Pension Plans

1) Defined-contribution pension plans.
2) Defined-benefit pension plans.

1) Defined-Contribution Pension Plans: Provides benefits based on the amount contributed to an employee’s individual account plus any earnings and forfeitures of other employees that are allocated to the account. Pension plan contributions are determined by formula and not by actuarial requirements (except for target benefit pension plans).

• Profit sharing pension plans.
• Money purchase pension plans.
• Target benefit pension plans.
• Stock bonus pension plans.
• ESOPs.
• Thrift or savings pension plans.
• 401(k) pension plans.

Annual Pension Plan Limitation: Annual additions to any participant’s account is the sum of the following: (1) Employer contributions, and (2) Employee contributions, and (3) Forfeitures. 

2) Defined-Benefit Pension Plans: Any qualified pension plan that is not considered a defined-contribution pension plan. Under a defined-benefit pension plan, the annual pension benefits must be definitely determinable using a formula contained in the pension plan. Forfeitures under a defined-benefit pension plan cannot be used to increase the benefits any employee would otherwise receive under the pension plan. The most common types of defined-benefit pension plans are (a) flat-benefit pension plans, and (b) unit-benefit pension plans.

Flat-Benefit Pension Plan: A flat-benefit pension plan is one which pays a set amount on pension, typically over the lifetime of the employee. The amount provided under the pension plan could be a flat monthly pension benefit, or an amount based on a certain percentage of employee compensation.

Unit-Benefit Pension Plan: The pension benefit for each participant depends on compensation earned and length of service to the company. Thus it can provide for greater pension benefits for long-service employees than for short-term employees with the same average compensation. A typical formula would allot to each participant a percentage of the final annual compensation (for example, 3%) multiplied by the number of full years of employment with the company, payable monthly starting at normal pension age.

Annual Pension Plan Benefit Limitation: A defined-benefit pension plan is limited by the maximum benefit that an employee may receive at normal pension age.

1) $90,000 with cost-of-living adjustments starting in 1989 and tied to annual cost-of-living increases in Social Security, or
2) 100% of the participant’s average "compensation" for the highest three consecutive years.

• Employer receives an immediate tax deduction. Employee does not receive pension benefits until some time in the future.
• Income earned within the pension plan fund is tax deferred.
• Employee incurs no tax liability until amounts are distributed from the pension plan.
• Qualified "lump-sum" distributions can receive favorable tax treatment; for example, 5-year or 10-year averaging.
• Qualified distributions can be rolled over into an IRA tax free.
• If qualifying distributions are made in the form of stock of the employer corporation, tax on the appreciation in the value of the stock is deferred until the stock is sold.

Generally, current earnings from qualified pension plans (and IRAs) are tax exempt. In certain circumstances, however, qualified pension plans can be subject to tax on unrelated business taxable income (UBTI). UBTI is income from a trade or business regularly carried on and not related to the exempt purpose of the organization. If an exempt organization (a qualified pension plan is considered an exempt organization trust) has investment income that generates more than $1,000 of UBTI, the trust will be required to file Form 990-T and pay income tax at regular corporate rates.

• A qualified pension plan should not invest in any partnership that conducts an active trade or business. The income from the business will be considered unrelated to the exempt purpose of the pension plan.
• A qualified pension plan should not invest in any partnership that has unrelated debt-financed property that produces rental income. Income from unrelated debt-financing is required to be reported as UBTI.
• A qualified pension plan should not borrow funds to make investments. Any income will be considered from unrelated debt financing and reported as UBTI.
• A qualified pension plan should not invest in a real estate investment trust (REIT) that is not publicly traded. The REIT may be treated as a partnership for pension plan investment purposes and generate UBTI.