Retirement Plans

Tom Pedreira

Email this article Print this page

Retirement plans are really nothing more that formal contracts to provide retirement benefits. Some plans you can set up by yourself. Others plans may be sponsored by your employer.

A "qualified" retirement plan is one that complies with applicable law so that taxes are deferred on contributions and earnings thereon until withdrawn. The federal law that governs such plans is the Employee Retirement Income Security Act (ERISA). ERISA establishes non-discrimination rules and other safeguards to protect employee benefits.

While not legally obligated to do so, employers may establish retirement plans to attract prospective employees and to keep current employees. Employers have an incentive to set up "qualified" plans because they get tax benefits in the process.

It is also possible to set up "non-qualified" plans, which means that they do not qualify for the same tax benefits. When employers establish such plans, they are usually for highly compensated executives.

Examples of "Qualified" Retirement Plans

Popular "qualified" plans include:

• IRA

  The simplest qualified retirement plan is an individual retirement account (IRA). An IRA is essentially a contract with yourself to keep money in a tax-qualified account until retirement. One benefit of an IRA is that taxes are deferred contributions and the subsequent earnings until they are withdraw.

• 401(k) Plans

  A 401(k) plan is a type of deferred compensation plan. You may annually contribute roughly $10,000 of your earnings. Your employer may match a percentage of what you contribute. You are not taxed on contributions until you receive distributions. There can be stiff penalties for withdrawals before age of 59-1/2. A great incentive to participate is that contributions can grow and accumulate until withdrawal, all on a pre-tax basis.

• Profit Sharing Plans

  A profit sharing plan allows an employer to supplement other retirement benefits by letting employees share in profits. Contributions are at the discretion of the employer. If contributions are made, however, they must be on a non-discriminatory basis. Usually, an employer makes contributions based on a percentage of total annual pay roll.

• Pension Plans

  The two basic qualified pension plans are:

  Defined benefit plans, which provide retirement benefits where the employer promises retirees a pension in a specific amount, with the benefit set by a formula based on years of service X final average salary X a percentage figure.

  The employer must contribute to the plan on a regular basis so that sufficient funds are available to pay required benefits to all retired employees as they come due. The employer bears the risk of having sufficient funds to pay the pensions.

  Defined contribution plans, which require employer to contribute a specific amounts to their plans. Employees are also typically required to make contributions. Each employee has an account, and has available at retirement the amount of money that is then in this account. The employee bears the investment risk.

Examples of "Non-Qualified" Retirement Plans

The types of non-qualified plans are unlimited. They can be as simple as making a contract with yourself to contribute to a savings account each month, or they can be complicated as deferred compensation arrangements that are funded by insurance.

A deferred compensation plan funded by insurance is probably the most popular "non-qualified" plan. It involves an employer's agreement to pay compensation to a key employee in the future if certain conditions are met (e.g., working continuously for the company until retirement). The goal is for the employee not to be taxed on the compensation until it is paid. A common approach is to fund the plan with insurance benefits, the premiums for which may or may not be tax deductible to the employer.

Related Resources