Retirement Plans 101

Recognizing the importance of planning for retirement and the inadequacy of Social Security in meeting the needs of retirees, Congress enacted laws to encourage Americans to set aside current income to secure their financial futures. Retirement planning that meets statutory requirements provides investors with current and future tax benefits, enhanced investment returns, asset protection, and financial security.

Tax advantaged retirement plans come in many forms and can be classified in several ways. Some retirement plans can only be sponsored by businesses, government entities and non-profits, while others can be formed only by individuals. Self-employed individuals and small business owners can sponsor employer plans even if they are the only plan participants. In fact, small businesses have the greatest flexibility to maximize the tax and investment benefits available to qualified employer-sponsored plans.

Employer-sponsored retirement plans that are governed by Section 401 of the Tax Code are often referred to as Qualified Plans. Examples of Qualified Plans are: 401(k) Plans, Profit-Sharing Plans, Money Purchase Plans, and Defined Benefit Plans. Retirement plans that are governed by Section 408 of the Tax Code are not referred to as Qualified Plans, but provide similar tax advantages. Retirement plans governed by Section 408 are: IRAs in their various forms, including Traditional IRAs, Roth IRAs, employer-sponsored SEP-IRAs, and employer-sponsored SIMPLE-IRAs.

Another way retirement plans are classified is based on whether they are defined contribution or defined benefit plans. Defined contribution plans limit the retirement benefit to whatever value has accumulated within an individual account belonging to a retiree. Defined benefit plans, like traditional pension plans, provide specified retirement benefits that are not dependent on the value of individual accounts. In a defined benefit plan the sponsoring employer is required to ensure the plan has the funds to pay benefits. Businesses can generally contribute – and therefore deduct – more each year to a defined benefit plans than to defined contribution plans. However, defined benefit plans are often more complex and, thus, more costly to establish and maintain than other types of plans.

Types of Tax Advantaged Retirement Plans

Individual Retirement Arrangements – IRAs

Traditional IRA: Available to all individuals and contributions may be fully or partially deductible and amounts in the traditional IRA (including earnings and gains) are not taxed until distributed.

Roth IRA: Available to all individuals and all qualified distributions, including earnings and gains on after-tax contributions, are distributed tax-free.

Simplified Employee Pension Plan (SEP-IRA): A SEP plan allows employers to contribute to traditional IRAs (SEP-IRAs) set up for employees. A business of any size, even self-employed, can establish a SEP.

Salary Reduction Simplified Employee Pension Plan (SARSEP): A SARSEP is a Simplified Employee Pension (SEP) plan that permits employee salary reduction contributions. New SARSEPS can no longer be formed.

Savings Incentive Match Plan for Employees (SIMPLE IRA Plan): A SIMPLE IRA plan allows employees and employers to contribute to traditional IRAs set up for employees.

Qualified Plans

Defined Contribution Plans

Profit-Sharing Plan: A profit-sharing plan accepts discretionary employer contributions. There is no set amount that the law requires the employer to contribute.

401(k) Plan: A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts.

Money Purchase Plan: Money purchase plans have required contributions. The employer is required to make a contribution to the plan each year for the plan participants.

Employee Stock Ownership Plans (ESOPs): An employee stock ownership plan (ESOP) is an IRC section 401(a) qualified defined contribution plan that is a stock bonus plan or a stock bonus/ money purchase plan. An ESOP must be designed to invest primarily in qualifying employer securities as defined by IRC section 4975(e)(8) and meet certain requirements of the Code and regulations.

403(b) Tax-Sheltered Annuity Plans: A 403(b) plan (also called a tax-sheltered annuity or TSA plan) is a retirement plan offered by public schools and certain 501(c)(3) tax-exempt organizations. Employees save for retirement by contributing to individual accounts. Employers can also contribute to employees’ accounts.

457(b) Deferred Compensation Plans: Plans of deferred compensation described in IRC Section 457 are available for certain state and local governments and non-governmental entities tax exempt under IRC Section 501. They can be either eligible plans under IRC 457(b) or ineligible plans under IRC 457(f). Plans eligible under 457(b) allow employees of sponsoring organizations to defer income taxation on retirement savings into future years. Ineligible plans may trigger different tax treatment under IRC 457(f).

Defined Benefit Plans

Traditional Defined Benefit Plan: Defined benefit plans provide a fixed, pre-established lifetime benefit for employees at retirement. Participants do not have individual accounts and are entitled to annual benefits based on a formula outlined in the plan document.

Hybrid Plans – Cash Balance Plans & Pension Equity Plans (PEP): Hybrid plans contain features of both defined benefit and defined contribution plans. In a Cash Balance Plan, participants receive an accumulated benefit, which is the current balance of a hypothetical “account” that grows with annual credits. In a Pension Equity Plan, participants’ benefit are expressed as a lump sum, but there are no hypothetical accounts.