Category Archives for Retirement plans

Deferred Contribution Plans

Defined Contribution Plans

Defined Contribution Plans

Defined contribution plans focus on the accumulation rather than eventual distribution of retirement funds. An employee chooses to divert a portion of their wages (called elective deferral) up to some specific annual limit to a specially designated savings plan.  An employee, rather than an employer, assumes all investment risks. The diverted funds affect Social Security and Medicare taxes but are not included as taxable income in the year they are received. An employee pays income tax when the funds are distributed during their retirement years. There is a wide range of defined contribution plans based on an employee’s elective deferral of wages.

 401(k) plans are a common employer-sponsored among private companies.  The allocated funds are reported on IRS Form W-2, Wage and Tax Statement, Box 12.  Beginning after January 1, 2006, employees can contribute additional after-tax funds to a special Roth 401(k) plan that offers eventual tax-free distributions subject to required minimum distribution (RMD) rules.

403(b) (also called tax-sheltered annuities) plans are available to public education employers and 501(c)(3) tax-exempt organizations. Beginning after January 1, 2006, these employees can also contribute after-tax funds to a specially-designated Roth account similar to the saving plan offered under employer-sponsored, private company 401(k) programs. Thrift Savings Plans are also available to those employees who work in public education and religious organizations.

501(c)(18)(D) plans based exclusively on employee contributions were formed before June 25, 1959.  These plans, whether qualified or nonqualified, have a maximum contribution of either employee compensation up to 25% or a maximum $7,000.  The employee contribution is added on IRS Form W-2, Wage and Tax Statement, Box 1 and deducted on IRS Form 1040, US Individual Income Tax Return, line 36.

457(b) and 457(f) plans were established for state and local government employees as well as independent contractors. A 501(c) tax-exempt organization can offer either a qualified or non-qualified retirement saving plan (such as a 457(f) plan) to a specific group of employees.  There is also an after-tax designated Roth option within these plans.

SIMPLE IRA and SEP are deferred contribution plans specifically for SOHO owners and sole proprietors.

Other available retirement plans such as Savings Incentive Match Plans for Employees (referred to as SIMPLE IRA plans) and Simplified Employee Pensions (referred to as SEP) plans that benefit both employer and employees.  These deferred contribution plans replaced Salary Reduction Simplified Employee Pension Plan (referred to as SARSEP) established before 1997.

Retirement savings plans

Long-term retirement savings plans, like IRA-based and 401(k) employer sponsored programs, are either qualified or non-qualified for tax-favored treatment by the Internal Revenue Service. Qualified plans have rules regarding non-discrimination among employees and minimum coverage and participation requirements. A non-qualified retirement plan might, for example, favor one particular group of employees such as a few highly compensated employees over others. Such plans are not subject to the same rules and regulations as the more common qualified plans.

A financial arrangement specifically defines benefits or contributions.  When an employer defines a benefit plan, they commit to some specific form of future payment that will be provided in periodic amounts dependent on age and retirement status.  When contributions rather than benefits are defined, employees typically choose to defer a portion of their wages (an elective deferral) toward a specially designated savings plan.  While employers can contribute to these employee savings plans, they do not commit to any predetermined benefits. In fact, each individual employee is responsible for their own investments.  Examples of elective deferral plans such as 401(k), 403(b), and 457 plans are named after specific sections in the US Internal Revenue Code.

Retirement savings plans

Retirement savings plans

Defined benefit plans are increasingly less common than defined contribution programs.  Most employers favor a qualified plan that affords employees some way to save for their future retirement without too many long-term obligations.  A sole proprietor can choose from among several qualified programs including the SEP IRA, SIMPLE IRA if they have employees, and a solo (safe harbor) 401(k) if they are work by themselves.

Retirement arrangements are extremely important for your future financial security. Choices between a 401(k) or a personal IRA-based program depend on your job, your age, and lifestyle choices.  Carefully consider whether you will remain in your current job or even career over, for example, the next 10 years.  Job changes have grown more common in the current workplace and roll-over options are an important program feature.

Any retirement savings plan takes time; saving money, even with tax advantages, is over the long-term.

Before making any financial decisions that will have long-term results, you need to spend time comparing 401(k) with the more “personal pension” programs like a traditional IRA and Roth IRA.  IRS Code that define 401(k) and IRA maximum contribution limits seem to change with every new tax year.  Once invested in a retirement saving program, continue to review changes in tax laws regarding the qualified distribution of funds.  Remember, for example, that traditional IRA plans have a required minimum distribution (RMD) when you reach age 70 1/2. Spend time researching and understanding financial features that distinguish 401(k) plans from IRA-based plan payouts.  Seek advice from a practiced financial advisor or tax professional. Retirement savings plans and your ability to secure a comfortable retirement will depend on carefully researched and properly executed financial decisions.