What Is It?
A thrift plan (also called a savings plan) is a type of qualified defined contribution plan in which your employees are directly involved in funding the retirement benefits that will ultimately be paid. Participating employees elect to contribute a certain percentage of their compensation to the plan through payroll deduction, and you typically supplement those employee contributions with employer-matching contributions. Your matching contributions may be made on a dollar-for-dollar basis or under some other type of formula, and are often a strong incentive for employees to participate in the plan. To keep track of employee contributions and matching amounts, you must maintain individual plan accounts for your participating employees.
Unlike a 401(k) plan, employee contributions to a thrift plan are not made on a pre-tax basis. Instead, the employee must pay income tax on his or her compensation before contributing any money to the plan. For this reason, employers that use a thrift plan often do so to supplement a defined benefit plan or other primary retirement plan maintained by the company.
Caution: Thrift plans have largely been replaced by 401(k) plans. 401(k) plans can allow employees to make contributions on a pre-tax or after-tax basis. In addition, 401(k) plans can allow employees to make after-tax Roth contributions. While earnings on an employee's after-tax contributions to a thrift-plan are taxed when distributed, earnings on Roth 401(k) contributions are tax free if certain conditions are met.
Caution: A thrift plan should not be confused with the federal Thrift Savings Plan (TSP), a retirement program for federal civilian employees and military personnel.
What Types of Employers Can Use a Thrift Plan?
Whether you are a large company, a tax-exempt organization, a sole proprietor, or any other type of employer, you are generally eligible to establish and maintain a thrift plan. However, this type of plan is not necessarily appropriate for all employers. A thrift plan is generally best suited for employers with a large number of employees who are relatively young, have substantial time to accumulate retirement savings, and are willing to accept some investment risk with their money in exchange for some control over how funds are invested.
Tip: A thrift plan is sometimes used by employers who want to supplement a defined benefit plan with a plan that features individual participant accounts and allows employees to save on a tax-deferred basis. By offering both types of plans, an employer may be able to meet the needs of all employees.
Tax Benefits of Thrift Plans
Tax Considerations for Employees
Your employees' contributions to a thrift plan generally cannot be made on a pre-tax basis. This is not the case, however, with any employer-matching contributions you make to the plan. When you put money into the plan on behalf of your participating employees, those dollars are not currently included in the employees' taxable income. The employees will not pay income tax on the employer money in their plan accounts as long as that money remains in the plan. Similarly, funds held in the thrift plan grow on a tax-deferred basis. This means that any earnings from plan investments are not included in the employees' taxable income as long as they remain in the plan. (After-tax Roth contributions are not permitted.)
Of course, when a participating employee begins to receive distributions from the thrift plan during retirement, he or she will be subject to federal (and possibly state) income tax on employer contributions, as well as on any investment earnings. However, the rate at which a plan distribution is taxed depends on the employee's federal income tax bracket for the year, and many employees may be in a lower tax bracket by the time they begin receiving distributions. If an employee receives a distribution from the plan prior to age 59 ½, he or she may be subject to a 10% premature distribution penalty tax (unless an exception applies), in addition to ordinary income tax.
Tip: The portion of a thrift plan distribution that represents employee contributions will not be subject to income tax. This is because employee contributions to the plan are made on an after-tax basis, so those dollars were already taxed and will not be taxed again when distributed.
Tip: If a participating employee born prior to 1936 elects to take a lump-sum distribution from the thrift plan, he or she may be eligible for special tax treatment.
Tax Deduction for Employer
As an employer maintaining a thrift plan, you can reap a significant income tax benefit. Your employer-matching contributions to the plan are generally tax deductible on your federal income tax return for the year in which you make them.
Tax-deductible employer contributions to a defined contribution plan cannot exceed 25% of the total compensation of all employees covered under the plan. Any contribution in excess of this limit is not tax deductible, and may also be subject to a 10% federal penalty. For purposes of calculating your maximum tax-deductible contribution, the maximum compensation base that can be used for any one plan participant is $285,000 for 2020 (up from $280,000 in 2019).
Caution: Annual additions to any one participant's plan account are limited to the lesser of $57,000 (in 2020, up from $56,000 in 2019) or 100% of the participant's compensation. Annual additions include total contributions to the participant's plan account, and any reallocated forfeitures from other plan participants' accounts. You must treat all qualified defined contribution plans you maintain as a single plan for purposes of calculating the annual additions limit.
Other Advantages of Thrift Plans
Your Employer Contributions Are Flexible
As the employer maintaining the thrift plan, you have complete discretion as to whether you wish to contribute to the accounts of your participating employees. It is customary with this type of plan for the employer to match at least a portion of the employees' contributions, but it is not mandatory that you do so. If you do decide to make employer-matching contributions, you can generally choose the amount of the match. For example, you might choose to match 50% or some other portion of the contribution made by each employee, up to a specified limit.
You need only follow the requirements of the plan you have set up. If your plan document provides for employer-matching contributions, then you must make contributions according to the formula specified, but only on behalf of those employees who are themselves contributing to the plan.
Tip: In addition to matching contributions, a thrift plan may permit you, at your discretion, to make voluntary employer contributions to the plan. Consult a retirement plan specialist for more information.
The Plan Offers Your Employees Flexibility And Incentive
Your employees have some discretion over their contributions to a thrift plan. Since participation in the plan is voluntary, employees can elect to receive all of their compensation in cash and not contribute to the plan at all. (Of course, employees who choose this option will not be entitled to any employer-matching contributions under the plan.) Employees who choose to participate in the plan generally have some flexibility when deciding how much (i.e., what percentage of compensation) to contribute to their accounts. Participating employees may also be free to change their contribution amount at certain times during the year, and employees who opt not to participate can often join the plan at a later time.
Further, since employee contributions are made through payroll deductions, employees who choose to participate in the plan may find it a convenient and reliable way to set funds aside for retirement. Of course, the potential for employer-matching contributions is also a strong incentive for employees to participate in the plan.
Disadvantages of Thrift Plans
Employees Cannot Participate Unless They Contribute to The Plan
From your employees' standpoint, a thrift plan has potential drawbacks when compared to other employer-sponsored retirement plans. An employee can generally only participate in your thrift plan by electing to contribute a portion of his or her compensation to the plan. If an employee chooses not to contribute to the plan he or she will receive no employer-matching contributions and will not be considered a participant in the plan. This is in contrast to a pure profit-sharing or money purchase pension plan (both of which do not require employee contributions), and may discourage plan participation among employees who cannot afford to put part of their compensation into a retirement plan.
Caution: Since participation in a thrift plan is limited to employees who contribute, the plan may fail to satisfy the nondiscrimination requirements that must be met for a plan to be qualified if non-highly compensated employees elect not to participate.
Employee Contributions Can Generally Be Made Only on an After-Tax Basis
Another potential drawback for employees is that their contributions to a thrift plan generally must be made on an after-tax basis. This is in contrast to 401(k) plans and some other types of plans, which permit employee contributions to be made on a pre-tax basis. As a result, 401(k) plans are generally more advantageous and widely used than thrift plans.
The Administrative Costs May Be High
Because employee contributions and employer-matching amounts must be individually accounted for in the plan, the administrative costs associated with a thrift plan are often relatively high. These costs are typically greater than the administrative costs associated with a pure profit-sharing or money purchase pension plan that don't allow employee contributions.
The Plan Is Subject to Specific Requirements and Testing
Like most retirement plans, a thrift plan is subject to nondiscrimination requirements under federal law. Basically, this means that your highly compensated employees (see below for definition) may not benefit substantially more under the plan than your non-highly-compensated employees. A thrift plan is generally subject to the same nondiscrimination testing requirements as a 401(k) plan.
Caution: As a "contributory" retirement plan, a thrift plan may have to satisfy a special nondiscrimination test that compares the relative contribution percentages of highly compensated employees with those of non-highly compensated employees.
A thrift plan is also subject to federal "top-heavy" requirements. A thrift plan is considered to be top-heavy if the total of the account balances of all the key employees exceeds 60% of the total of the account balances of all employees. (Generally, the key employees are the owners and company officers.) If your plan is top-heavy, you generally must make a minimum annual contribution of 3% of compensation to the accounts of all non-key-employees.
Finally, a thrift plan is subject to the reporting, disclosure, and other requirements that apply to most qualified plans under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code.
Tip: ERISA doesn't apply to governmental and most church retirement plans, plans maintained solely for the benefit of non-employees (for example, company directors), plans that cover only partners (and their spouses), and plans that cover only a sole proprietor (and his or her spouse). State and local governmental plans are also exempt from discrimination testing.
How to Set Up a Thrift Plan
Have a Plan Developed for Your Business
Due to the nature of the rules governing qualified retirement plans, you will most likely need a retirement plan specialist to develop a thrift plan that meets legal requirements, as well as the needs of your business. Here are some of the issues to consider (this is by no means a comprehensive list):
- Determine the plan features most appropriate for your business — Carefully review your business, looking at factors such as cash flow and profits, your desired tax deduction, and your employee population (including years of service, ages, salaries, and turnover rate). This will assist you in determining appropriate plan features, including investment vehicles, contribution levels, and employee eligibility requirements.
- Decide if employees will direct their own investments. If so, decide if your plan will comply with Section 404(c) of ERISA, in order to limit the liability of plan fiduciaries for losses employees may incur as a result of their own investment decisions.
- Choose the plan trustee — The assets of the plan must be held in a trust by a trustee. The trustee has overall responsibility for managing and controlling the plan assets, preparing the trust account statements, maintaining a checking account, retaining records of contributions and distributions, filing tax reports with the IRS, and withholding appropriate taxes. The plan trustee can be you or a third party, such as a bank.
- Choose the plan administrator — Administering the plan involves many duties, including determining who is eligible to participate in the plan, determining the amount of benefits and when they must be paid, and complying with reporting and disclosure requirements. The plan administrator may also be responsible for investing plan assets, and providing informational and required investment educational services to plan participants. The employer is legally permitted to handle these responsibilities in-house, but plan sponsors often hire a third-party firm to assist with plan administration.
Submit the Plan to the IRS for Approval
Once a plan is developed, the plan should be submitted to the IRS for approval unless it is a prototype or similar plan previously approved by the IRS. Since there are a number of formal requirements that must be met (for example, you must provide a formal notice to employees), a retirement plan specialist should assist you with this task. Submission of the plan to the IRS is not a legal requirement, but it is highly recommended.
The IRS will carefully review the plan and make sure that it meets all of the applicable legal requirements. If the plan meets all requirements, the IRS will issue a favorable "determination letter." Otherwise, the IRS will issue an adverse determination letter indicating the deficiencies in the plan that must be corrected.
Adopt the Plan During the Year for Which It Is to Become Effective
You must officially adopt your plan during the year for which it is to become effective. A corporation generally adopts a thrift plan or other retirement plan by a formal action of the corporation's board of directors. An unincorporated business should adopt a written resolution in a form similar to a corporate resolution.
Provide Copies of the Summary Plan Description (SPD), and Other Required Disclosures, to All Eligible Employees
ERISA requires you to provide a copy of the summary plan description (SPD) to all eligible employees within 120 days after your thrift plan is adopted. An SPD is a booklet that describes the plan's provisions and the participants' benefits, rights, and obligations in simple language. On an ongoing basis you must provide new participants with a copy of the SPD within 90 days after they become participants.
You must also provide employees (and in some cases former employees and beneficiaries) with summaries of material modifications to the plan. In most cases you can provide these documents electronically (for example, through email or via your company's intranet site). ERISA may require that you also provide additional information to participants. For example, if you allow employees to direct their own investments, specific detailed information about the plan and its investments must be provided on a periodic basis.
File the Appropriate Annual Report With The IRS
Each employer that maintains a qualified retirement plan is generally required to file an annual report with the IRS. The annual report is commonly referred to as the Form 5500 series return/report. You must file the appropriate Form 5500 series return/report for your plan for each plan year in which the plan has assets. Consult a tax or retirement plans specialist for more information.
Questions & Answers
What Employees Do You Have to Include In Your Thrift Plan?
You generally must include all employees who are at least 21 years old and have at least one year of service. Two years of service may be required for participation as long as the employee will be 100% vested immediately upon entering the plan. If desired, you can impose less (but not more) restrictive requirements.
Tip: For eligibility purposes, a year of service is generally a 12-month period during which the employee has at least 1,000 hours of service.
When Must Plan Participation Begin?
An employee who meets the plan's minimum age and service requirements must be allowed to participate no later than the earlier of:
- The first day of the plan year beginning after the date the employee met the age and service requirements, or
- The date six months after these conditions are met
How Is Compensation Defined?
Compensation may be defined differently for different plan purposes. For determining the annual additions limitation, compensation generally includes all taxable personal services income, such as wages, salaries, fees, commissions, bonuses, and tips. It does not include pension-type income, such as payments from qualified plans, nonqualified pensions, and taxable compensation due to participation in various types of stock and stock option plans.
In addition, compensation includes voluntary salary deferrals to 401(k) plans and cafeteria plans. (Employers have some flexibility to include or exclude certain items of compensation.) This definition also applies when determining which employees are highly compensated.
What Is a Highly Compensated Employee?
For 2020, a highly compensated employee is an individual who:
- Was a 5% owner of the employer during 2019 or 2020, or
- Had compensation in 2019 in excess of $125,000 and, at the election of the employer, was in the top 20% of employees in terms of compensation for that year. (This $125,000 limit rises to $130,000 in 2020.)
When Do Employees Have Full Ownership of the Funds In Their Accounts?
The process by which employees acquire full ownership of their plan benefits is called "vesting." Employee contributions must vest immediately. In general, employer contributions either must vest 100% after three years of service ("cliff" vesting), or must gradually vest with 20% after two years of service, followed by 20% per year until 100% vesting is achieved after six years ("graded" or "graduated" vesting).
Caution: Plans that require two years of service before employees are eligible to participate must vest 100% after two years of service.
Tip: A plan can have a faster vesting schedule than the law requires, but not a slower one.
What Happens to an Employee's Account If the Employee Terminates Before He or She Is 100% Vested?
If a participant in your thrift plan separates from service before being 100% vested in the plan, the employee will forfeit the amount that is not vested. The amount forfeited can then be used to reduce future employer contributions under the plan, or can be reallocated among the remaining participants' accounts. The IRS generally requires forfeiture allocation in proportion to participants' compensation rather than in proportion to their existing account balances.
Do You Need to Receive a Favorable Determination Letter from the IRS In Order for Your Plan to Be Qualified?
No, a plan does not need to receive a favorable IRS determination letter in order to be qualified. If the plan provisions meet IRC requirements, the plan is considered qualified and is entitled to the accompanying tax benefits. However, without a determination letter, the issue of plan qualification for a given year does not arise until the IRS audits your tax returns for that year. By that time, it may be too late for you to amend your plan to correct any disqualifying provisions.
A determination letter helps to avoid this problem because auditing agents generally will not raise the issue of plan qualification with respect to the "form" of the plan (as opposed to its "operation") if you have a favorable determination letter (or if a pre-approved prototype plan is used).
What Happens If the IRS Determines That Your Plan No Longer Meets the Qualified Plan Requirements?
The IRS has established programs for plan sponsors to correct defects. These programs are designed to allow correction with sanctions that are less severe than outright disqualification. Your tax professional will be able to assist you in following these programs should the need arise. However, if you are unable to correct the defects in your plan as required, the plan may be disqualified. Loss of a plan's qualified status results in the following consequences:
- Employees could be taxed on employer contributions when they vest, rather than when benefits are paid
- Your deduction for employer contributions may be limited
- The plan trust would have to pay taxes on its earnings
- Distributions from the plan become ineligible for special tax treatment, and cannot be rolled over tax free
Do You Have Fiduciary Responsibility for Your Employees' Accounts?
Caution: This section assumes that your plan is subject to ERISA. Special considerations apply to plans that are not subject to that law.
You (or the applicable plan fiduciary) have a fiduciary responsibility to exercise care and prudence in the selection and appropriate diversification of plan investments. Failure to meet that duty could result in your liability to the plan for any losses incurred. You may even have liability for imprudent investment choices by your employees if your plan allows participants to select the investments in their account ("self-directed plans"). However, you may be able to limit your liability for investment losses that occur as a result of a participant's exercise of investment control over his or her own account if you satisfy the requirements of Section 404(c) of ERISA. Section 404(c) requires that you:
- Allow participants to choose from a broad range of investments with different risk and return characteristics
- Allow participants to give investment instructions at least as often as every three months
- Give participants the ability to diversify investments generally and within investment categories, and
- Give each participant sufficient information to make informed investment decisions.
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