A pension is a steady income given to a person, usually after retirement. The point of a pension is to give you income after you retire. Your employer sets up a pension plan to provide money for your retirement. With certain exceptions, pension plans are generally governed by a federal statute called the Employee Retirement Income Security Act of 1974 (ERISA).
Contributions to Pensions
The contributions that employers make to pensions are tax deductible. The investment earnings on the plan assets are tax deferred. The distributions that employees receive from the plan are taxed as ordinary income.
Maximum contributions to a pension plan depend on plan type (e.g., defined benefit, profit sharing), whether the employee is covered by more than one plan, and whether the plan is top-heavy, which refers to plans (mainly for small firms) where a disproportionate amount of the benefits accrue to the owners of the firm and key employees.
Participation and Vesting of Pensions
You usually have to work five to ten years to be part of a pension plan. You could lose your pension if you have not worked at a place long enough to have benefits and decide to change jobs. If you do have benefits, you can usually keep the money in that account until you retire. Some places will also let you remove the money, but you'll have to pay a penalty tax.
Types of Pensions
There are two main types of pension plans. One is called a "defined benefit" plan; the other is called a "defined contribution" plan.
Defined Benefit Plans
A defined benefit plan will provide for a specific dollar amount to be paid upon retirement, whether a pre-defined dollar amount or an amount based upon your salary and service with the particular employer. Because present-day contributions must provide enough money to fund benefits in the future, an employer's contribution amounts are required to be calculated by an actuary.
Defined Contribution Plans
A defined contribution plan does not promise a specific benefit but rather provides for the amount that is to be contributed to your pension accounts. Under a defined contribution plan, you and your employer or both will contribute to your pension account, and the funds will be invested for your benefit. You will receive the total amount of the contributions to the account in which you are vested, as well as any gains that have accumulated from investing the funds. However, the invested funds are also subject to losses from poor investments.
Profit-sharing plans, 401(k) plans, 403(b) plans, and employee stock ownership plans are all examples of defined contribution plans. The maximum tax-deductible contribution that an employer can make is currently 25% of salary or $46,000, whichever is greater.
Money Purchase Pension Plan
One type of defined contribution plan is called a money purchase pension plan, which requires an employer to make fixed annual contributions to your retirement account. Typically, contributions to a money purchase pension plan represent a certain percentage of your annual salary. Once the employer establishes the contribution level, it can only be decreased by a formal process dictated by ERISA, even if the employer's business is not profitable for a given year.
Simplified Employee Pension Plan
Another type of defined contribution plan is the simplified employee pension plan (SEP). With a SEP, the employer makes contributions directly to your individual retirement account (IRA). Because of the ease of administration, many small businesses and organizations with few employees offer SEPs to their employees.
Questions for Your Attorney
- How much can I contribute to my pension tax free?
- Why can my employer contribute more to a SEP than I can to my 401(k)?
- What exactly is ERISA?