Qualified retirement plans are Congressionally approved retirement plans which have several major tax benefits.
A. The employer's contributions can be deducted for income tax purposes.
B. The earnings on the plan's investments accumulate on a tax deferred basis.
C. When the funds are distributed at retirement age they may be eligible for favorable tax treatment.
D. Taxpayers may be in a lower income tax bracket after retirement.
Two Principal Types Of Plans
Qualified Retirement Plans can generally be classified as either "defined benefit" or "defined contribution" plans.
Defined benefit plans define the benefit amount each participant will receive at retirement age and then estimate how much must be contributed each year to accumulate the necessary future fund. Interest rates ages of participants, etc., will have an effect on the calculation. The amount of the contribution is generally determined by an actuary. The investment risk rests on the employer.
Defined contribution plans generally put a percentage of current salaries into the plan each year. The amount at retirement will depend on the investment return and number of years until a participant retires. The investment risk rests on the participant.
Plan Type |
Contributions |
Retirement Benefits |
Investment Risks |
Defined Benefit |
Vary |
Fixed |
Employer |
Defined Contribution |
Pension-Fixed Profit Sharing-Vary |
Vary |
Employee |
What Is The "Best" Type Of Plan?
There is no "best" type of plan. The choice of what type of plan to use is an individual one. The answer depends on factors such as employer goals and available cash flow.
Defined Benefit Plans
The employer contributes an "actuarially determined amount" sufficient to pay each participant a fixed or defined benefit at his or her retirement. Methods of defining the benefit may be based on a flat percentage of compensation, a percentage which increases with years of service, a percentage which changes at certain compensation levels, etc.
This type of plan generally favors older employees, because more of the employer's contributions must go into his or her account to make certain that there will be enough to pay the promised (or defined) benefit at retirement age.
Defined Contribution Plans
There are several variations of defined contribution plans. Sonic of the more common ones include;
A. Money Purchase Pension: The employer contributes a specified percentage of the participating employee's salary each year. Whatever that fund grows to is what the retiring employee receives.
B. Target Benefit Pension Plan: The target benefit plan has elements of both the defined benefit and defined contribution plans. The benefits are determined as if the plan were a defined benefit plan, while the defined contribution plan annual contribution percentage and dollar amount limitations apply to the actual contributions.
C. Traditional Profit Sharing Plan: Similar to the money purchase pension, except that contributions do not need to be a specific percentage and they do not need to be made every year as long as they are "recurring and substantial."
D. Age-Weighted Money Purchase And Profit Sharing Plans: Money purchase and profit sharing plans in which employer contributions are allocated to provide an assumed equivalent retirement benefit at normal retirement age.
E. "Cross Tested" or "Super Integrated" Money Purchase and Profit Sharing Plans: These plans establish groups of participants to which are allocated specified allocation percentages. They must satisfy very complicated discriminatory requirements under Reg. 1.401 (a)(4).
F. Stock Bonus Plan: Similar to the traditional profit sharing plan. The plan may~ but is not required to, invest primarily in the employer's stock.
G. ESOP - Employee Stock Ownership Plan: Like a stock bonus plan, to which the employer can contribute company stock instead of cash. The plan must be primarily invested in company stock.
H. IRC Sec. 401(k) Plan: Also called a cash or deferred plan, this plan is any stock bonus plan or profit sharing plan which meets certain participation requirements of IRC Soc. 401(k). An employee can agree to a salary reduction or to defer a bonus which he or she has coming.
I. SIMPLE Plans: 'SIMPLE" stands for Savings Incentive Match Plan for Employees. SIMPLE plans can be in either an IRA format or a 401(k) format.
J. SEP: "Simplified Employee Plan." An SEP is a group of individual "IRAs" to which an employee may contribute more than the traditional IRA or Roth IRA.