Do You Really Save Money Using a "Prototype" Retirement Plan?

The marketing of qualified retirement plans and the methods of establishing plans has increased in the last several years. This article describes different ways a retirement plan may be adopted and the advantages and disadvantages of each.

Retirement plans must be in writing. The plan document must contain certain provisions to be tax qualified (meaning the employer's contributions are deductible when made, but participants are not taxed on the contributions or earnings until they are actually received). The document need not follow an IRS pre-approved format. The two major types of plan documents available to employers are:

1. a plan sponsored by an organization for adoption by its members or customers, which consists of an adoption agreement and a separate plan document (called a .master or prototype plan.), and
2. a plan that is individually tailored for an employer’s unique circumstances (called an individually drafted plan.)

Master or Prototype Plan

An employer who adopts a master or prototype plan completes an adoption agreement to elect certain options which are specified in detail in a separate plan document. (The difference between a master and prototype plan is that the assets of master plans are commingled in a single fund, while the assets of a prototype plan are not commingled with other plans.)

An employer adopting a master or prototype plan has the choice of using a "standardized" or "nonstandardized" adoption agreement. If a standardized adoption agreement is properly completed, IRS approval of the plan is usually unnecessary. A nonstandardized adoption agreement allows the choice of additional options but is not automatically qualified.

A nonstandardized adoption should be submitted to the IRS for approval (which may defeat one of the purposes of using a master or prototype plan in the first place.)

An advantage of adopting a master or prototype plan is that the initial cost may be lower since the plan is established by merely completing blanks in the adoption agreement, as opposed to drafting specific plan provisions. Similarly, when a plan is updated to reflect a change in tax laws, the plan document will be amended by the sponsor for all employers, eliminating the need to amend each plan separately. (However, a new adoption agreement for each employer will be necessary.)

Finally, an employer who adopts a standardized master or prototype plan usually incurs no cost in having the plan approved by the IRS. Employers who adopt a nonstandardized master or prototype plan pay a $125 fee to the IRS, plus fees for a plan professional to complete and submit the approval application.

The main disadvantage of adopting a master or prototype plan is that the employer is limited to the options set forth in the adoption agreement. In most cases the adoption agreement cannot be modified to fit the needs or desires of the employer. An employer must accept the provisions offered by the master or prototype plan, or prepare its own plan.

Often, the initial cost savings by adopting a master or prototype plan will be more than offset by the cost to the employer of certain provisions included in the master or prototype plan.

Example of Standardized Master or Prototype Plan

For example, a standardized master or prototype plan must provide contributions for all participants who have completed at least 500 hours of service during the plan year, even if they terminate employment before year end. If an employer contributes 10 percent of pay to a standardized plan, a terminated employee who earned $40,000 while working at least 500 hours during a plan year will receive $4,000.

If the employer adopted another type of plan document, contributions would not be required. In this situation, the master or prototype plan will be more expensive if only one or two participants terminate employment. If an employer experiences considerable turnover, the additional expense can be tremendous.

Another disadvantage is that a master or prototype plan can be difficult to work with. The employer must review both the adoption agreement and the separate plan document to determine the actual terms of its plan. Both documents (and usually the summary plan description) will include provisions not applicable to that specific employer. Other disadvantages include:

1. the plan is often designed to protect the interests of the document sponsor rather than the employer;
2. the documents may be prepared and administered by individuals who are unfamiliar with legal requirements of tax qualified plans;
3. the employer may not have a local contact person to help with questions regarding the administration of the plan;
4. the plan document is often provided at low cost to obtain the investment business, but the cost may be recovered through higher management or record keeping fees, and
5. a new plan has to be adopted each time the employer wants to change investment companies. While it may be appropriate for an employer to adopt a master or prototype plan in certain situations, initial cost savings must be weighed against some significant future costs and disadvantages.

Individually Drafted Plans

Individually drafted plans are used by employers that want to take advantage of provisions allowed by law, but not offered as an option by the master or prototype plan. There are two types of individually drafted plans:

1. a volume submitter plan, and
2. an individually designed plan.

A volume submitter plan offers employers a wide variety of plan provisions allowed by law using language which has been reviewed by the IRS. However, unlike the master or prototype plan which offers only a few options, a volume submitter plan normally offers hundreds of variations.

Employers adopting a volume submitter plan should obtain IRS approval of the plan as written for that employer. Even though the plan is individually drafted, the user fee charged by the IRS is only $125 (the same as for a nonstandardized master or prototype plan).

The employer has much more flexibility with a volume submitter plan than a master or prototype plan. The IRS even permits employers to make changes to the provisions previously reviewed, or add some unique provisions. Volume submitter plans are easy to work with because they include only those plan provisions applicable to the employer. Law firms and some other professional firms may provide volume submitter plans for use by their clients.

If an employer's situation is unusual, or the employer desires special or unique provisions to meet its objectives, an individually designed plan can be used. For example, employers that want to satisfy the nondiscrimination requirements applicable to qualified retirement plans by using an allocation or benefit formula which provides maximum permitted discrimination in favor of owners or highly compensated employees must adopt an individually designed plan.

This type of plan will cost more to establish, and the employer must pay a higher IRS fee (between $700 and $1250) to obtain IRS approval. Paying the higher fees will be worthwhile for these employers because the plan will enable the higher paid employees to receive larger contributions than provided for other employees.

Conclusion

There are several ways to establish a tax qualified retirement plan. The method best suited for a particular employer will depend on that employer's situation. While there are reasons to choose one type of document over another, what is most important is that the employer receive the best possible advice at the time the plan is established.

Regardless of the document ultimately used, the plan must accomplish the employer's objectives at a reasonable cost. An employer that attempts to save expense by choosing a document provided at the lowest initial cost may end up paying substantially more due to increased administrative fees and higher contributions due to a less than perfect plan design.