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Any size company can participate in Defined Benefit Plan. You can also set up a Defined Benefit Plan if you are self-employed. First you adopt a written plan that is communicated with your employees and then invest the plan assets. The deadline to set-up is the last day of that year (December 31 for calendar year employers). Generally, you can claim tax credits for part of the ordinary and necessary costs of starting up a qualified plan. Most qualified plans follow a Master or prototype plan approved by the IRS. Under a Master Plan, a single trust or custodial account is created, for the use of all employers. Under a prototype plan, a separate trust or a custodial account is established for each employer. Financial institutions such as Trust, banks, trade or professional organizations, insurance companies and mutual funds can provide IRS plans. Trust Administration Services does not sponsor a Master or Prototype plan document for Defined Benefit Plans. Therefore, the client will need to work with their attorney or CPA (third party administrator) to obtain a plan document. Individually designed plans can also be set up and you can apply for approval by paying a fee and requesting a determination letter from the IRS.
Contributions must be enough to satisfy the minimum funding standard for each year. The amount is based on the plan formula using funding requirements in section 412 of IRS Publication 560. A qualified plan is normally funded by your employer contributions. Employees can also fund the plan, but they are nondeductible. Future earnings are tax-free. If you are self-employed, contributions can be made from net earnings in the trade or business for which the plan was set-up, not your investments.
Contributions are considered made if; you make them by the due date of your tax return, the plan was established by the end of the year and the plan treats the contribution like it was received on the last day of last year. In addition, the trustee must advise the custodian and/or the plan administrator the year for which the contribution applies. If you contribute to a defined benefit plan and defined contribution plan, your deduction is limited. It cannot exceed the lesser of the following amounts:
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100% of the participants average compensation for his or her highest 3 consecutive years; |
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$175,000 for 2006 |
If you are self-employed a computation to figure your maximum deduction is needed. Your contributions and net earnings are needed to determine the deductions. Use the worksheet in Chapter 5 of IRS Publication 560 to determine the deduction (Link to Publications). Employers can deduct the contributions for employees on their tax return.
An amount paid to participants from a qualified plan is called a distribution. Distributions may be nonperiodic or lump sum. They can also be periodic such as annuity payments or certain loans. See IRS Publication 575 (Link to Publications) for more information. A qualified plan must provide that each participant will receive their entire interest in the plan by the required beginning date or regular periodic distributions. These distributions rules apply to each qualified plan. That means that you cannot take a distribution from one plan to apply for another.
If the account balance is to be distributed, the plan administrator must figure the minimum amount required to be distributed each calendar year. This is figured by dividing the account balance by the appropriate life expectancy. Distributions must also meet the minimum distribution incidental benefit requirement. Which means, the plan is used to provide retirement benefits to the employee. After an employee passes away, only incidental benefits can remain for the distribution to the employee’s beneficiary. The required distribution date from a qualified plan is the calendar year in which he or she reaches 70 1/2 or the year he or she retires with the employer maintaining the plan.
Tax Treatment of Distributions
Distributions from a qualified plan, minus a prorated part of the costs basis (if applicable), are subject to tax in the year the distribution takes place. In few instances, does a participant have cost basis. An exception is a rollover in a traditional IRA or eligible retirement plan. An eligible rollover is not any of the following:
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A required minimum distribution; |
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A series of equal payments made at least once a year over the employees life expectancy, the joint lives of the employee and beneficiary or a period of 10 years; |
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Hardship distribution; |
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A portion that represents the employee’s nondeductible contributions; |
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A corrective distribution; . |
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Loans; |
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Dividends; |
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The cost of insurance coverage. |
If a participant is expected to receive $200 or more from a plan, the payer must withhold 20% for federal income tax. If the participant chooses instead to have the plan pay it to an IRA or another eligible plan, no withholding is required. If no income tax is withheld and no rollover occurs, the recipient may have to make estimated tax payments.
There is a 10% early withdrawal tax if there are distributions before the age of 59 1/2 unless the following circumstances prevail:
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A beneficiary receives the funds when the employee passes away; |
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A qualifying disability for the employee; |
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It is a part of a series of equal periodic payments after separation of service, at least annually, for the life expectancy of the employee or their designated beneficiary; |
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If it is made during separation of service when the employee reaches 55; |
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A domestic relations order; |
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For the employee as a medical expense deduction; |
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To reduce excess contributions; |
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To reduce employee or matching employer contribution; |
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To reduce deferrals; |
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An IRS Levy. |
To report the tax on early distributions, file Form 5329.
For more information, consult the Department of Treasury, Internal Revenue Service Publication 560 Retirement Plans For Small Businesses listed under Publications. |
