Retirement Programs: Which One Is Right for Your Nonprofit?

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With all the current changes and additions to regulations covering retirement programs, the choices of plan types have expanded—but so have the possible pitfalls to installing and maintaining a competitive retirement program for your nonprofit organization. This article is meant to cover some of the more popular “qualified” retirement plans available to nonprofits and some basic requirements to adopt and maintain an effective plan for your organization and its employees.

A “qualified” retirement plan is one that provides:

  • A tax exemption for the fund that is established to provide benefits;1
  • A deduction by the employer for contributions made to the fund;2 and
  • A deferral of the taxes to be paid by the employee on the employer’s contributions made on the employee’s behalf, the employee’s contributions, and the earnings that may accumulate on both within the retirement fund.3

Standard Retirement Programs

There are two broad categories for qualified retirement plans: defined benefit plans and defined contribution plans. Defined benefit plans include pension and annuity plans that offer a specific benefit to the employee throughout his or her retirement.4< The benefit the employee is to receive at or during his or her retirement is based upon the amount of the employee’s wages and the years of service with the employer. An actuary must be employed each year to determine an amount, based upon certain assumptions,5 that the employer must contribute to the plan trust on behalf of the employees to cover retirement benefits for each current employee as projected through retirement. The money is not specifically allocated to individual accounts maintained for each employee and employees cannot contribute into such a plan on their own behalf. In a defined benefit plan, the employer is solely responsible for funding the plan and ensuring that there are enough dollars in the plan trust to cover the retirement benefits projected by the actuary for the employees.

Defined benefit plans have lost their popularity over the years, especially among smaller nonprofit employers, as the annual costs are often unpredictable and the employer must fund the amounts as required by law each year and as determined by the actuary for the plan to be in compliance. If interest rates increase and performance of the investments within the plan are solid, the employer may see a reduction in the required annual contributions. However, costs are likely to go up in times of poor market performance. Changes in personnel within an organization can also affect the volatility of the required contributions. The risk (and reward) is on the employer; the employee takes no responsibility for contributions, investment selection, or performance of the fund.

Defined contributions plans include profit sharing and money purchase plans. For such plans a separate accounting must be provided for each employee who is covered by the plan, and the employee’s retirement benefit will be based solely on contributions made to the plan by the employer (and employee if allowed) and the earnings on these contributions.6 The reason these types of plans are coming more into favor is not just that the employer has more control over the amounts the organization is required to contribute to the plan each year on behalf of its employees, it is also that the employees are allowed to “self-direct” the investment of contributions made on their behalf. Typically, the employee’s choice of investments is limited to a select group of investments; however, even with a limited number of funds, the employee now takes on the responsibility for the outcome of the dollars that will eventually be available at his or her retirement. The earnings (and losses) in each employee’s own investment portfolio are dictated by the investment choices made by that employee.
In addition, a feature can be added to such plans to allow for the employee to contribute some of his or her compensation to this retirement portfolio (see “401(k) plans” below).

Of the two types of defined contribution plans available, profit sharing plans allow the employer more flexibility in the amount of the contributions made each year, in that the nonprofit organization can change the amount of the contributions it chooses to make each year on behalf of its eligible employees—as long as the contributions are “substantial and recurring.” The term “profit sharing” is a misnomer, however, as the contributions made annually to the plan have nothing to do with profits and such a plan can be maintained by a nonprofit organization.7

Money purchase plans are also a type of defined contribution plan; however, unlike a profit sharing plan, an employer’s annual contributions are fixed (within the plan documents) as a percentage of eligible employees’ annual compensation.8 For example, under a money purchase plan, the plan may require that the employer contribute 5% of each participating employee’s wages with no regard to the financial performance of the organization for that fiscal period.

Annuity plans are another form of defined contribution plans, which are funded through the direct purchase by the employer of an annuity contract or contracts for the employees.9 In addition, certain nonprofit organizations10 may provide retirement benefits for its employees through the purchase of annuities or by contributing to a custodial account invested in mutual funds.11 This type of plan is typically referred to as a “403(b) plan” or a “tax-sheltered annuity plan” (TSA).

Also, 401(k) plans are now available to nonprofit organizations. In this type of plan, all contributions are considered to be employee contributions because the employee is given the option of taking the contribution in cash or having it paid to the plan. This is known as an “elective contribution” because the contributions coincide with a salary reduction agreement.12 Some know 401(k) plans as “cash or deferred arrangements” (CODAs) and in many cases, an employer may add a 401(k) “option” to the defined contribution plan so that both employer and employee contributions can be made to the employee’s account.

Simpler Retirement Programs

In addition to the standard plans, current law allows for SIMPLE13 retirement plans for employers who have 100 or fewer employees who received at least $5,000 of compensation from the employer in the preceding year.14 However, the employer is not allowed to maintain any other plan. An eligible employer who establishes and maintains a SIMPLE plan for at least one year, but fails to qualify in a subsequent year (i.e., the employer employs more than 100 employees making in excess of $5,000 each per annum), will continue to be considered eligible for the two years following the last year in which they did qualify.15

There are two types of SIMPLE plans: a SIMPLE IRA and a SIMPLE 401(k). A SIMPLE IRA must permit each eligible employee to elect to have the employer make payments either directly to the employee in cash or as a contribution (i.e., a percentage of the employee’s compensation) to the employee’s SIMPLE account.16 Contributions are limited to $9,000 for 2004 and $10,000 for 2005, which are lower than employee contributions allowed in a standard 401(k) or 403(b) retirement program and, while employer contributions can be made to match these employee contributions, the employer contributions cannot exceed 3% of the contribution made by the employee contribution.17 This too is less than the limits imposed on the standard retirement program options. However, establishing and maintaining a SIMPLE program is, well, much simpler.

There is also little or no cost to establish and administrate such programs.

For standard 401(k) and 403(b) programs, plan documents must be adopted and filed with the authorities, summary descriptions of the plan must be given to each employee, annual discrimination testing must be performed by a qualified professional, and an information return (i.e., the Federal Form 5500) will need to be filed. Start-up costs to establish a qualified plan can run in excess of $1,000, while costs to ensure that the plan stays in compliance with ever-changing regulations as well as for annually testing for discrimination and filing the information return can cost an additional $750 to $1,500 each year.

However, for a SIMPLE IRA plan, a straightforward three-page form need only be completed by the employer to establish the plan. The form is not filed with the authorities, but rather maintained in the employer’s files. No annual filing or discrimination tests are required.

As such, smaller nonprofits should consider using the funds they would spend to establish and administrate a 401(k) or 403(b) plan to make an additional contribution on behalf of their employees within a SIMPLE plan.

The limitations of employee contributions for a SIMPLE 401(k) plan are the same as the SIMPLE IRA, and the matching limitations are basically the same as well. Again, if you can live with the reduced contributions limits, the advantage to a SIMPLE 401(k) plan over the standard plan is that there are fewer tests for plan discrimination and no annual filing requirements, and as such, the cost to implement and maintain it will be less.

Steps to Implementation

While the laws and regulations governing qualified retirement programs are complex, this should not discourage a nonprofit organization from installing and aggressively funding a qualified pension plan. If we in the sector intend to attract and retain qualified individuals, we must provide competitive benefits, and retirement benefits are certainly some of the more important ones, especially for those employees with long-term commitments to our organization.

Determine the amount of funds your organization may be able to set aside for your employees annually. If the funds are significant, consider a defined contribution plan. If your organization cannot provide more than a few hundred dollars per employee (or a few thousand in total) and you have fewer than 100 employees, consider a SIMPLE plan.

Ask your employees about their interest in saving on their own behalf for their retirement. An employer may find that a confidential questionnaire given to each employee may assist them in making an informed decision about the type of plan they eventually establish. Ask the employees the amount or percentage of their compensation that they are likely to set aside if a plan were to be put in place and how much more they might be induced to save if the employer were to match their contribution. Be certain the employee understands the effect on his or her take-home pay in making a contribution with every pay period. Remember that federal and state income taxes are deferred on such contributions, so any contribution made by your employees should have less of an effect on their take-home pay than they might think (see table on page 80).
Encourage your young people to invest in their retirement. The time value of money has an amazing effect on the dollars you set aside in the early years of your employment. For example, if an employee were to start saving for retirement at age 33 by setting aside $100 each month into a qualified pension plan through age 65 for a total investment of $39,600, he or she would have approximately $170,000 available for retirement at age 65. However, if he or she started to save at age 25 and stopped at age 33, for a total investment of only $10,800, that balance would accumulate to approximately the same amount of $170,000 at age 65.18 The idea is convince your employees to start early and to continue to contribute a percentage of their pay, as their pay increases, through the day they retire. They will be happy they did and the more participation among your employees within your defined contribution program, the more likely you will be to pass the annual discrimination testing.

If you decide that a SIMPLE plan is the way to go, all you need to do is establish tax-deferred accounts for your employees with any reputable bank or investment firm. Cost should be minimal. Just be certain to ask about asset management charges, which will fluctuate depending on the type of investments you may select for the plan.

If you do decide to go with a defined contribution plan, the amount you plan to invest annually (and the number of participating employees) is likely to determine the companies that are willing to do business with you. Large 401(k) providers typically will not work with small groups unless big dollars are involved. 403(b) providers tend to be more lenient with such requirements.

In addition, it is important to know that the company providing the investment vehicles for your pension contributions may not be in the business of administrating the defined contribution plan (i.e., ensuring compliance with the law). In such cases you need a third party administration (TPA) company to assist in the establishment and annual maintenance of the plan. (Such services and fees have been described previously in this article.)

When selecting either company, be certain to obtain a letter of engagement defining the services and detailing the fees. In addition to an asset management fee assessed on your plan investment, the investment company or investment manager may also charge additional fees for “other services” on the account.

Conclusion

While your organization should proceed with caution when implementing and maintaining a qualified retirement program, it should proceed. We owe it to our employees to give them a vehicle in which to save for their retirement and to assist them in the savings through making as much of an employer contribution as possible. Salary or hourly wages is only a part of compensation and we, as employers, should not make it the only part. I have seen many of my nonprofit clients faced with the dilemma of an employee with 10 to 20 years or more of tenure with their organization and no significant dollars on which to retire. It is daunting to think that after so many years of serving a nonprofit organization and building its program and reputation, your long-term employees might retire with little or no savings. Plan ahead and plan now. We, in the sector, dedicate our lives to helping others. Don’t forget the employees that dedicate themselves to such noble causes.

Endnotes

1. Internal Revenue Code Section 501(a); Reg. §1.401(f)-1(c)(1)
2. Code Sec. 404. An employer/company can deduct the amount of the contribution it makes to a qualified plan on behalf of its employees subject to certain limits. While such a “business” tax deduction may not necessarily be of interest to a tax-exempt nonprofit, the nonprofit should still comply with the limits set forth in the law, as allowing contributions to go beyond such limits will increase the possibility of not passing the discrimination tests that may be required depending on the type of qualified pension plan in place with the employer.
3. Code Sec. 402(a). Federal and state income tax is deferred on contributions made to a qualified plan by or on behalf of the employee subject to certain annual limitations. Employee contributions are subject to applicable social security tax.
4. Code Sec. 414(J)
5. Reg. §1.401-1(b)(1)(i)
6. Code Sec. 414(j)
7. Code Sec 401(a)(27)
8. Reg. §1.401(b)(1)(i)
9. Code Secs. 403(a)(1) and 404(a)(2)
10. Public school systems and tax-exempt educational, charitable, or religious organizations (i.e., 501(c)(3) organizations)
11. Code Sec. 401(b)(1)(A)
12. Code Secs. 401(k) and 402(e)(3; Reg. §1.401(k)-1 and 1.401(a)-1(d)
13. SIMPLE is an acronym that stands for Savings Incentive Match Plan for Employees.
14. Code Sec. 401(k)(11)(C) and 408(p)(2)(C)(i)(I)
15. Code Sec. 40-1(k)(11)(A) and (D)(i); Code Sec. 408(p)(2)(C)(i)(II)
16. Code Sec. 408(p)(2)(A)(ii)
17. Code Sec. 408(p)(2)(A)(iii) and Code Sec. 408(p)(2)(C)(ii).
18. This calculation assumed an annual interest rate of 7.5% compounded monthly.
19. Although you can use fewer hours and a lower age, you cannot generally go above these amounts.
20. For for-profit entities, there are limitations on the amount of contributions that the employer can deduct.
21. Vesting represents the non-forfeitable interest of the employee in his or her account balance. By law, an employee is fully vested in any contribution he or she makes on his or her own behalf. Contributions made by the employer on behalf of the employee will “vest” based on the vesting schedule defined within the plan documents (with the exception of a SIMPLE IRA, which is always 100% “owned” by the employee whether the contribution was made by the employer or the employee). Thus, if a plan defines vesting at a rate of 20% annually, an employee would receive 40% of the employer’s contributions if that employee were to leave the employ of the organization after two years of service (as defined by the plan).
22. The top-heavy test is a test designed to ensure against a plan primarily benefiting the key employees or those that are considered by law to be highly compensated. A plan that does not pass this test is considered to be top heavy.
23. The ADP or the Actual Deferral Percentage test is a special test designed to limit the extent to which elective contributions made on behalf of highly compensated employees may exceed the elective contributions made on behalf of non-highly compensated employees under a 401(k) plan.
24. The ACP or the Actual Contribution Percentage test is a special nondiscrimination test applied to employer matching contributions and employee contributions.
25. The limits established by Internal Revenue Code (IRC) Section 415 currently require that annual additions to an employee’s account under a defined contribution plan cannot exceed the lesser of $40,000 or 100% of the employee’s compensation (not exceeding $200,000). For defined benefit plans, the IRC defines the maximum annual retirement benefit for any participant as one not to exceed the lesser of $160,000 or 100% of the participant’s average compensation (not exceeding $200,000) for the participant’s three consecutive years of highest compensation.

About the Author

Thomas Raffa is the managing partner of RAFFA, P.C., a certified public accounting, technology, and consulting firm based in Washington, D.C., with over 100 professionals dedicated to the nonprofit sector. Call 202-822-5000, www.raffa.com, www.iknow.org.