Qualified Retirement Plans
Retirement is sometimes referred to as the “golden years.” However, retirement is not very golden for those without enough money to retire comfortably. Longer life spans and growing concern over the future of Social Security retirement benefits are just two of the reasons why you should consider a sound retirement planning. For many Americans, qualified retirement plans are the keystone of retirement planning.
Defined Benefit Plan
The purpose is to provide a specified retirement benefit. Employers bear the investment risk. Annual employer contributions can sometimes fluctuate widely and generally must be determined by an actuary or other financial administrator. A defined benefit plan promises either a stated benefit at retirement or a benefit determined according to a fixed formula. As the name implies, a defined benefit plan focuses on providing a specified benefit at retirement. The employer bears the responsibility of providing an adequate retirement income based on the benefit promised or the benefit formula utilized.
Defined Contribution Plan
The purpose is to set aside funds to the individual accounts of participants based on an established contribution formula. Employers are generally committed only to making annual contributions. Plans are often easier to administer than defined benefit plans, and the employees bear all investment risk.
Money Purchase Pension Plan
Under this type of defined contribution plan, employer contributions are based on a set percentage of each employee’s compensation. The employer is required to make annual contributions, and an employee’s ultimate pension benefit is equal to the total employer contributions plus the earnings (or minus any investment losses) on those contributions, and minus any administrative expenses. Under a money purchase plan, an employer is obligated to make annual contributions.
Profit Sharing Plan
A defined contribution plan under which employers base contributions on profits or income, or a determination by the board of directors. The employer is not necessarily obligated to make annual contributions, but contributions must be recurring and substantial. These defined contribution plans, sometimes also called discretionary plans, are similar to money purchase pension plans in that the amount of an employee’s retirement benefit depends on the amount in an individual employee’s account at retirement. The distinguishing feature of this plan, however, is that the employer is not obligated to make contributions each year, but there must be recurring and substantial contributions.
Savings or Thrift Plans
Employee savings or thrift plans are a form of defined contribution plan that may require mandatory employee contributions as a condition of plan participation. The employer matches such employee contributions under a formula specified in the plan. For example, the employer may contribute 50 cents for each dollar contributed by the employee up to a stated cap (e.g., 3% of compensation). The employee may be permitted to make contributions over the maximum that the employer will match (i.e., over 6% of compensation in our example).
Employee Stock Ownership Plan (ESOP)
A defined contribution plan in which plan assets are invested primarily in securities of the employer corporation. A basic advantage of the ESOP is that the employer makes its contributions in cash or employer securities. In other words, an employer that is strapped for cash in a particular year can make its contribution in the form of securities and still enjoy the tax deduction. As in the case of a profit-sharing plan, the employer is not required to make a plan contribution every year unless the ESOP has borrowed to acquire employer securities. If the employer does borrow to purchase the securities, the interest paid on the loan is deductible.
Target Benefit Plan
A cross between a defined benefit and a money purchase pension plan. Employers base contributions on a target benefit formula established at the plan’s inception, which includes an assumed earnings rate. Because the contribution formula is not adjusted in subsequent years to reflect actual plan earnings, the employee bears all investment risk. Contributions are allocated to separate accounts maintained for each participant.
Section 401(k) Plan
A 401(k) plan is a retirement plan under which a participant is allowed to defer compensation, and the employer contributes this elective deferral to the employee’s account within the employer-sponsored 401(k) plan. Sole proprietors and partners with employees may also sponsor and participate in 401(k) plans. The Appeal of 401(k) Plans:
- Contributions are made with before-tax dollars.
- Funds accumulate income tax deferred.
- Distributions from the plan may be income-taxed under the annuity rules or as a lump-sum distribution.
- Employer contributions (if any) are tax deductible up to the prescribed limits.
Simplified Employee Pension (SEP) Plan
A special type of employer retirement plan under which the employer makes contributions to each participant’s separate individual retirement account (IRA), reducing plan administration, recordkeeping, and reporting. Employers can deduct their SEP contributions, up to 25 percent of compensation for each employee. In addition to the employer’s deduction, employees can exclude from their gross income the amount of the employer SEP contributions made on their behalf.
A SEP plan must be established under a written agreement that specifies the terms of the plan regarding eligibility and participation, allocation of contributions, etc. There are three options available with regard to the written agreement:
Once the written agreement is executed by the employer, each eligible employee must establish a SEP at a financial institution of his/her choice to receive the contributions that will be made.
Establishing the SEP and contributing to it can be done anytime during the employer’s tax year and up to and including the date the tax return is due, including extensions.
Each calendar year for which the employer decides to make a contribution, it must contribute to the SEP for every employee who has reached age 21 and worked for the employer at any time during three of the last five years. Less restrictive eligibility requirements may be established. (Indexed amount for 2003).
Simple IRA
SIMPLE IRA stands for Savings Incentive Match Plan for Employees Individual Retirement Account. It is designed to be an investment option offered by employers to their employees in much the same method as a 401k. It is a tax-deferred investment that is pulled from your salary pre-tax as an automatic deduction from your paycheck.
As the name implies, contributions to a SIMPLE IRA are usually matched by the employer to help the employee’s retirement savings grow more quickly. The employer can decide to either match up to 3% dollar for dollar, or they can select a flat rate 2% contribution that is provided no matter what the employee contributes. Either way, the employer is subject to making a minimum contribution. A SIMPLE IRA can have a lower contribution limit than a 401k and also has lower costs to administer the plan. Not every company can offer the SIMPLE IRA to their employees. In order to qualify the company must have fewer than 100 employees. A two-year grace period is provided after the company goes over the 100 employee mark.
Keogh Plans
A qualified retirement plan maintained by a sole proprietor or partnership is often referred to as a Keogh or H.R. 10 plan. In the case of partnerships, the partnership entity, not the individual partners, must establish the Keogh plan. In general, Keogh plans are subject to the same requirements and limitations as any other qualified retirement plan, and they also receive the same favorable federal income tax treatment. However, self-employed individuals who are “owner-employees” cannot participate in a Keogh plan unless they provide coverage for essentially all full-time employees. An owner-employee is defined as either:
A sole proprietor, or
A partner who owns more than a 10% capital or profits interest in a partnership.