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 dec