Sidecar Accounts

Before the retirement community shifted to a pretax 401(k) system in the 1980s, many companies offered a supplemental savings account (to be used for short-term emergencies) to complement the defined benefit (DB) plans of their employees. These supplemental savings accounts are nearly identical to what are known today as “sidecar accounts.” A sidecar account is essentially an additional savings account that is directly linked to an employee’s existing retirement account. Under the sidecar system, funds are set aside in a short-term savings account to be used in times of emergency, in an effort to prevent the harsh tax penalties associated with hardship withdrawals from an employee’s retirement plan. Under these accounts, money will be taken from an employee’s paycheck and set aside until certain “buffer” threshold is reached. After this “buffer” amount is reached, all future funds will go directly into the employee’s retirement account, just as they would normally. To ensure a consistent, adequate amount of emergency funds between the employee and his or her retirement account, the funds will be replenished each time a withdrawal is made.

Unlike with a DB account, a participant in a defined contribution (DC) plan has the option of using some or all of his/her funds for non-retirement related expenses, mainly in times of hardship. Because these emergency funds are more readily available, one in four DC plan participants will, at some point during his or her career, use some or all of his/her savings for non-retirement based needs. This is known as leakage. Because of the increasing amount of leakage from DC accounts, a survey was conducted by LIMA, which showed that 2/3 of workers in today’s market have some interest in setting up an automatic emergency savings account in addition to their retirement account. Furthermore, 89% of employers have shown interest in offering this product. There have been further studies conducted, revealing that if an account can be psychologically associated with future income and long-term assets, with less availability for withdrawal, account holders will be more successful in resisting the temptation of making a hardship withdrawal or cash out. They will thus be more likely to prevent retirement leakage. For all of these reasons, sidecar accounts are gaining ground as a viable solution to combat account leakage in today’s retirement community.

Although these accounts come with many benefits, there are many financial and regulatory concerns surrounding them. The first among these is: who should be responsible for delivering the account to customers? Due to their already-established payroll-based structure for retirement contributions, employers seem to be the most logical option for delivering these accounts. An employer would be able to package the 401(k) and sidecar accounts together and enroll workers in both simultaneously. As simple as it may sound, many employers may not be ready to take on the added responsibility and administrative costs associated with this new plan benefit.

So, if linking the two accounts is not a viable option for a company, there are still several other paths to choose from:

  • Individually sold accounts: While still a viable option, this path is rarely chosen because linking the sidecar account with the normal retirement account can be complicated. Secondly, it can be difficult to integrate the second account with the employer’s payroll system so that savings are automatically deducted from paychecks, just like they would be with normal retirement deferral percentages.
  • MyRA: This plan option was offered by the US Treasury Department and is set up in such a way that it could be split up into both long-term and sidecar accounts. Under this system employers could more easily fund their employees’ accounts through payroll deduction.
  • Secure Choice: These retirement programs are state-led, but privately managed, and automatically enroll workers into their own IRA. Oregon, a Secure Choice state, has expressed interest in offering this form of sidecar account as an option to retirement savers. These programs use Roth IRAs, meaning they can more easily be treated as hybrid accounts in order to serve both short-and long-term needs. A downside to this is that transfers from an IRA can take up to three business days, so they may not be the best option in times of sudden hardship where funds would be needed immediately.

These options offer a lot of food for thought when it comes to helping employees protect their retirement savings. But, once an account structure has been chosen, the next step is to decide whether or not to offer automatic enrollment. If this turns out to be the best option, there are several ways to go about it, but each has its own set of serious disadvantages.[1] In an effort to combat these issues, one might look to active choice as the most viable option. Especially since research has shown that forcing employees into an active choice can greatly increase participation (even if not quite to the same levels achieved by automatic enrollment).



We believe the time is right to move from theoretical discussions about sidecar accounts into concrete action and real-world testing. Indeed, many researchers and policymakers are answering the call, actively exploring the possibility of pilot testing sidecar models. As they grapple with next steps, we hope that this analysis can help illuminate the key design choices they will face and the main considerations that should inform their decisions. We acknowledge that a sidecar account, if designed poorly, could be yet another complicated, parallel savings structure in the sea of 401(k)s, 403(b)s, IRAs, HSAs, and 529s. But if done well, we strongly believe that a sidecar account could improve the financial well-being and security of Americans in both the short and long term — an outcome that is good not only for families, but for the economy overall.

The Aspen Institute: Financial Security Program

[1] Aspen Institute: Financial Security Program. Driving Retirement Innovation: Can Sidecar Accounts Meet Consumers’ Short and Long-Term Financial Needs? Pg. 7

Hardship Withdrawals from 401(k) and 403(b) Plans

On February 23, 2017, the Internal Revenue Service released its Substantiation Guidelines for Safe-Harbor Distributions from Section 401(k) Plans. And on March 7, 2017 they released a similar memorandum regarding section 403(b) plans. These two statements outlined the requirements for safe harbor hardships in an effort to better inform the public about which events allow a plan participant to qualify for such a distribution. They also outlined steps to follow for determining whether or not a participant is eligible for a hardship distribution. Under these regulations, section 403(b) plans are subject to the same rules as the 401(k) guidelines outlined below.

The IRS gives two main steps when determining whether or not a distribution request meets the “immediate and heavy” financial need requirement:

Step 1:

  • Determine whether the employer or third-party administrator, prior to making a distribution, obtains: (a) source documents (such as estimates, contracts, bills and statements from third parties); or (b) a summary (in paper, electronic format, or telephone records) of the information contained in source documents.
    • If a summary of information on source documents is used, determine whether the employer or third-party administrator provides the employee notifications required on Attachment I prior to making a hardship distribution.

Step 2:

  • If the employer or third-party administrator obtains source documents under Step 1(i)(a), review the documents to determine if they substantiate the hardship distribution.
  • If the employer or third-party administrator obtains a summary of information on source documents under Step 1(i)(b), review the summary to determine whether it contains the relevant items listed on Attachment I.
  • If the notification provided to employees in Step 1(ii) or the information reviewed in Step 2(ii) is incomplete or inconsistent on its face, you may ask for source documents from the employer or third-party administrator to substantiate that a hardship distribution is deemed to be on account of an immediate and heavy financial need.
  • If the summary of information reviewed in Step 2(ii) is complete and consistent but you find employees who have received more than 2 hardship distributions in a plan year, then, in the absence of an adequate explanation for the multiple distributions and with managerial approval, you may ask for source documents from the employer or third-party administrator to substantiate the distributions. Examples of an adequate explanation include follow-up medical or funeral expenses or tuition on a quarterly school calendar.
  • If a third-party administrator obtains a summary of information contained in source documents under Step 1(i)(b), determine whether the third-party administrator provides a report or other access to data to the employer, at least annually, describing the hardship distributions made during the plan year.

In an article, entitled Do’s and Don’ts of Hardship Distributions, the IRS gives further advice regarding what to do and what not to do when determining hardship eligibility. They first suggest reviewing the terms of hardship distribution outlined in the plan document, including:

  • Whether or not the plan allows for hardship distributions
  • The procedures the employee must follow to make the distribution request
  • The plan’s definition of what qualifies as a hardship
  • Any limits to the amount/type of funds eligible for hardship distribution


After taking all necessary precautions to make sure the plan allows for the type of withdrawal being requested, the employee must then make sure the distribution is on account of an “immediate and heavy financial need” as defined under § 1.401(k)-1(d)(3)(iii)(B) of the Income Tax Regulations. The distribution will be considered in compliance with these regulations if it is for one or more of the following:

  • Expenses for medical care deductible under section 213(d) for the employee or the employee’s spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan;
      • Costs directly related to the purchase of a principal residence;
      • Payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan;
      • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;
      • Payments for burial or funeral expenses for the employee’s deceased parents, spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan; or
      • Expenses for the repair of damages to the employee’s principal residence that would qualify for the casualty deduction under section 165,

and the employee has provided written representation that the need cannot be adequately addressed from other sources such as:

  • Through reimbursement or compensation by insurance or otherwise;
      • By liquidating the employee’s assets;
      • By ceasing elective deferrals or employee contributions under the plan; or
      • By other distributions or nontaxable loans from plans maintained by the employer or by another employer, or by borrowing from commercial sources on reasonable commercial terms in an amount sufficient to satisfy the need,

or if a need can’t be relieved by one of the actions listed above without increasing the amount of need. For example, a plan loan can’t reasonably relieve the need for funds to purchase a principal residence if the loan would disqualify the employee from obtaining other necessary financing.


Once it has been determined that the plan allows for hardship distributions, and the sources available for distribution have been determined, the following steps should be taken to begin the distribution process:

  • Obtain a statement/verification of the employee’s hardship as required by the plan document’s terms
      • Determine that the exact nature of the employee’s hardship qualifies for a distribution under the plan
      • Document (following plan’s guidelines) that the employee has exhausted all other options outside of the hardship distribution
      • Document the employee’s lack of other resources (spousal/minor children’s assets) if applicable
      • Make sure the distribution amount does not exceed amount required to satisfy the employee’s immediate financial need (may be adjusted to account for any taxes or penalties at time of distribution)
      • Make sure the amount of distribution does not exceed any limits under the plan, and consists only of eligible amounts
      • Let the employee know if receival of the distribution will suspend them from making contributions to the plan for at least six months

If your plan is not properly making hardship distributions, go here to correct any mistakes:


The IRS also released a list of responses to some FAQs regarding hardship withdrawals, such as:

  • What is the maximum amount of elective contributions that can be distributed as a hardship distribution from a 401(k) plan?
      • Cannot be more than the amount of the employee’s total elective contributions, including designated Roth contributions, as of the date of distribution reduced by the amount of previous distributions of elective contributions
      • Generally does not include earnings, qualified non-elective contributions, or qualified matching contributions unless the plan specifically allows for certain grandfathered amounts to be included
      • If provided by the plan, other amounts such as regular matching contributions and discretionary profit-sharing contributions can also be distributed in times of hardship
    • What are the consequences of taking a hardship distribution of elective contributions from a 401(k) plan?
      • Hardship distributions are eligible to be included in gross income (unless they consist of designated Roth contributions) and may be subject to additional taxes on early distributions of elective contributions
      • Unlike loans, hardship distributions are not repaid to the plan, so they will result in a permanent reduction in the employee’s account balance under the plan
      • A hardship distribution cannot be rolled over into an IRA or other qualified plan (§ 402(c)(4))
      • Hardship distributions may be subject to the 10% early distribution tax on distributions made prior to reaching age 59 ½
    • Are hardship distributions allowed from an IRA?
      • There is generally no limit when an IRA owner may take a distribution from his/her IRA, but there may be unfavorable tax consequences including an additional tax on early distributions
      • Certain distributions from an IRA that are used for expenses similar to those that may be eligible for hardship distributions from a retirement plan are exempt from the additional tax on early distributions
      • Any distribution from an IRA for higher education expenses or to finance a first-time home purchase is exempt from the early distribution tax (§ 72(t)(2)(E),(F))

In its Substantiation Guidelines for Safe-Harbor Distributions from Section 401(k) Plans, the IRS also gave a more detailed outline of the types of documentation required for each hardship distribution:

  • Notifications the Employer/Administrator must provide to the employee:
        • Notification that the distribution is taxable, and additional taxes could apply
        • The distribution amount cannot be more than the amount required to solve the “immediate and heavy financial need”
        • Earnings on elective contributions from QNEC or QMAC accounts are not eligible for hardship distribution
        • The recipient must preserve all source documents and make them available at any time, upon request, to the employer or administrator
      • General information required for a hardship request:
        • Participant name
        • Total cost of the event causing hardship
        • Amount of distribution being requested
        • Certification (provided by participant) that all information provided is true and accurate
        • Specific information required on deemed hardships
      • Medical care:
        • Name of individual who incurred the medical expenses
        • Above’s relationship to the participant
        • The purpose of medical care provided
        • Name and address of service provider
        • Total cost of medical expenses not covered by insurance
      • Purchase of principal residence:
        • Will this be the participant’s principal residence?
        • Residence address
        • Purchase price
        • Types of costs/expenses covered by withdrawal (down-payment, closing costs, and/or title fees)
        • Name and address of lender
        • Purchase/sale agreement date
        • Date of closing
      • Educational payments:
        • Name of individual on whose behalf the payments are being made
        • Above individual’s relationship to the participant
        • Name and address of educational institution
        • Categories of payments involved
        • Period covered by the educational payments (beginning and end dates of up to 12 months)
      • Foreclosure/eviction from principal residence:
        • Is this the participant’s principal residence?
        • Residence address
        • Is this a foreclosure or eviction?
        • Name and address of party that issued foreclosure/eviction notice
        • Date of foreclosure/eviction notice
        • Payment due date in order to avoid foreclosure/eviction
      • Funeral and burial expenses:
        • Name of deceased
        • Relationship to participant
        • Date of death
        • Name and address of service provider (funeral home, cemetery, etc.)
      • Damage repairs to principal residence:
        • Is this the principal residence of the participant?
        • Address of residence that sustained damage
        • Description of cause of damage, including date of the casualty loss
        • Describe repairs required, including date(s) of repair (whether still in progress or already completed)


Lastly, in their 401(k) Plan Fix-It Guide: Hardship distributions weren’t made properly article, the IRS also gave some helpful pointers in determining whether or not a company’s hardship distribution program is being abused or poorly managed. The first warning sign is that too many hardship requests are being made by one group or division; the second is that requests for distributions from multiple employees appear identical, because each situation should have its own individual circumstances; the third and last warning that they offer is to beware of instances where only the highly compensated employees have hardship distributions, because this may be a sign that the rank-and-file employees have not been properly notified of the availability of hardship distributions under their plan.


The Cadillac Tax

Health insurance has always been a hot topic of conversation both in the political and financial worlds, and it’s easy to see why, especially in recent years. Health care costs continue to skyrocket, not just for individuals, but also for employer-sponsored health care plans. For example, 2017 has seen health care costs increase at 79% of respondents’ organizations, as well as an 11% increase in plan costs. Due to these increasing costs, employers have started to tend towards giving more compensation in the form of benefits, rather than cash. This is all good and well…until insurance contributions lose their tax-exempt status.

The Cadillac Tax, now set to take effect in 2020, is an excise tax of 40% that will be imposed on high-value benefits above certain thresholds (e.g. $10,200 for individual coverage and $27,500 for family coverage).

The soon-to-be-implemented tax is not the only health care problem employers are facing at the moment. Employers and HR reps have recently listed some potential challenges to complying with the ACA, such as the annual reporting requirements and the time investment that will be required to stay compliant under the complex new law. Furthermore, over 66% of organizations with a seasonal workforce have reported further issues with staying compliant with the ACA. These include:

  • Tracking and monitoring employee hours and status;
  • Understanding how the ACA applies to seasonal employees;
  • Inconsistent definition of a “seasonal employee”; and
  • Administering employer-sponsored plans for seasonal employees.

The key takeaway is that employees value employer provided benefits, specifically health insurance. Employers face a dilemma of controlling an employee’s total compensation while divvying up the resources to satisfy the individual desires of each employee. Doing so in the context of ERISA regulations can be daunting task but the outcomes are advantageous for the employer and employee.

Is PBGC Coverage Required for Your Plan?

The Pension Benefit Guaranty Corporation was established on September 2, 1974 under President Gerald R. Ford with the signing of ERISA (the Employee Retirement Income Security Act). According to Ford, “Under this law, the men and women of our labor force will have much more clearly defined rights to pension funds and greater assurances that retirement dollars will be there when they are needed.” President Ford was correct; this program did much to help America’s retirees. However, it is not without flaw, and a recent IRS audit case has brought to light some new problems within the PBGC.

Before we get ahead of ourselves, let’s start by outlining exactly what the PBGC is and what it does: essentially this organization acts as an insurance policy for defined benefit pension plans offered by private-sector employers. However, there are some plans that the PBGC does not support. These include: “Professional service employers” that currently, and at no point in the plans history, have more than 25 active participants, church groups and federal, state or local governments.

It is easy to label churches and government organizations as being such, but it has recently proven to be difficult to determine what exactly it means to be a “professional service employer.” In her article Surprise! You Are (or Are Not) a Professional. And You Are (or Are Not) Covered by the PBGC, Ilene Ferenczy tells of a recent IRS audit where a financial advisor was deemed a professional, and therefore his plan was exempt from PBGC coverage. The financial advisor had been operating as if he was eligible for PBGC coverage because he had no reason to suspect otherwise. Since similar occupations such as computer network specialists, real estate brokers, and general contractors are not considered professionals, he felt safe in assuming that he wasn’t one either.  However, it seems that the formerly objective definition of “professional” under PBGC is becoming increasingly subjective, and this could pose many consequences down the line.

According to Ferenczy, this new confusion in definition has led many advisors who are not eligible for PBGC coverage to continue to operate their plans as if they are. She gives us a startling statistic: a search of DB plans with an occupational code of either insurance broker or investment advisor was run, and it found that of the 650 plans, 68% of them had been coded as being PBGC-covered. This means that they had been paying unnecessary premiums and incorrectly calculating their plan contributions. In the event of an audit, this could have detrimental consequences.

So, it is easy to see that plan sponsors need more predictability when it comes to determining whether or not they are covered under PBGC, and in light of this new information, it may be time that you double check with your actuary to make sure that your plan is indeed eligible for the PGBC coverage you’ve already been operating under.

For further information about PBGC coverage, go to:

To read about the recent audit case and its outcomes, go to:

Supreme Court Helps to Clarify Definition of ERISA “Church Plans”

The Employee Retirement Income Security Act (ERISA) was signed in to law in 1974 and was designed to protect the beneficiaries of retirement plans. However, due its strict funding rules and required fees for the PBGC (Pension Benefit Guaranty Corporation), certain plans are given exclusion from ERISA to help them save money. There are several groups that have been provided these exclusions, one of which is church organizations. Originally only churches themselves fell under this category, but eventually Congress felt the need to expand on this definition, so in 1980 they made an amendment to ERISA. From this point on, a “church plan” has been defined as:

  • A plan established and maintained for its employees (or their beneficiaries) by a church or by a convention or association of churches includes a plan maintained by an organization, whether a civil law corporation or otherwise, the principal purpose or function of which is the administration or funding of a plan or program for the provision of retirement benefits or welfare benefits, or both, for the employees of a church or a convention or association of churches, if such organization is controlled by or associated with a church or convention or association of churches.. 1002(33)(C)(i)

However, there is some ambiguity in this definition that has led to controversy on exactly how it should be interpreted. These controversies came to an end as a result of the recent Supreme Court case of Advocate Health Care Network et al. v. Stapleton et al.

The final Supreme Court ruling for this case took place on June 5, 2017.  The Defendants’ argument was unanimously upheld, stating that “a non-church—such as a church-affiliated hospital or school—may establish a church plan so long as the plan is maintained by an organization qualifying under section 3(33)(C)(i) that is controlled by or associated with a church.” Considering that this definition had already been used by the U.S. Department of Labor (DOL), Internal Revenue Service (IRS), and the Pension Benefit Guaranty Corporation (PBGC) for over 30 years, this ruling came as a relief to plan sponsors who had already been operating under this definition.

Although this was a huge win for plan sponsors who have “avoided millions of dollars in penalties, attorney fees, back fees, and PBGC premiums,” (Every word matters: Supreme Court finds “church plans” include those established by church-affiliated organizations), it may leave the retirement of thousands in jeopardy. Participants in these plans are less secure in their retirement because ERISA’s funding, vesting, and fiduciary requirements will not apply to them. This could potentially end in hospital employees spending their entire careers contributing to pension plans that will be insolvent by the time they retire. This is not the only problem people are having with the court’s ruling.

Of the arguments against the ruling, the most popular is that it is unfair to secular organizations that have to compete with non-ERISA church affiliated organizations, despite the fact that these “church-affiliated” organizations run more like a secular ones. According to Justice Sotomayer, “Church-affiliated organizations operate for-profit subsidiaries, employee thousands of people, earn billions of dollars in revenue, and compete with companies that have to comply with ERISA.” Many have argued that this gives an unfair and undue edge to church-affiliated hospitals over the non-church-affiliated ones.

For these and several other reasons, this will almost certainly not be the end of legislation concerning ERISA church-affiliated plans. Not only is there disagreement over the fairness of the ruling as a whole, but the Court has also left many questions unanswered, such as: “What exactly constitutes a ‘principle purpose organization’ that may attain a church plan?”; “What does it mean to be ‘controlled by’ or ‘associated with’ a church?”; and “Exactly how close must the connection between hospitals and the church be?” The Court may have clarified the general definition of “church plans” to some extent, but the exact guidelines as to what qualifies as a “church-affiliated organization” may not be as clear as hoped. Stay tuned for updates on this ongoing discussion.


For further reading:

Religious Institution Client Alert, June 2017: U.S. Supreme Court Interprets ERISA Church Plan Exemption In Favor of Religious Charities:

Unanimous Supreme Court Decision In Favor of “Church Plan” Defendants:

Every word matters: Supreme Court finds “church plans” include those established by church-affiliated organizations:

Better Solutions for Today’s Retirement

With the introduction of 401(k) plans in 1980, the responsibility for retirement contributions shifted from the employer to the employee. Unfortunately, the employee had no way of gauging what those contributions should be, or how the contributions should be invested. Thirty-six years later, little has changed.

As we near the first wave of retirement for those whose retirement will be funded largely through 401(k) contribution plans, it’s useful to ask: How did we get here? and What can improve the situation?

Mid-Century Workers and Pension Plans

Pension plans, more precisely called defined benefit plans, were very effective for employees because they did exactly that: They defined the benefit. The employer was responsible for funding the future obligation of providing a stated benefit, or pension, to retired employees. The funding obligation was based on actuarial assumptions and expected investment returns. Lower expected investment returns meant that employers needed to make larger contributions to meet the benefit obligation. Of course, higher investment returns reduced the employer’s funding obligation.

Employers certainly had an incentive to reduce their contribution cost. Aggressive employers utilized an aggressive investment strategy, resulting in wide fluctuations of investment returns. Those fluctuations meant less stability in long-term funding expectations.

In a complex, competitive business environment, the challenge of meeting future obligations with the addition of each new employee meant less short-term flexibility—in other words, available cash—to quickly adapt an ever-changing business climate.

Next: Profit-Sharing

Profit-sharing plans were the first step for employers to alleviate the funding obligation of defined benefit plans. Instead of defining the benefit, employers could define the contribution as a fixed cost, regardless of investment returns.

Initially the employer’s contribution was similar to that of the defined benefit plan. The primary difference was the unfunded liability, created either by market fluctuations or failed aggressive investment strategies.

401(k): Employees Take the Reins

Under a 401(k) plan, the employee is tasked with defining their income needs in retirement, determining the inputs (inflation, expected market returns, etc.), calculating the necessary contribution, and periodically recalculating and adjusting based on ever-changing assumptions. Even for the most financially astute employee-investor, this can be a daunting task that can quickly break down, leaving the retiree in a precarious situation. Unfortunately, this is where most employees have ended up.

Maintaining the status-quo will continue to produce failed outcomes. Progressive employers who realize and appreciate the value of their employees will take action to clearly define a path to retirement, and alleviate the planning burden employees face. Transitioning a 401(k) plan to a defined benefit-styled plan can

  • simplify the retirement planning process,
  • produce sustainable retirement outcomes, and
  • empower employees to make the decisions that are right for them.

This approach focuses on what’s needed to achieve retirement readiness, and less on the employer’s match. flexComp provides a framework and management platform that benefits employers, advisers, and employees. Using flexComp, employers can make more informed decisions for the betterment of their workforce. flexComp helps advisers effectively manage investment portfolios that focus on outcomes. Employees using flexComp can be empowered to make lifestyle decisions on their terms, instead of forced decisions at retirement.

Better outcomes require better solutions.

Employees & Short-Term Value

In today’s world of instant gratification, it’s no wonder that workers value short-term benefits the most. According to a worldwide study of more than 10,000 workers conducted by Mercer, a salary increase was preferred over all types of benefits.

While saving for retirement may seem to some like saving for a stranger, U.S. workers did rank DC plans and DC matches as the second and third most popular benefit — topped only by health care. In all, 74% of American workers were concerned about retirement. This is not surprising given the fact that 72% defer less than 10%. Levels of concerned varied widely depending on gender, age, ethnicity and industry.

The trend setters in the DC market are generally larger companies, but smaller employers create more jobs. Most small business owners are more concerned about the uncertain economy and taxes than about providing benefits to employees.

While DC plans are important, other than fiduciary liability and some administrative work — much of which can be outsourced — they cost the employer virtually nothing compared with the cost of providing health benefits. That’s important too.

With concern about retirement high among workers — most of whom are not on track to replace healthy percentages of income in retirement — the Mercer research shows that employers can attract better workers by not only making DC plans available at minimal or no cost and with limited effort and liability, but also by providing some sort of financial incentive, like a match that appeals to workers’ growing need for instant gratification — but also to their longer-term concerns about their retirement years.

Corrective Distributions

The 401(k) plan has emerged as the most popular form of retirement plan in the United States. This trend will likely continue for some time for a number of reasons. One is the cost savings to employers, since deferral contributions are paid by employees. Another is the fact that 401(k) plans are more easily understood than traditional retirement plans and consequently more appreciated by employees.

One aspect of 401(k) plans that is not so easily understood is the annual contribution nondiscrimination testing. This article will review the mechanics of this required testing and correction methods for failed tests as well as provide this link to one of our proprietary plan designs that eliminates and prevents corrective distributions.

Highly Compensated Employees

Every 401(k) plan, other than “SIMPLE” plans, “Safe Harbor” plans or “Qualified Automatic Contribution Arrangements,” requires an annual test to prevent discrimination in favor of the group of employees referred to as “highly compensated employees” (HCEs). Employees who fall into the following two categories are considered to be HCEs:

  • An owner of more than 5% of the employer in the testing year or the previous year (family stock attribution rules apply which treat an individual as owning stock owned by his spouse, children, grandchildren or parents), or
  • An employee who received compensation in excess of a specified limit from the employer in the previous year (e.g., employees who earned more than $115,000 in 2013 will be considered HCEs in 2014). The employer may elect that this group be limited to the top 20% of employees based on compensation.
401(k) Nondiscrimination Testing

The nondiscrimination rules require average deferrals and average contributions for the HCE group to be within a certain range of the average deferrals and contributions for the “non-highly compensated employee” (NHCE) group.

Testing of employee deferrals is referred to as the ADP test (Average Deferral Percentage). The ACP test (Average Contribution Percentage) includes the employer match contributions, employee voluntary after-tax contributions and certain forfeitures allocated on the basis of deferrals or matching contributions.

Each participant’s deferral or contribution percentage is determined by dividing the applicable deferral or contributions by the compensation defined in the plan document. Averages are then determined for the HCE and NHCE groups by dividing the sum of the deferral or contribution percentages by the number of employees in the group. Below is an example of the ADP determination:

Employee Compensation Deferral ADP
Employee Compensation Deferral ADP
HCE 1 $200,000 $12,000 6.00%
HCE 2 110,000 5,500 5.00%
HCE Total: 11.00%
HCE Average (11.00% ÷ 2): 5.50%
NHCE 1 50,000 4,000 8.00%
NHCE 2 40,000 2,000 5.00%
NHCE 3 30,000 0 0.00%
NHCE 4 20,000 800 4.00%
NHCE Total: 17.00%
NHCE Average (17.00% ÷  4): 4.25%

The HCEs’ average may only exceed the NHCEs’ average (for both the ADP and ACP tests) by specific limits summarized as follows:

HCE Percentage
2% or less NHCE % x 2
2% – 8% NHCE % + 2
more than 8% NHCE % x 1.25

In the above example, the maximum ADP of the HCE group is 6.25% (the NHCE average of 4.25% plus 2%). The test passes since the ADP of the HCE group is 5.50% which is less than the 6.25% maximum.

Catch-up contributions (available to participants who are age 50 or older if permitted by the plan) that exceed a statutory limit or plan-imposed limit are not included in performing the ADP test. Also, compensation for plan purposes is subject to an annual limit ($255,000 for 2013 and $255,000 for 2014). For example, assume Harry earned $300,000 in 2013 and deferred $23,000 (the maximum deferral of $17,500 for 2013 plus the maximum catch-up contribution of $5,500). His deferral percentage is calculated by dividing $17,500 (his deferral without the catch-up contribution) by $255,000 (the compensation limit for 2013).

Employees Included in Testing

In performing the ADP test, all active and terminated employees eligible to defer at any time during the plan year are included, whether or not they actually made a deferral.

The following employees are included in the ACP test, regardless of whether they received matching contributions or made after-tax contributions:

  • Active employees who have met the plan’s requirements to receive a match as of the plan year-end being tested (e.g., if the plan requires active employees to have more than 500 hours of service during the plan year in order to receive matching contributions, employees with less than 501 hours are not included);
  • Employees who terminated during the plan year being tested if they met the plan’s requirements to receive a match (e.g., if the plan requires 1,000 hours of service and/or employment on the last day of the plan year, employees who have not met these requirements are not included); and
  • All employees eligible to make voluntary after-tax contributions at any time during the plan year.

Plans that allow employees to participate before they reach age 21 or complete one year of service are permitted to exclude such employees from the test if they are NHCEs.

If the plan covers both union and non-union employees, each group must be tested separately.

Testing Methods

Two testing methods are permitted. The first method is current year testing where current year deferral and contribution percentages are used to compare the percentages of both HCEs and NHCEs.

The other method is prior year testing where the deferral and contribution percentages for NHCEs in the prior year are compared with HCE deferral and contribution percentages in the current year. The prior year testing method gives employers the ADP and ACP limits for the HCEs in advance, which reduces the chance of a failed test at year-end and the need for taxable refunds or other corrective measures.

Whichever testing method is chosen, regulations require it to be specified in the plan document. The testing method may only be changed by amendment, subject to certain restrictions on changing from current year to prior year testing.

Correcting Test Failures

Plans that do not pass the ADP and/or ACP tests must take some action, such as making corrective distributions or additional employer contributions.

Refund Deferrals/Matching Contributions

The most common method used to correct a failed ADP or ACP test is to make corrective distributions of the excess deferrals or contributions, plus earnings (in some cases, forfeiture of matching contributions may be required).

Corrective distribution amounts (determined by a required leveling method) are allocated among the HCEs based on the dollar amount of their deferrals or contributions. If the plan permits catch-up contributions and the participant is 50 or older and has unused catch-up contributions remaining, the ADP refund is first offset by the unused catch-up contributions.

These distributions must be made within 2½ months of the plan year-end in order to avoid a 10% penalty (this deadline is extended to six months for plans that meet the eligible automatic contribution arrangement requirements). The final deadline for making corrective distributions with the penalty is the last day of the following plan year. For plan years beginning on or after January 1, 2008, these distributions are taxable in the year in which they are distributed (for plan years prior to 2008, distributions made before the 2½-month period are taxable in the prior year).

by Richard Phillips AIF, ERPA, CPC, QPA, QKA

Cash Balance Plans for Larger Tax-Deferred Contributions

Cash Balance Plan: What is it? How does it work?

There are two main types of qualified retirement plans: defined contribution (DC) and defined benefit (DB). The maximum annual contribution to a DC plan is $54,000, while the contributions to a DB plan could be in excess of $215,000. This makes DB plans a much better option for those who are behind on retirement savings. Furthermore, by combining the two, you could have an annual contribution of over $269,000. Today we will discuss cash balance plans, a pre-tax DB plan with several characteristics similar to a more traditional 401(k) profit sharing plan.

A cash balance plan has the ability to supplement an existing 401(k) plan with substantially larger contributions and tax savings.


What is a cash balance plan?

Under a defined contribution plan (e.g. profit sharing and 401(k) plan), the “contribution” is defined in the plan document and your balance at normal retirement is a function of contributions and investment returns. A defined benefit plan, on the other hand, does not define the contribution but rather defines the benefit that will be paid at retirement. In order to pay a monthly benefit, as defined under the terms of the defined benefit plan, you need to have a large enough sum accumulated by retirement to provide the required stream of income (benefit). The sum needed at retirement is considered a liability. The annual contribution needed to fund the liability is simply a time value of money calculation. For example, let’s assume you need $1,000,000 in 15 years to fund the “promised benefit,” you would need to contribute $46,342 each year for 15 years at a 5% interest rate to fully fund your obligation. At 3%, the annual contribution increases to $53,767. To some extent the only variable you can control is the interest rate assumption because the benefit is contractually promised in the plan document, and retirement in this example is 15 years away.

A cash balance plan is a type of defined benefit plan, but it has several characteristics that are similar to a profit sharing plan. The first is pay/contribution credits and the second is the hypothetical account balance. Unlike a profit sharing plan, the cash balance plan will also have a stated interest crediting rate defined in the plan document. Understanding these three components and how they work is critical to effectively managing a cash balance plan.

Pay Credits

The cash balance plan document will state either a flat dollar amount or a percentage of a participant’s compensation that will be contributed (“allocated”) to their hypothetical account. This is typically referred to as pay credits or compensation credits.

Hypothetical Account Balance

The pay credits are allocated to the participant’s hypothetical account. It is hypothetical because the account does not really exist. Each year that the plan is active, the participant will receive a pay credit allocation plus an interest credit to their hypothetical account. At retirement, this hypothetical account balance will be converted to a benefit, hence the defined benefit. What is different about a cash balance plan is that the benefit is not explicitly defined but is determined from the accumulated hypothetical account. The only promise that is made is the amount of the pay credit that will be allocated to the participant’s hypothetical account each year. To illustrate the hypothetical account, let us assume the annual pay credit for a participant is $10,000 for 20 years and an interest crediting rate of 5%. At the end of 20 years, normal retirement in our example, the hypothetical account balance is $330,660. Annuitizing the hypothetical account balance would produce a benefit of approximately $21,510 annually. This annual benefit is the “defined benefit” of the plan and is the number that is used for non-discrimination testing and determining the meaningful benefit under IRC 401(a)(26).

Interest Credits

Since this is a defined benefit plan, the document must state the rate of interest that will be credited to the participant’s hypothetical account each year. This interest crediting rate can be defined as a fixed rate, e.g. 5%, or a variable rate tied to some index. If a variable rate is used, the index is typically the 30 year Treasury Yield. Two key issues are in play when considering the fixed rate and the variable rate.

The first issue is the minimum participation regulations under IRC 401(a)(26). Compared to the 125-page definition of compensation, this vague section of the Code is only two paragraphs. The regulation states that the plan must benefit the lesser of 40% of the eligible workforce, or 50 participants. While this is the only official guidance, a letter written by the director of employee plans at the IRS went on to state that, in addition to this minimum participation rule, each participant should receive a “meaningful benefit.” Otherwise, the participants are not considered effectively participating. The IRS has unofficially taken the position that if a participant receives a 0.5% accrual then they are deemed to have received a meaningful benefit. For staff employees, the 0.5% accrual may be satisfied if the pay credit for example is 1.75% of their annual compensation. But how does this relate to the interest crediting rate of the plan?

The interest crediting rate is used to determine if the pay credit plus interest satisfies the 0.5% meaningful benefit accrual. A higher interest rate means you can get by with a lower contribution. Using the fixed rate method yields a very predictable contribution requirement for the staff. Conversely, under the variable rate method if interest rates fall then the staff contribution may have to be increased in order to satisfy the 0.5% meaningful benefit accrual. For example, let us assume that the variable interest crediting rate drops to 3.5% then the staff contribution may need to be increased from 1.75% of pay to 2.0% of pay. When considering IRC 401(a)(26), obviously the fixed rate method would be preferable.

The second issue is matching assets to liabilities. Under the fixed rate crediting method, if the actual investment returns are less than the fixed crediting rate then the hypothetical account balance, liability, will be in excess of the value of the plan’s assets. In other words, liabilities will be greater than assets, resulting in a deficit and underfunded plan. On the other hand, if the plan uses the variable rate method that is tied to an investable index then the interest credited to the hypothetical account balance will equal the plan’s assets. In this scenario assets will equal liabilities.

As you can see, there are pros and cons with each method. We lean toward using a variable rate because it is easier to match assets and liabilities, and through plan design we can manipulate eligibility and pay credits to more predictably satisfy the meaningful benefit requirement.

Actuarial Assumptions

In addition to the interest crediting rate stated in the plan document, the document must also state the actuarial assumptions used to calculate the conversion of the hypothetical account balance to a benefit for testing purposes. Given the fact that most all participants take a lump sum distribution at retirement, we will only discuss the two interest rates and leave the “normal form of benefit” (life annuity, etc.) for another day.

The first interest rate is the pre-retirement rate. This rate is used to project forward the accumulation of the pay credits in order to determine the hypothetical account balance at retirement. If the plan is using the variable rate method for actual interest credits, it is ignored here and the pre-retirement rate is substituted. We cannot predict the future returns of a variable rate, so a fixed pre-retirement rate is stated in the plan document. This pre-retirement rate is used for all testing up until the point of retirement. Other methods are available, but they are beyond the scope of our discussion.

The post-retirement rate is typically a fixed rate and is used in the actuarial calculations at retirement to estimate the annual benefit if the hypothetical account balance is annuitized.

Cash Flow Impact

As with any defined benefit plan, the plan sponsor should consider the cash flow implications before finalizing the decision to implement a cash balance plan. After the first year of the plan, there is a minimum and maximum deductible amount. Sometimes the range between the minimum and maximum can be very large. However, we recommend that the aggregate pay credits of all participants be deposited to the trust annually, even if this is in excess of the required minimum. Contributing the pay credits annually will minimize funding issues down the road.

If the plan uses a fixed interest crediting rate method, then there will be years where the actual investment returns are less than the interest that is credited to participant accounts. If this situation persists, the liabilities of the plan (aggregate hypothetical account balances) will exceed the value of the plan’s assets resulting in an underfunded status, which could lead to mandated higher contributions and/or distribution restrictions.


Cash balance plans can be a very effective tool for increased pre-tax contributions. Conceptually, they are easier for plan sponsors and participants to understand (pay credits and interest credits) but they have quite a few moving parts. It is important to understand the interplay between the various components when establishing the plan, and for ongoing operation.

Contact us if you would like more information on cash balance plans.

Profit Sharing Plans: Better Ways to Use Them and Why

A Profit Sharing Plan is another special type of defined contribution (DC) plan under which employers, rather than employees, are the ones making contributions. After the company makes its annual contribution, the total contributions are then allocated to individual employee accounts, generally using the “comp-to-comp” method, but several other methods are also available. Because the contributions to, and earnings on, profit sharing plans are generally not taxed until they are distributed, they can offer significant tax savings for small businesses, as well as help them reach the tax deferral limit of $54,000 (2017).

The history of Profit Sharing Plans

Prior to 401(k) plans, profit sharing plans were an alternative to defined benefit (DB) plans. Originally designed as a way for companies to share profits with employees on a pretax basis, and provide retirement security, profit sharing plans were very popular into the early 1990s. As more companies adopted 401(k) plans, the popularity of profit sharing plans began to wane.

401(k) plans gave employers a means by which they could eliminate their contribution to only the employees electing to make deferrals. Shifting the retirement funding responsibility to employees neutralized the argument for companies to offer profit sharing plans.

Companies sponsoring 401(k) plans in lieu of profit sharing plans may have lost sight of the concept of total compensation, and instead offer a menu of ancillary benefits without a focus on retirement readiness. Employees on the other hand, are feeling less secure about retirement and have little guidance on the preparations they need to make. The end result is employees who are less prepared for retirement, and employers with a misguided sense of the cost/benefits of a profit sharing plan.

Offering a Profit Sharing Plan could be a great idea for your company, especially if there’s a consultant running it.

The rise in popularity of 401(k) plans and the ease of administration has diminished the need for retirement plan consultants. Consultants with the background and knowledge of the nuances of profit sharing plans can make profit sharing plans a viable option for most closely held businesses. A carefully designed profit sharing plan can provide the retirement security employees are looking for, eliminate the added cost employers are concerned about in a very competitive business environment, reap additional tax savings for employees and the employer, and give the business owners a vehicle to maximize their contributions. How is this possible?

Maximizing plan benefits for your business

Internal Revenue Code Section 410(b) became effective January 1, 1989 and states that for a retirement plan to be qualified and receive favorable tax treatment it must benefit a minimum number of employees. The common view by practitioners is that IRC 410(b) is very complicated and is seldom used. My view is quite different.

As prescribed by IRC 410(b), only 70% of the eligible workforce must be included. This “coverage ratio” can be further reduced with a careful plan design. For discussion purposes let’s assume we could reduce the coverage ratio to 35%. This means that out of 100 eligible employees only 35 would have to be included in the profit sharing plan. Building on this point, the next step would be to identify the 35 employees who are key to the company’s success and are serious about planning for retirement.

Based on a series of actuarial assumptions and calculations, and a 30 year working career average, we know that employees need to have 6.25% of their annual compensation earmarked for retirement. Having identified employees who are serious about retirement, we can evaluate their commitment, current earnings, and employer provided benefits to arrive at the optimal base level of compensation. The plan formulas are then structured to maximize the contribution for the business owner while providing a meaningful benefit for select employees.

Profit Sharing Plans benefit both employers and employees.

The evolution of this process renders sustainable outcomes for the employer and employee. The employee feels very secure about retirement and less likely to be hired away by a competitor. The employer has a win because more profits of the business can be shifted to the owners on a tax favored basis without a significant increase in staff cost. It’s not uncommon for the closely held business owner to pick up an additional contribution of 15% of their earned income.  If the plan is designed properly there are additional tax savings. The benefits far outweigh the cost.


Profit Sharing Plans: Key Facts

  • They can be offered in addition to other retirement plans
  • Can be offered to a business of any size, but work best for companies with 100 or fewer employees
  • Allow for flexible, tax-deductible contributions
  • A good option if cash flow is an issue
  • Benefits all employees, from the rank-and-file to the owners/managers
  • The annual contribution limits for 2017 are: the lesser of 25% of compensation or $54,000 ($60,000 for participants who are age 50+)
  • The plan may allow participants to transfer their benefits when they leave the company
  • Employer contributions are discretionary and can be changed from year-to-year depending on the company’s performance
  • A Form 5500 must be filed each year
  • May have higher administrative costs than other, more basic plan options such as SEP or SIMPLE IRA‘s
  • Requires discrimination testing and participant disclosures, including testing to determine that the benefits do not discriminate in favor of highly compensated employees (HCEs)
  • The minimum required distributions start at age 70 ½
  • There is a 10% early withdrawal penalty if the withdrawal is made before the participant has reached age 59 ½ (some exceptions may apply)