Generally retirement plans fall into two categories: Defined Contribution and Defined Benefit. The Employee Retirement Income Security Act (ERISA) covers two types of pension plans: defined benefit plans and defined contribution plans. There are important differences between the two that ultimately describe how benefits will be paid out from the different types of retirement plans. More commonly employers are replacing defined benefit plans with defined contribution plans, primarily due to the expense and long-term obligations associated with running a defined benefit plan.
Employers can save significant money in future years by having a defined contribution plan over a defined benefit plan. Unlike a defined benefits plan, where you would just need to make your contributions to receive your benefits upon retirement, defined contribution plans require continual action on your part to grow as efficiently as possible.
What is a Defined Contribution Plan?
A defined contribution plan provides an individual account for each participant and provides benefits based solely on the amount contributed to the participant’s account. A defined contribution plan that satisfies the definition of a retirement system must provide for an allocation to the employee’s account of at least 7.5 percent of the employee’s compensation during any period under consideration.
401k, 403b, and 457 Plans
A variety of plan types could meet the requirement: for example, plans established under Internal Revenue Code sections 401(a), 403(b) or 457. Contributions from both the employer and the employee maybe used to make up the 7.5 percent. Employer contributions can be calculated with employee contributions to reach the 7.5 percent.
A plan with only employee contributions would also satisfy the minimum benefit requirement, provided contributions constitute at least 7.5 percent of compensation. However, the 7.5 percent cannot include any earnings on the account.
Earnings or compensation is considered “base pay” as long as “base pay” is reasonable. A defined contribution retirement system may disregard overtime pay, bonuses, and/or single sum amounts received on account of death or separation from service, amounts received under a bona fide vacation, compensatory time or sick leave pay plan, or funds received under severance pay plans.
Any compensation in excess of the social security maximum wage base for that particular year may also be disregarded for this purpose. For example, for tax year 2013, the social security maximum wage base is $113,700.
Generally, for an employee who holds more than one position with the same employer, all compensation with that employer is considered in applying the 7.5 percent test. However, at the employer’s option, compensation from only one position may be considered, if that position is not part-time, temporary, or seasonal. We will discuss part-time, temporary, or seasonal later in this “forum”.
What is a Defined Benefit Plan?
A defined benefit plan (for purposes of determining whether it qualifies as a public retirement system), is any plan other than defined contribution plan. A defined benefit plan determines benefits on the basis of a formula, generally based on age, years of service, and salary level.
A defined benefit retirement plan system that qualifies as an alternative to social security provides for a retirement benefit to the employee that is comparable to the benefit provided by the social security part of FICA. Generally, a plan meets the requirement if the benefit under the system is at least 1.5 percent of average compensation during an employee’s last three years of employment, multiplied by the employee’s number of years of service.
A defined benefit plan has safe harbor formulas that use the Final and highest average pay formulas of 36 months or less at 1.5%. Revenue Procedure 91-40 provides the formula for calculating benefits for periods more than 36 months (or 3 years).
- 37-48 months 1.55%
- 49-60 months 1.60%
- 61-120 months 1.75%
- Over 120 months 2.0 %
What does this mean for Social Security participation purposes?
If a government entity meets the safe harbor rules as participating in a defined benefit plan, then they have a “FICA replacement plan”. In short, if the government entity does not have a Section 218 Agreement and the retirement system plan meets the Revenue Procedure 91-40 safe harbor rules the government entity and the employees do not participate in Social Security. (Although anyone hired after March 31,1986 would participate in Medicare).