Because the traditional pension has decreased so substantially in popularity based on its heavy cost to employers, most workers in the country have or should have a qualified retirement plan. Assessing the options available through your employer or finding an independent retirement plan is a serious task you should not undertake without a solid understanding of the different types of plans and the situations in which those plans are most effective.
The most common plan is the 401(k). These and similar plans are offered through an employer who diverts, and in some cases concurrently contributes, to a pool of investment capital taken out of the employee’s salary monthly. IRA plans are similar but include no employer contributions and adhere to slightly different regulations as to acceptable investments within the account. Other plans tie the employee’s retirement capital to the performance of the company through profit-sharing schemes, and these put the least financial burden on employees.
What Is a Qualified Retirement Plan?
A qualified retirement plan is any plan covered under section 401(a) of the United States tax code. These plans generally provide workers an opportunity to make tax-exempt contributions to retirement savings accounts. The IRS uses the term “tax-deferred” to refer to these accounts because workers do not pay tax on the portion of their earnings they choose to invest nor the capital gains on those investment dollars. Distributions in retirement are taxed at the normal rate.
How Do Plans Benefit Employees?
The taxation benefits of a qualified retirement for employees are twofold. First, the portion of your earnings you contribute to a qualified retirement plan is not taxable. This gives you the opportunity to reduce your taxable income while saving for the future. Once a portion of your salary has been contributed to a qualified plan, the capital gains that occur within your plan are not taxable. So, qualified plans provide the opportunity to avoid income and capital gains tax. You only pay taxes on distributions in retirement.
How Do Plans Benefit Employers?
Qualified retirement plans are desirable for employers because they offer a low cost avenue for providing employees with a retirement savings strategy. In the most common type of qualified retirement plan, a 401(k), the employer is not obliged to contribute anything, although they often do. For employers who elect to contribute to the retirement plans of their employees, contributions are tax-deductible, so the employer stands to benefit from any contribution and is never required to make contributions.
Different Types of Plans
Each qualified retirement plan is similar to all the others in that contributions are tax-exempt. From there, the distinctions lie in who is making the contributions and what the limitations are on those contributions. To choose the best qualified retirement plan for you, you must assess the different types of plans in reference to your particular financial situation.
401(k)s and Similar Plans
The 401(k) is the most common type of qualified retirement plan. In a 401(k), the employee chooses a percentage of their salary to be diverted to the account every month. Because contributions are tax-exempt, employees reduce their annual income tax bill. Capital within the 401(k) can be invested in various equities, and the increased value of those equities is not taxable as a capital gain. However, distributions you receive from your 401(k) in retirement are taxable.
Employers can choose to make contributions to their employees 401(k) plans, but they are not required by law to do so. The most common contribution amount among American firms is 50 cents for every dollar the employee contributes. Plans with higher contributions on the part of the employer generally have more stringent eligibility requirements, while plans with minimal or no contrbution from the employer are usually open to most or all employees.
457 plans and 403(b) plans are the most common variants of the 401(k) model. 457 plans are most commonly used for government employees while 403(b) plans were developed for school teachers. Both of these plans are also widely offered by employers in the non-profit sector.
IRAs and Similar Plans
Like a 401(k), IRA plans are offered by an employer and contributions are tax-exempt. However, IRA plans do not receive contributions from the employer. This is preferable for many smaller businesses without the profit margins to make substantial contributions to the qualified retirement plans of their employees.
Small businesses that cannot afford to offer a 401(k) can provide their employees with a less administratively burdensome plan that allows for more flexible investment options with a Savings Incentive Match Plan for Employees (SIMPLE) IRA or a Simplified Employee Pension (SEP) IRA. Self-Employed workers have the option of creating an IRA for themselves through their own business or sole-proprietorship, or they can open a Keogh Plan, which is essentially an IRA developed specifically for the self-employed.
There are other retirement plans that cultivate investment capital for employees by cutting them in on their employer’s profits. One of the qualified retirement plans that uses this method is the Employee Stock Ownership Plan or ESOP. In an ESOP, employees receive a predetermined number of shares of their employers stock in lieu of the portion of their income that would be contributed to a 401(k). The primary risk in an ESOP is insufficient diversification. Because employees hold stock in just one company, if that company fails, the employee’s retirement savings will dry up quickly.
Profit-sharing plans avoid the diversification issue by simply cutting employees in on the profits the company makes. Contributions are discretionary and based on the firm’s performance. The biggest advantage of a profit-sharing plan is that employees sacrifice none of their salary and their employer makes annual contributions to the account. Money purchase plans are similar to profit-sharing plans in that the employer makes all contributions in more modest but fixed amounts.
What If I Need the Funds in My Qualified Retirement Plan Immediately?
If you need to draw on the funds in a qualified retirement plan before you have reached the prescribed age of 59 and a half, you can do so in a few different ways, depending on the plan. Early distributions from a 401(k) come with a 10% tax penalty from the IRS. In some cases, you can take a loan based on the value of an IRA, which must be payed back with interest to the account.
How Can I Access a Qualified Retirement Plan?
401(k), 457, 403(b), ESOP, profit-sharing, money purchase, and SIMPLE IRA plans are only available through an employer, and employers are not legally obliged to offer any retirement plan at all.
What If I Am Self-Employed?
If you are self-employed, work part-time, work for an employer that does not offer a qualified retirement plan, or have non-traditional earning method of another variety, your best bet is to create a SEP IRA or a Koegh plan.
What Is behind the Popularity of 401(k) Plans?
401(k) plans have proliferated throughout the country because they are cheap for employers. Pension plans are on the decline in the United States because the cost of paying employees long after they have retired is a considerable expense that can be avoided by offering a 401(k), which obliges the employer to contribute nothing and rewards them every time they do contribute through a tax deduction.
What Is the Difference between an IRA and a 401(k)?
In a 401(k), the employer can, and often does, make contributions to augment their employee’s pool of investment capital whereas in an IRA all contributions necessarily come from the employee. The reason IRA plans remain popular is because restrictions on what investments can be made within the account are less strict than the rules governing 401(k) investment options. The major downside to an IRA for high earners are the lower annual contribution limits compared to 401(k) plans.
If you work for an employer that offers a profit-sharing plan or an ESOP, the long-term viability of the plan is highly dependent on the success of the company. Ask yourself how long you can see your employer remaining profitable enough to offer benefits and invest accordingly. In the case of the 401(k), you should pay close attention to the employer’s contribution; if they plan to contribute nothing, pursue other options. If they offer a solid 50% match, it is probably worth sticking around. Small-business owners and employees, like self-employed workers, are relegated to IRA plans, the varieties of which cater to different circumstances.