Employer-Sponsored Retirement Plans
Employer-sponsored retirement plans are relatively straightforward. They are retirement plans established by your employer. Your company can make partial or full contributions to these plans, or make no contributions at all. There are two types of employer-sponsored retirement plans: defined benefit and defined contribution.
What is a Defined Benefit Plan?
A defined benefit plan (sometimes called a pension plan) is a retirement benefit determined by a particular formula, which often includes years of service and final average pay.
The plan defines the specific monthly benefit to be paid at retirement and is usually funded solely by the employer. There are no individual accounts and money is held in a trust fund and paid out to the individual at normal retirement age (usually 65).
These plans are no longer common because employers see pension funding as riskier. Defined benefit plans are riskier because they can become underfunded and the employer bears all of the risk for ensuring the plan pays all of its guaranteed benefits.
What is a Defined Contribution Plan?
A defined contribution plan is a retirement plan in which the employer, employee, or both contribute to the employee’s individual account on a periodic basis.
Contributions are usually based on a percentage of the employee’s annual earnings.
Your employer then invests this money on your behalf. Defined contribution plans have restrictions that dictate when and how each employee can withdraw money without a penalty.
As of 2015, defined contribution plans accounted for $6.7 trillion of the $24 trillion in total retirement plan assets in the U.S.
What are the Types of Defined Contribution Plans?
The most popular type of defined contribution plan is a 401(k). These plans, named after the section of tax code that governs them, let you decide how much money you want to contribute. Your employer then takes money directly from your paycheck and places it in your account, on your behalf.
Employers who use 401(k)s for their defined contribution plans will often match whatever contributions you make, up to a certain percentage, often tax-free.
For example, your company may match 100 percent of your contributions up to 5 percent of your salary. If you make $50,000 a year and contribute 5 percent, or $2,500, your employer would also provide $2,500.
Your overall contributions would then be $5,000 every year. The annual maximum contribution limit for 401(k), 403(b), and most 457 plans in 2019 is $19,000. And, the catch-up limit for those 50 or older, is $6,000.
Personal contributions to a 401(k) can be taken from pre-taxed money, meaning you don’t have to pay income taxes for the amount you contribute to your plan. In other words, every dollar you contribute to your 401(k) lowers your overall taxable income.
Investment earnings are accrued on a tax-deferred basis. Tax-deferred growth means that you will not have to pay any taxes on your 401(k) earnings until you begin withdrawals. At that point, you will have to pay regular taxes.
Some companies require that you become vested in the company before you gain full rights to your employer’s contributions to your retirement account. Becoming vested means an individual has to have a certain amount of years of service.
If you quit before you are fully vested, you will not be able to keep all of the money that the company has contributed to your account. Still, you always retain 100 percent of the money you contributed, whether you’re vested or not.
403(b) plans are similar to 401(k) plans but are only offered to government employees and those of tax-exempt groups such as churches, hospitals, and schools.
There are two other differences between 403(b) and 401(k) plans. 403(b) plans usually offer a more limited array of investment choices, and most 403(b) plans allow you to vest immediately.
Besides these differences, 401(k)s and 403(b)s largely work the same. Additionally, they have the same 2019 contribution limits.
457(b) Plans are designed for governmental employers such as cities, counties, and states. These plans allow employees to save money tax-free for retirement, just like a 401(k) for a 403(b).
Certain tax-exempt, non-governmental, entities may also qualify for 457(b) plans. Contributions and earnings on retirement money are both tax-deferred under a 457(b) plan.
Additionally, these plans avoid the majority of testing rules and can be discriminatory, so be sure to understand all of the nuances of your 457(b).
Annual contributions to a 457(b) account, cannot exceed the lesser of:
- 100 percent of the participant’s includible compensation, or
- The elective deferral limit ($19,000 in 2019)
401(a) plans are a type of money purchase plan, also known as money purchase pension plans. Money purchase plans offer contributions based on either a dollar-based or percentage-based amount. These contributions can be made by either the employer, employee or both.
The big difference with money purchase plans is that they require a fixed amount of contributions. A fixed contribution amount means that the company has to make annual payments to each employee’s account, regardless of its profitability that year.
No matter what an employee does or does not contribute, the employer must still contribute. Also, unlike a profit-sharing plan, employers using a money purchase plan must make the same contribution to each employee’s account.
401(a) plans are made available to eligible employees of governmental agencies, educational institutions, and nonprofit organizations. Typically, 401(a) plans have delayed vesting where the employer money is “owed” after 3-5 years of service.
Profit-sharing plans give an employee a share of the company’s profit for that quarter or year. These accounts are created by the employer and accept discretionary employer contributions.
Discretionary contributions mean that businesses are allowed to choose when and how much they will contribute to each employee’s account. An employer, therefore, may decide not to contribute anything during a given quarter or year.
Still, a set formula has to be established to determine how contributions are determined. This formula cannot discriminate in favor of highly compensated employees. The total contribution limit for profit-sharing plans is $56,000 in 2019.
Employee Stock Ownership Plan (ESOP)
An employee stock ownership plan allows employees to buy stock directly, be given as a bonus, or receive stock options.
These plans seek to align the employee and company by investing workers’ money into the performance of the company and their stock.
Defined Benefit Vs Contribution Plans
|Defined Benefit Plan||Defined Contribution Plan|
|Employer Contributions and/or Matching Contributions||Employer-funded. Federal rules set amounts that employers must contribute to plans to ensure that plans have enough money to pay benefits when due. There are penalties for failing to meet these requirements.||There is no requirement that the employer contributes (Exception: SIMPLE and safe harbor 401(k)s, money purchase plans, SIMPLE IRAs, and SEPs). The employer may have to contribute to certain automatic enrollment 401k plans.
The employer may choose to match a portion of the employee’s contributions or to contribute without employee contributions. In some plans, employer contributions may be in the form of employer stock.
|Employee Contributions||Generally, employees do not contribute to these plans.||Most plans require the employee to contribute to an account to be established.|
|Managing the Investment||Plan officials manage the investment, and the employer is responsible for ensuring that the amount it has put in the plan plus investment earnings will be enough to pay the promised benefit.||The employee often is responsible for managing the investment of his/her account, choosing from investment options offered by the plan. In some plans, plan officials are responsible for investing all the plan’s assets.|
|Amount of Benefits Paid Upon Retirement||A promised benefit is based on a formula in the plan, often using a combination of the employee’s age, years worked for the employer, and/or salary.||The benefit depends on contributions made by the employee and/or employer, the performance of the account’s investments and fees charged to the account.|
|Type of Retirement Benefit Payments||Traditionally, these plans pay the retiree monthly annuity payments that continue for life. Plans may offer other payment options.||The retiree may transfer the account balance into an individual retirement account (IRA) from which the retiree withdraws money, or may receive it as a lump sum payment. Some plans also offer monthly payments through an annuity.|
|Guarantee of Benefits||The Federal Government through the Pension Benefit Guaranty Corporation (PBGC), guarantees some amount of benefits.||No federal guarantee of benefits.|
|Leaving the Company Before Retirement Age||If an employee leaves after vesting in a benefit but before the plan’s retirement age, the benefit generally stays with the plan until the employee files a claim for it at retirement. Some defined benefit plans offer early retirement options.||The employee may transfer the account balance to an individual retirement account (IRA) or, in some cases, another employer plan, where it can continue to grow based on investment earnings. The employee also may take the balance out of the plan but will owe taxes and possibly penalties, thus reducing retirement income. Plans may cash out small accounts.|
Individual Retirement Plans
Individual retirement plans are owned and ran by you, the individual employee. Your employer does not contribute to these plans, as they are self-directed savings vehicles. There are three main types of individual retirement plans: Traditional IRAs, Roth IRAs, and Rollover IRAs.
Traditional Individual Retirement Accounts (IRAs)
Traditional IRAs are individual retirement accounts that allow contributions to grow tax-deferred, and any contributions are tax-deductible (depending on income, there are phase-outs for deductions).
Under a traditional IRA, contributions, and any earnings are taxable when withdrawn. Also, there are no income limits to make contributions to a traditional IRA. Additionally, traditional IRAs have minimum required distributions starting when the individual turns 70 ½.
Traditional IRAs are best for an individual that believes they will be in a lower tax bracket when they retire, then the one they are currently in. IRA contribution limits are $6,000 for 2019.
Roth IRAs have several key differences compared to a traditional IRA. The first difference is that Roth IRAs offer tax-free growth, rather than tax-deferred growth. Similarly, you can make tax-free withdrawals from a Roth IRA. Contributions to a Roth IRA are not tax-deductible. These lack of deductions means that you are making contributions with after-tax dollars.
Unlike a traditional IRA, there are income limits for making contributions to a Roth IRA. Also, contrary to a traditional IRA, there is no minimum required distributions during the lifetime of the original owner.
Because you are using after-tax dollars to fund your plan, Roth IRAs are ideal for an individual that believes he/she will be in a higher tax bracket when they retire, then the one they are in now.
A Rollover IRA lets you roll over your 401(k), 403(b), 457 plans with a former employer into an IRA. These accounts let you consolidate multiple employer-sponsored plans into one IRA without incurring any penalties.
Additionally, your plan assets continue to remain invested on a tax-deferred basis. Consolidating multiple plans makes it easier for you to allocate and monitor your retirement assets.
Pros and Cons of Employer-Sponsored vs. Individual Plans
As with any decision, there are positives and negatives to both retirement strategies. For this comparison, we will compare a 401(k) and a traditional IRA.
|Pros: 401(k)||Cons: 401(k)||Pros: IRA||Cons: IRA|
|Higher Contribution Limits: The contribution limits for 401(k)s, as of 2019, is $19,000 per year, plus a $6,000 catch-up contribution for those 50 and over.||Limited Flexibility: Many 401(k)s offer fewer comparative investment options.||Tax-Deferred: Contributions to a traditional IRA are made on a tax-deferred basis.||Lower Contribution Limits: In 2019, IRA contributions limits are $6,000, and $7,000 if age 50 or older.|
|Employer Matches/Contributions: Your employer may match each of your contributions, usually up to a certain limit. Also, employer contributions don’t count towards your total contribution limit.||IRA Deductibles Excluded: Those who contribute to a 401(k) can reduce, or even eliminate the income tax deductions allotted for an IRA.||Not employer-sponsored: An IRA is not dependent on your employer. This means that you can use an IRA even if you work on a part-time or contract basis.||Contributions May Not Be Deductible: For individuals with access to a workplace retirement account, contributions to an IRA may not be deductible.|
|Borrowing Capability: Some 401(k) plans come with a provision that allows you to take out a loan on your savings, in the case of an emergency or financial crisis. Usually, you can borrow up to $50,000 or half your 401(k) balance, whichever is less.||Taxable Income Upon Withdrawal: When you begin to withdraw your money, it is taxed as additional income. Additionally, there is a 10 percent penalty if you withdraw before the age of 59½.||Easy and Cheap to Start: Plan holders set up their own IRA. Setup can usually be done without the help of a financial planner, which saves both time and cost.||Penalties for Early Withdrawal: Traditional IRAs offer similar penalties for early withdrawal as 401(k)s|
|Easy Setup: Most employers make the setup of a 401(k) very simple, and because contributions come directly from your paycheck, it is easy to contribute.||Possible Waiting Periods: Upon changing employers, you may have to wait six months to a year before they will allow you to join their 401(k) plan.||Increased Investing Options: IRAs typically have more investment options including more: stocks, bonds, mutual funds, and CDs.||Required Withdrawals: Again, like 401(k)s, traditional IRAs require policyholders to begin minimum withdrawals at the by the age of 70½|
|Deferred Taxes: There is no tax on interest or capital gains made in your 401(k), until withdrawal.||Required Withdrawals: Plan holders must begin receiving minimum distributions by the age of 70½. If you are still working, this may make you subject to a higher rate of tax than if you were to wait until retirement.||More control: You get to decide when and where you open the plan, investing options, and how your contributions are allocated.||Less Protection: IRAs offer less creditor protection as a 401(k) plan. Some states provide a certain level of creditor protection for IRAs, but it is usually less than that of an employer-sponsored plan.|
|Income Tax Reduction (during the year of contribution): During the same year that you make a contribution to your plan, you can deduct the amount you placed in your 401(k) from your net income.||Tax Deductions: Contributions to a traditional IRA can be claimed as a tax deduction, depending on your income bracket.|
Qualified Retirement Plans
What is a qualified plan?
A qualified retirement plan is one that meets certain requirements established by the Employee Retirement Income Security Act of 1974 (ERISA). Under ERISA plans that are “qualified” are subject to most of ERISA’s restrictions.
Qualified plans are designed to offer individuals added tax benefits on top of their regular individual retirement plans, or IRAs.
Employers deduct an allowable portion of pretax wages from the employees, and the contributions and earnings of the plan, then grow tax-deferred until withdrawal.
If a qualified plan allows contributions to be made from paycheck deductions, this also reduces an employee’s present income-tax liability by reducing their taxable income.
A qualified plan only allows certain types of investments, which vary by your plan’s type, but usually include publicly traded securities, real estate, mutual funds, and money market funds.
Employer-sponsored plans, defined benefit, and contribution plans, are qualified plans.
Qualified plans must meet several criteria to be considered qualified, including:
- Disclosure = Documents pertaining to the plan’s framework and investments must be available to participants upon request
- Coverage = A specified portion of employees, but not all, must be covered
- Participation = Employees who meet eligibility requirements must be permitted to participate
- Vesting – After a specified duration of employment, a participant’s rights to pensions are non-forfeitable benefits. Vesting provisions must not discriminate in favor of Highly Compensated Employees (HCE)
- Once earned, benefits may not be forfeited
- Testing = Qualified plans must satisfy the IRS in both form and operation and are subject to various testing requirements. The IRS administers a determination letter program that enables plan sponsors to get advanced assurance on their retirement plan document
A qualified plan also has to comply with a similar list of IRS requirements, including:
- Minimum Participation Requirements
- Operate in Accordance with Plan
- No Cutback by Plan Amendment
- 401(k) ADP and Distribution Requirement
- Matching/Employee Contribution ACP Test
- Elective Deferral Test
- 415 Maximum Contribution/Benefit Limit
- 401(a)(17) Maximum Compensation Limit
- Top-Heavy Requirements
- Minimum Vesting Requirements
- Minimum Distribution Requirements
- Consent for Distribution Requirement
- Joint and Survivor Annuity Requirements
- Direct Rollover Requirements
- Assignment or Alienation Prohibition
- Nondiscrimination Requirements
- Coverage Requirements
- 401(a)(26) Participation Requirement
- Funding Requirements
- Exclusive Benefit Requirement
- Reporting and Disclosure
What is a non-qualified plan?
Non-qualified plans can be established for one individual, or for a select number of employees. These plans offer a greater amount flexibility but carry a larger amount of risk.
Nonqualified plans are not subject to ERISA but are exempt from the participation, vesting, funding, and fiduciary provisions. These plans also have to comply with several regulations of the IRS.
There are four main types of nonqualified plans:
- Deferred Compensation
- Executive Bonus Plans
- Group Carve-out Plans
- Split-dollar Life Insurance Plans
Contributions to nonqualified plans are usually nondeductible to the employer, and taxable to the employee as well. Still, these plans can help highly compensated employees defer taxes until retirement when they are in a lower tax bracket.
Because nonqualified plans aren’t covered by ERISA, they do not experience the same tax advantages as qualified plans. Still, plan assets can grow tax-deferred, provided they meet two conditions (as per the IRS):
- Plan assets must be segregated from the rest of the employer’s assets.
- Plan assets must be subject to a substantial risk of forfeiture. (Meaning this money may be seized by creditors in the event of bankruptcy.)
Pros and Cons of Nonqualified Plans
As with any decision, there are both benefits and disadvantages to choosing to implement a nonqualified plan.
|No Limits on Contributions – Hundreds of thousands of dollars may be placed in these plans in a single year.||Substantial Risk of Forfeiture – Funds placed in nonqualified plans are usually subject to attachment from creditors.|
|Tax-Deference – If the two IRS requirements are satisfied, all money in these plans can grow tax-deferred, similar to if it were in a qualified plan.||“Golden Handcuff” Provisions – Employees who do not complete their tenure with the company, or do not fulfill other requirement specified within the plan will generally forfeit their rights to the benefits that they would otherwise have been paid.|
|Insurance Benefits – Some nonqualified plans can pay significant death benefits. These plans can also contain several types of protection in a single policy (disability, critical illness, death).||Potential Lack of Tax-Deference – If the two IRS requirements are not met, assets in a nonqualified plan will not grow tax-deferred.|
|Freedom from ERISA – These plans do not have to meet several ERISA requirements that qualified plans do.|
|Substantial Flexibility – Nonqualified plans can be built to match the needs of the participants.|
|Ease-of-Use – These plans require minimal reporting and filing, and are generally cheaper to create and run than qualified plans.|
What are Top-Hat Plans?
A top-hat plan is a plan that is, “unfunded and maintained by an employer primarily for providing deferred compensation for a select group of management or highly compensated employees.”
As a rule of thumb, all nonqualified plans, are designed to qualify as top-hat plans.
Deferred Compensation Nonqualified Plans
The objective of deferred compensation plans is to lower the amount of tax paid by a highly-compensated employee.
This objective is accomplished by deferring a portion of the employee’s compensation until retirement when he or she will (hopefully) be in a lower income tax bracket.
There are two sub-categories of deferred compensation plans: True deferred compensation plans and salary continuation plans. These plans are designed to provide executive employees with supplemental retirement income.
The main difference between the two sub-categories is their funding source. A true deferred compensation plan allows an executive to defer a portion of his income, oftentimes a bonus, into the account.
A salary continuation plan allows the employer to fund the future retirement benefit on behalf of the executive. Both of these plans allow for the earnings to accumulate tax-deferred. The income received at retirement is taxed as ordinary income.
Executive Bonus Plans
Under an executive bonus plan, an executive has issued a life insurance policy (can also include other benefits such as critical illness, disability, etc.) with premiums paid by the employer as a bonus to the executive.
These premium payments are considered compensation and are therefore deductible to the employer. Although these bonus payments are taxable to the employee. An employer may pay a second (double) bonus more than the premium amount to cover these taxes.
A split-dollar plan is used to provide a key employee with a permanent life insurance policy. The policy, under this arrangement, is purchased on the life of that employee. Ownership of the policy is then split between the employer and employee.
Common split-dollar plans have the employer paying the mortality cost, while the employee pays the balance of the premium. Upon death, the majority of the benefit is paid to the employee’s beneficiaries, and the employer receives a portion equal to its investment.
Group carve-out plans are another life insurance plan. These plans allow an employer to carve out a key employee’s group life insurance in excess of $50,000 and replace it with an individual policy.
This allows the key worker to evade the imputed income on group life insurance in excess of $50,000. The employer redirects the premium it would have paid on the excess group life insurance to the individual policy of the key employee.
Qualified vs. Non-qualified Plans
|Plan Feature||Qualified Plan||Nonqualified Plan|
|Eligibility||Must be available equally to all employees as defined by the plan||Can be made available only to select employees|
|Compensation deferral limits||Yes; total dollar limits are adjusted each year by the IRS; pre-tax maximum for 2016 is $18,000||No IRS-defined limits|
|Distribution timing||Generally, cannot take distributions before age 59½ except for certain financial hardships||Several options available but once a distribution option is elected, it cannot be changed; Section 409A restrictions apply|
|Mandatory distributions||Yes; must take Required Minimum Distributions starting at age 70½||Not required by IRS but plan rules may apply|
|Assets protected from company creditors||Yes||No|
|Loans||Yes, if the plan allows||No|
|Participant and company tax deduction on deferrals||Yes, in the year of deferral||Yes, but not until distribution|
|Rollover to IRA upon job loss||Yes, under terms of the plan||No|
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