7.9 Qualified Retirement Plan Types, Characteristics, and Purchasers
Qualified retirement plans are generally classified into two primary categories:
Defined Benefit Plan
A defined benefit plan is a retirement plan designed to provide employees with a predetermined benefit at retirement. The benefit amount is typically calculated using a formula that considers factors such as the employee's length of service with the employer and their highest or final average salary.
Under this type of plan, the employer is responsible for funding the promised retirement benefit. The employer must contribute sufficient funds to ensure that the plan has adequate assets to pay the specified pension benefits when employees retire. Because the retirement benefit is fixed and known in advance, the employer bears the investment risk and funding obligation associated with maintaining the plan.
For employees, this structure provides greater certainty regarding the amount of income they can expect to receive during retirement, since the benefit is defined by the plan rather than determined by investment performance.
Defined Contribution Plan
A defined contribution plan is a retirement plan in which the retirement benefit is determined by the total value of the employee's account at the time of retirement. The account value depends on the amount of contributions made to the plan and the investment performance of those contributions over time.
Contributions to the plan may be made by the employer, the employee, or both, depending on the structure of the plan. Typically, a specified amount or percentage of compensation is contributed to the employee's individual account each year.
Unlike a defined benefit plan, the final retirement benefit is not predetermined. Instead, the amount available at retirement reflects the accumulated contributions and any investment gains or losses within the account.
Characteristics of Certain Qualified Plans
Savings Incentive Match Plan for Employees (SIMPLE)
A Savings Incentive Match Plan for Employees (SIMPLE) is a type of qualified retirement plan designed primarily for small employers. A SIMPLE plan may be established as either a SIMPLE IRA or a SIMPLE 401(k).
Under a SIMPLE plan, employer contributions are immediately 100% vested. This means that employees have full ownership of the employer's contributions as soon as the contributions are made to their accounts.
SIMPLE plans are available only to businesses with fewer than 100 employees. In addition, the employer generally must not maintain another qualified retirement plan for employees during the same year.
One significant advantage of a SIMPLE plan is that it reduces administrative complexity and costs compared with many other types of employer-sponsored retirement plans, making it a practical option for smaller organizations.
Simplified Employee Pensions (SEPs)
A Simplified Employee Pension (SEP) is a type of qualified retirement plan that allows employers to contribute to retirement accounts for their employees. SEPs are commonly established by private-sector businesses that do not maintain another qualified retirement plan.
This type of plan is particularly popular among self-employed individuals and small business owners because it is relatively simple to establish and administer.
Under a SEP plan, the employer makes contributions to individual retirement accounts (IRAs) set up for eligible employees. These contributions are made solely by the employer and are generally tax-deductible as a business expense.
When funds are distributed from the SEP IRA, the amounts received by employees are generally taxable as ordinary income at the time of distribution.
Self-Employed Plans (HR-10 or KEOGH Plans)
Keogh Plans, also known as HR-10 Plans, are qualified retirement plans designed for self-employed individuals and unincorporated businesses, such as sole proprietors, as well as their eligible employees.
To participate in a Keogh plan, an individual must be actively involved in the business. Silent partners who serve only as investors and do not participate in the daily operations of the business are generally not eligible to participate in the plan.
If the employer contributes to the plan for their own retirement account, they must also make proportionate contributions for eligible employees based on the same percentage of compensation. Employer contributions made to the plan are tax-deductible as a business expense.
Prior to changes in tax law enacted in 2001, Keogh plans were widely used by high-income self-employed individuals because of their favorable contribution limits. However, many self-employed individuals now choose SEP IRAs, which offer similar contribution limits but involve simpler administration and reduced paperwork.
Profit-Sharing and 401(k) Plans
A 401(k) plan is a type of defined contribution retirement plan commonly offered by for-profit employers. This plan allows employees to save for retirement by making elective salary deferrals, meaning employees may choose to contribute a portion of their compensation to the plan before taxes are applied.
In most 401(k) plans, employees contribute a percentage of their salary or wages to their individual retirement accounts. Employers may also make matching contributions or additional employer contributions, depending on the structure of the plan.
Some 401(k) plans are structured to include profit-sharing features. Under this arrangement, employees may choose either to receive certain compensation as current taxable income or to defer that income into the qualified retirement plan, allowing taxes on those funds to be postponed until they are withdrawn, typically during retirement.
Employee Contributions in a Defined Contribution Plan
When employees participate in a defined contribution arrangement, they determine the amount they wish to contribute, either as a percentage of their income or as a fixed dollar amount per payroll period. The employer is responsible for withholding the elected contribution from the employee's paycheck and forwarding those funds to the plan custodian in a timely manner.
Participants typically direct their contributions into a selection of investment options, most commonly mutual funds. Employers may also provide matching or additional contributions, provided that the contribution formula does not discriminate in favor of highly compensated employees.
Profit-Sharing Plan Structure
When a plan includes a profit-sharing component, the employer determines the conditions under which profit-based contributions will be made. In general, contributions to a profit-sharing plan are expected to occur in at least three out of five consecutive years, although the amount of each contribution may vary depending on the employer's profitability and plan provisions.
Tax-Sheltered Annuities (TSAs)
Tax-Sheltered Annuities (TSAs) are retirement plans available to employees of public schools and certain nonprofit organizations. These plans are authorized under Internal Revenue Code (IRC) Section 403(b) and are often referred to as 403(b) plans. Eligible employers include public educational institutions and nonprofit organizations that qualify under IRC Section 501(c)(3).
Under a TSA arrangement, an employee may agree to have the employer reduce the employee's salary by a specified amount, with that amount being contributed to a retirement fund or annuity contract on the employee's behalf. Because the contributions are made through salary reduction, employees do not make direct payments to the retirement account.
The retirement account or annuity contract is owned by the employee and is generally nonforfeitable, meaning the employee retains ownership of the funds. Benefits are typically paid when the employee retires, terminates employment, or dies.
Contributions to a TSA are generally made on a pre-tax basis, and the earnings on those contributions accumulate on a tax-deferred basis until funds are withdrawn.
State College Tuition Plans – 529 Plans
A 529 Plan, also known as a State College Tuition Plan, is a savings program typically sponsored by a state government or educational institution. These plans are designed to help families save for college and other post-secondary education expenses for a designated beneficiary.
Although contributions to a 529 plan are not federally tax-deductible, the plan offers significant tax advantages. The earnings on contributions grow tax-deferred, and withdrawals are not subject to federal income tax when the funds are used for qualified education expenses. In many cases, withdrawals are also exempt from state income taxes.
Funds in a 529 plan may be used to pay for qualified education expenses for the designated beneficiary, which may include a child, grandchild, or other eligible individual. These expenses generally include tuition, fees, books, supplies, and certain room and board costs associated with post-secondary education.
Quiz
1. Which of the following best describes a defined benefit plan?
A. The retirement benefit depends on investment performance in the employee's account.
B. The retirement benefit is predetermined based on factors such as salary and years of service.
C. Only employees contribute to the retirement plan.
D. Contributions are made only through salary reduction agreements.
Correct Answer: B
Rationale: Defined benefit plans promise a specific retirement benefit determined by a formula that typically includes length of service and final average salary. The employer is responsible for funding the plan and bears the investment and funding risk.
2. In a defined contribution plan, the amount of retirement income an employee receives depends primarily on:
A. The employee's highest salary and years of service
B. The amount of contributions and investment performance of the account
C. The employer's guaranteed pension formula
D. A government-established retirement schedule
Correct Answer: B
Rationale: Defined contribution plans accumulate funds in an individual account for each employee. The final benefit depends on total contributions and investment gains or losses, rather than a predetermined pension amount.
3. Which of the following is a key characteristic of a SIMPLE retirement plan?
A. It is only available to companies with more than 500 employees.
B. Employer contributions are immediately 100% vested.
C. Only employees may contribute to the plan.
D. The employer may offer several other retirement plans simultaneously.
Correct Answer: B
Rationale: SIMPLE plans are designed for small employers with fewer than 100 employees. A defining feature is that employer contributions are fully vested immediately, meaning employees have immediate ownership of those contributions.
4. Which retirement plan is commonly used by self-employed individuals and small business owners and allows employers to contribute to IRAs for employees?
A. 401(k) Plan
B. Defined Benefit Plan
C. Simplified Employee Pension (SEP)
D. 529 Plan
Correct Answer: C
Rationale: A SEP allows employers to make tax-deductible contributions to IRA accounts established for employees. It is widely used by self-employed individuals and small businesses because it is simple to establish and maintain.
5. What is a primary tax advantage of a 529 State College Tuition Plan?
A. Contributions are federally tax-deductible.
B. Earnings are tax-free when used for qualified education expenses.
C. Withdrawals are always tax-free regardless of how funds are used.
D. The plan guarantees a fixed return.
Correct Answer: B
Rationale: Although contributions to a 529 plan are not federally tax-deductible, the investment earnings grow tax-deferred and may be withdrawn tax-free when used for qualified education expenses, such as tuition, books, and certain room and board costs.