-plan/
[7] “Types of Retirement Plans,” U.S. Dep’t of Labor, https://www.dol.gov/general/topic/retirement/typesofplans
[8] Id.
[9] “RetirementPlans and ERISA FAQs – What is ERISA?”
[10] Id.
[11] Id.
[12] “Nondiscrimination Rule,” Investopedia, https://www.investopedia.com/terms/n/nondiscrimination_rule.asp
[13] Id.
[14] “Nondiscrimination Testing Overview,” DWC, https://www.dwc401k.com/knowledge-center/nondiscrimination-testing-overview
[15] Id.
[16] Id.
[17] Joanne Sammer, “Clearing Annual 401(k) Compliance Test Hurdles,” Society for Human Resource Management, (Nov.15, 2013), https://www.shrm.org/resourcesandtools/hr-topics/benefits/pages/401k-compliance-testing.aspx.
[18] “401(k) Plan Overview,” Internal Revenue Service, https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview (last visited Sept. 16, 2018).
[19] “RetirementPlans and ERISA FAQs – What is ERISA?”
[20] Id.
[21] Melissa Phipps, “Profit Sharing Plan,” The Balance, (Aug. 8, 2018), https://www.thebalance.com/profit-sharing-plan-2894303.
[22] “RetirementPlans and ERISA FAQs – What is ERISA?”
[23] Id.
[24] “Vesting,” Investopedia, https://www.investopedia.com/terms/v/vesting.asp
[25] Rebecca J. Miller, Robert A. Lavenberg, & Ian A. Mackay, “ERISA: 40 years later,” Journal of Accountancy, (Sept. 1 2014), https://www.journalofaccountancy.com/issues/2014/sep/erisa-20149881.html.
[26] “RetirementPlans and ERISA FAQs – What is ERISA?”
[27] Id.
[28] Id.
[29] “Retirement Topics – Defined Benefit Plan Benefit Limits,” Internal Revenue Service, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-defined-benefit-plan-benefit-limits
[30] Id.
[31] Id.
[32] “COLA Increases for Dollar Limitations on Benefits and Contributions,” Internal Revenue Service, https://www.irs.gov/retirement-plans/cola-increases-for-dollar-limitations-on-benefits-and-contributions; Beth Pinsker, “Catch-Up Contributions Put Retirees Way Ahead,” Time, (Jan. 11, 2016), http://time.com/money/4175048/401k-catch-up-contributions/.
[33] “Retirement Topics – Exceptions to Tax on Early Distirbutions,” Internal Revenue Service, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions
[34] “Tax Penalties on Early Withdrawals from Retirement Plans,” Efile.com, https://www.efile.com/tax-penalty-early-retirement-withdrawals-distributions/ (
[35] “Retirement Plans and Saving for College,” FinAid, http://www.finaid.org/savings/retirementplans.phtml
[36] “Form 5329 – Exceptions to Early Withdrawal Penalty,” TaxSlayer, https://www.taxslayer.com/support/218/form-5329–exceptions-to-early-withdrawal-penalty
[37] “Qualified Retirement Plans vs. Nonqualified Plans,” Zacks, https://finance.zacks.com/qualified-retirement-plans-vs-nonqualified-plans-6114.html
[38] Id.
[39] “Non-Qualified Plan,” Investopedia, https://www.investopedia.com/terms/n/non-qualified-plan.asp#ixzz5PUBIbSV8
[40] “Qualified Retirement Plans vs. Nonqualified Plans,” Zacks, https://finance.zacks.com/qualified-retirement-plans-vs-nonqualified-plans-6114.html
[41] “Nonqualified Deferred Compensation Plans,” Fidelity, (May 20, 2015), https://www.fidelity.com/viewpoints/retirement/nqdc.
[42] “TED: The Economics Daily – The Last Private Industry Pension Plans,” U.S. Dep’t of Labor, Bureau of Labor Statistics, (Jan. 3, 2013), https://www.bls.gov/opub/ted/2013/ted_20130103.htm.
[43] Id.
[44] Kathleen Elkins, “A Brief History of the 401(k), Which Changes How Americans Retire,” CNBC, (Jan. 4, 2017), https://www.cnbc.com/2017/01/04/a-brief-history-of-the-401k-which-changed-how-americans-retire.html.
[45] Id.
[46] Id.