Retirement plans are really nothing more than 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 meeting certain tax and employee benefit laws so tax is deferred on contributions and earnings. Usually, you don't owe income tax until the funds are withdrawn. The federal laws governing these plans include the Employee Retirement Income Security Act (ERISA) and tax laws. ERISA establishes non-discrimination rules and other safeguards to protect employee benefits.

An employer doesn't have to offer a retirement plan. There are several key advantages that prompt employers to offer this benefit. There are tax benefits for employer and employee. A strong plan attracts job candidates and encourages current employees to stay. An ERISA-covered plan is free of state regulation and is protected from certain lawsuits.

Employers can set up "non-qualified plans" that don't meet the law or receive the tax benefits. This plan type is typically used for benefits for highly compensated employees.

ERISA Requirements

An ERISA pension plan must either:

  • Provide retirement income or
  • Result in a deferral of income to the end of covered employment or beyond

Other requirements include:

  • The plan must be set up or maintained by an employer, an employee organization or by both
  • The plan must include at least one common-law employee
  • The plan must be established or maintained by an employer or an employee organization involved in interstate commerce

ERISA also covers welfare plans, such as health care, severance pay and life insurance.

Examples of "Qualified" Retirement Plans

Popular "qualified" plans include:

401(k) Plans

A 401(k) plan is a type of deferred compensation plan. It's also called a "defined contribution" plan - the amount added to your account is set, or defined. You can contribute part of your earnings to your 401(k) account, and those amounts aren't taxed. Employers often offer to match a percentage of your contribution, which is also tax-free. Contributions and earnings on your account grow tax-free; you pay tax when you make withdrawals or receive distributions. Be aware penalties are stiff for withdrawals before you're 59-1/2 years old.

The maximum amount you can contribute each year can vary; usually it's set by a formula found in the law. The limit for 2009 was $16,500; Congress pre-empted the formula and kept the amount the same in 2010. If you're 50 or older, the limit may be higher for "catch-up contributions." Your employer can provide the exact rules that apply to your 401(k) plan.

Profit Sharing Plans

A profit sharing plan allows an employer to supplement other retirement benefits by letting employees share in profits. The employer has discretion in making contributions. However, contributions must be made on a non-discriminatory basis. Contributions are usually based on a percentage of total annual payroll.

IRAs

An individual retirement account (IRA) is basically a savings or investment account for an individual. You may have a tax deduction for your IRA contribution, and there are several types of IRAs. IRAs aren't considered ERISA pension plans, and don't have to meet ERISA reporting and disclosure requirements where:

  • No contributions are made by the employer or employee organization
  • Participation in the program is completely voluntary
  • The sole functions of the employer or employee organization is, without endorsing the program, to permit the sponsor to publicize its plan to employees or members and collect contributions through payroll deductions or dues check-offs, and
  • The employer or employee organization receives no compensation other than expense reimbursement for its payroll deductions or dues check-offs

Pensions

A "pension," where the employer promises retirees set payments in retirement, is a "defined benefit plan." Typically, the benefit is set by a formula based on years of service times final average salary times a percentage figure. Payments may be made monthly or in a lump sum.

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

Examples of "Non-Qualified" Retirement Plans

The types of non-qualified plans are unlimited. Options range from your simple promise to add to a savings account each month, or complex deferred compensation plans funded with insurance.

A deferred compensation plan funded by insurance is probably the most popular "non-qualified" plan type. An employer agrees to pay compensation to a key employee in the future if he or she meets certain conditions. For example, the employee must work for the employer until retirement. The plan objective is to defer income tax on the employee's pay until it's paid out in retirement. A common approach is to fund the plan with insurance benefits. The premium payments may or may not be tax deductible to the employer.

Questions for Your Attorney

  • What incentives does my employer have to provide an ERISA pension plan?
  • What are the 401(k) plan options for smaller employers?
  • What kinds of IRAs are covered by ERISA?