Planning for retirement can be confusing, but it is worth the effort, especially when retirement plans are sponsored by your employer. Familiarize yourself with the different types of employer-based plans to better understand your retirement options
When companies offer employer-sponsored retirement plans, it can be a powerful recruitment tool for potential employees. In general, most companies provide qualified retirement plans that offer tax benefits for their employees to take advantage of. It’s important to understand at least the basics of common qualified retirement plans that employers typically offer so that you can accurately assess your retirement options.
Defined Benefit Plans Versus Defined Contribution Plans
In general, qualified retirement plans can be categorized as either defined contribution plans or defined benefit plans. There are two major differences that separate the two:
- In a defined contribution plan, most of the money comes out of an employee’s paycheck to fund his or her retirement plan, whereas funds contributed to a defined benefit plan are the responsibility of the employer.
- Defined benefit plans have a specified benefit amount in the form of an exact dollar amount or specific formula that is controlled by the employer, whereas defined contribution plans do not have a guaranteed benefit amount and investments are controlled by the employee.
In the past 20 years, defined benefit plans have been reduced severely or eliminated completely by most companies, and defined contribution plans are now the most common type of plan.
A traditional pension plan is the most common plan type that falls under the “defined benefit” category of retirement plans. Pension plans have a specified benefit amount that will be paid to the employee upon his or her retirement. The specific amount is typically controlled by the employer, and is most often determined by a formula that depends on the employee’s tenure, salary, job duties and importance to the company. For example, an employer might offer the average of the final three years’ salary of the employee’s tenure multiplied by the number of years the employee served the company.
Usually the employer funds the plan, though, in some rare cases, employees may also contribute. Though employees do not have control over how the plan is funded by their employer, they do usually have control over how the funds are distributed to them. For example, most employees may choose either a lump sum payout or a variety of other options that allow the benefit to be distributed over time.
A 401(k) plan is named after section 401(k) of the Internal Revenue Code. With this plan, employees have the option to elect a certain tax-deferred dollar amount or percentage to be deducted from their salary and placed into the retirement fund. Employees may contribute as much to their 401(k) as they would like, so long as they stay within the annual contribution limits that are set by the IRS. As added incentive to participate, many employers offer an employer-matching contribution feature. For example, an employer may offer a company match program of 50 cents for every dollar contributed, up to 6 percent of the total salary deferment. In other words, the employer will contribute a maximum of 3 percent of the employee’s total salary to his or her 401(k). In the event the employee elects to skip participation in the 401(k), the employer does not have to contribute to the fund.
Employee contributions to his or her 401(k) are always 100 percent vested because the money that is contributed to the plan is money that the employees were originally entitled to before making contribution elections. Vesting simply means that the employee is entitled to the money in the account. However, in many cases, an employee’s entitlement to employer contributions may be subject to a vesting schedule that is determined by the employer. The longer an employee is with the company, the more vested they become in the employer’s contributions.
Funds from a 401(k) account are not available for withdrawal by the employee without penalty until he or she reaches 59 ½ or encounters financial hardship. If a participant wishes to withdraw from his or her 401(k) account early he or she will be subject to a tax penalty of 10 percent.
The primary difference between a Roth 401(k) and a traditional 401(k) is that, in a Roth 401(k), employee contributions are made after taxes, so when employees withdraw funds at the time of retirement, they will not be taxed.
While many employers may choose to offer their employees the ability to make Roth contributions in addition to traditional contributions, they don’t necessarily have to offer a Roth contribution plan. An employee may elect to make both traditional and Roth contributions to his or her 401(k) if both contribution types are offered. Like the traditional 401(k), employer-matching contributions are a common feature of Roth 401(k) plans. However, even if the match is for Roth contributions, employer contributions are always of traditional 401(k) nature in that they are made with pre-tax dollars. Employer contributions are kept in a separate account that is taxed upon withdrawal.
A 403(b) is nearly identical to a 401(k)—the main difference is that, while 401(k)s are offered by many types of employers, 403(b) retirement plans may only be used by tax-exempt organizations such as certain charitable, religious and educational establishments. This type of plan allows employees to make contributions to their account before taxes and allows them to contribute as much as they would like, so long as they stay within the annual contribution limit. In some cases, a Roth 403(b) plan may be available for employees to make after-tax contributions. 403(b) plans are also similar to 401(k) plans in that employers commonly offer a matching contribution program and employees may invest their funds from a 403(b) plan into different investing vehicles. However, unlike 401(k)s, 403(b) plans may only be funded by mutual funds and/or annuities.
403(b) plans also offer an exclusive feature that other plans do not: the 15-Year Rule. If an employee’s past deferrals did not reach the contribution limit, the 15-Year Rule allows employees with at least 15 full years of service to the same company to make additional contributions to their plan of up to $3,000 more than the contribution limit.
Another significant difference between the 403(b) and 401(k) retirement plan is that employers of a 403(b) plan may also offer contributions to a 403(b) retirement plan on behalf of former employees for up to five years after an employee’s departure from the company. Former employees are immediately vested in these funds.
Much like a 401(k), 457 plans allow employees to defer a portion of their salary into their retirement savings plan, which offers a variety of investment options while deferring taxes until retirement or withdrawal. These plans are typically offered to state and local government employees.
The main differences between 457 plans and 401(k) plans come in the form of contribution limits and withdrawal penalties. Participants within three years of the retirement age that is specified by the plan (usually 59 ½) may contribute up to twice the annual limit if permitted by the plan. One significant difference from 401(k) and 403(b) plans is that, in a 457 plan, there is no withdrawal penalty if the employee withdraws from the funds prior to retirement. However, it should be noted that early withdrawals from a 457 plan are still taxed as ordinary income.
Thrift Savings Plans (TSP)
In general, TSPs are for Federal Employees’ Retirement System (FERS) employees and members of the armed forces. This plan closely resembles the plans discussed previously in that participants may deduct a set amount from their salary and have it placed in a tax-deferred savings account. TSPs also have the same contribution limits as 401(k), 403(b) and 457 plans. Much like the plans above, TSPs also offer the choice of traditional or Roth contributions.
However, unlike other plans, FERS employees enjoy a 1 percent agency automatic contribution to their TSP, even if they are not actively contributing to it themselves. FERS employees also enjoy further agency contributions, so long as they are making consistent contributions to their TSP each pay period. Members of uniformed services do not currently receive matching contributions.
Savings Incentive Match Plan for Employees (SIMPLE) IRAs
A SIMPLE IRA is another type of retirement plan that allows employees to defer a portion of their salary into a retirement fund. SIMPLE IRAs are available to any small business, and employers who offer a SIMPLE IRA plan cannot offer any other form of retirement plan. Employers are required to offer a matching contribution plan of either up to 3 percent of the income that the employee elects to contribute or 2 percent of income if the employee does not contribute to his or her own account. In addition, employees are 100 percent vested in their funds at all times. Participants who wish to withdraw funds from their SIMPLE IRA before age 59 ½ may be subject to a 10 percent tax penalty, but that penalty increases to 25 percent if a participant makes a withdrawal within the first two years of establishing the plan. A SIMPLE IRA plan does have an advantage, however, in that if the plan has been established for at least two years, funds in a SIMPLE IRA may be transferred tax-free to another tax-deferred account, such as an IRA.
Simplified Employee Pension Plans (SEPs)
SEPs are available to any business of any size. These differ significantly from other defined-contribution plans discussed previously in that they only allow contributions from the employer. Though employees do not have the ability to contribute to their SEP plan, they do have control over what the funds are invested in. Contributions in 2016 are limited to the lesser amount of either 25 percent of the employee’s salary or $53,000. Participants who wish to withdraw funds from their SEP plan before retirement may be subject to a 10 percent tax penalty. Companies who choose to use this plan often do so because there are very low administrative costs, they are easy to set up and operate and they offer flexibility with annual contributions if cash flow is an issue for the company. The contribution flexibility allows companies who often fluctuate between good years and bad years to change the contribution amounts to their employees annually, according to their cash flow.
Employee Stock Ownership Plans (ESOPs)
Companies who offer ESOPs typically set up a trust fund for their employees and contribute either cash to purchase company stock, or they contribute company shares directly to the plan. By rule, employees must be 100 percent vested in their shares within three to six years of employment. Much like the plans mentioned above, employees are not taxed on ESOPs until they reach retirement or leave the company. At the time of withdrawal from their ESOP, employees may either sell their shares on the market or back to the company.
Regardless of the type of plan offered, participating in an employer-sponsored retirement plan is part of a well-designed financial plan and considered to be one of the easiest ways to save for retirement. If you’re not participating in your employer’s plan, take time to learn more about your options today.