Retirement
Plans: The Employee Perspective
Presented by Jared Daniel of Wealth Guardian Group
What is the employee perspective on
employer-sponsored retirement plans?
Qualified
employer-sponsored retirement
plans can provide a number of tax and nontax benefits to employees. The
employee perspective on these plans should certainly consider the obvious tax
deferral and retirement savings benefits. Additionally, however, employees
should consider various strategies to optimize their benefits. For example,
employees will approach their retirement plans most effectively when they take
full advantage of employer-matched savings and by remaining with a particular
company at least until vesting has occurred. In some cases, moreover, the
advantages and disadvantages of borrowing from employer-sponsored plans should
be evaluated.
How are employer-sponsored retirement
plans categorized?
Employer-sponsored
retirement plans may be categorized in two ways: (1) they're classified as
either qualified or nonqualified, and (2) qualified plans are further
subdivided into defined benefit plans and defined contribution plans.
Qualified versus nonqualified plans
Qualified
plans are those that offer significant tax advantages to employers and
employees in return for adherence to strict Employee Retirement Income Security
Act (ERISA) and Internal Revenue Code requirements involving participation in
the plan, vesting, funding, disclosure, and fiduciary matters.
Nonqualified
deferred compensation plans, by comparison, are subject to less extensive ERISA
and Code regulation; and the design and operation of these plans is generally
more flexible. However, nonqualified plans are usually not as beneficial to
either the employer or the employee from a tax standpoint.
Defined benefit plans versus defined
contribution plans
A defined
benefit plan is a qualified employer pension plan that guarantees a specified
benefit level at retirement; actuarial services are needed to determine the
necessary annual contributions to the plan. These plans are typically funded by
the employer.
A
defined contribution plan, by comparison, is one in which each employee
participant is assigned an individual account, and contributions are defined
(in the plan document) on an annual basis, often in terms of a percentage of
compensation. Unlike a defined benefit plan, a defined contribution plan
doesn't promise to pay a specific dollar amount to participants at retirement.
Rather, the benefit payable to a participant at termination or retirement is
the value of his or her individual account.
Why should an employee participate in a
qualified employer-sponsored retirement plan?
Participation
in an employer-sponsored retirement
plan is probably the most effective way to save for retirement. If you have
an individual retirement account (IRA) rather than an employer-sponsored plan,
you know that your annual contribution amount is relatively limited.
Employer-sponsored plans allow much higher annual contributions. And, if your
primary method of saving for retirement is to personally invest in securities,
there is always a temptation to spend your savings prior to retirement. The
temptation to withdraw your money prematurely from an employer-sponsored plan
is severely curtailed. This is because many qualified plans don't permit in
service withdrawals at all, or permit them only for limited reasons (for
example, financial hardship). In addition, a 10 percent early distribution
penalty generally applies to the taxable portion of any withdrawal you make
before age 59½ (unless an exception applies).
In
addition to the retirement savings aspect of employer-sponsored retirement
plans, these plans can offer significant tax advantages. Certain defined
contribution plans allow employees to defer part of their salaries into the
plan. Deferring part of your compensation can lower your present taxes.
Postponing receipt of this taxable income is also useful, because when you
eventually realize the income at some future point, it's possible that you'll
be retired and/or in a lower tax bracket. Keep in mind that the earnings on
your plan contributions grow tax deferred until you take distributions. 401(k),
403(b), and 457(b) plans can also permit Roth contributions. Roth 401(k)
contributions are made on an after-tax basis, just like Roth IRA contributions.
This means there's no up-front tax benefit, but if certain conditions are met,
your Roth 401(k) contributions and all accumulated earnings are free from
federal income taxes when distributed from the plan.
How can an employee optimize his or her
retirement benefits?
One
way to optimize your retirement benefits is to ensure that you contribute to
the plan as much as the law allows in a given year. Also, keep in mind that if
your salary increases, so should your contribution level. For example, it's
nice for you to contribute a flat $100 to your 401(k) plan each month, but if
your salary increases by $1,000 each year, the amount of your contribution
should increase also in order to maximize your retirement savings. Contributing
to an employer-sponsored retirement plan, such as a 401(k) plan, can help you
save for retirement, defer taxes on your current income, and defer (or
eliminate) taxes on the earnings.
You
can also optimize your retirement benefits by taking full advantage of employer
matching contributions. Some employers, for example, might contribute 50 cents
for every dollar you contribute to the plan. In a very real sense, this gives
you an automatic 50 percent return on your investment.
Another
consideration is vesting. If your employer matches your contributions (or funds
the pension plan entirely), it may impose a vesting schedule on you. This means
that you will not be able to take ownership in the employer-funded part of a
pension plan until certain conditions have been met. Typically, the employer
will require you to work for the company for a set number of years before you
will become vested. If vesting occurs after 3 years of service and you're
thinking of leaving the company after 2 and one-half years, it would be
advisable for you to try to stick around for another six months.
Tip: Employer contributions to SIMPLE IRA, SIMPLE 401(k), and SEP
IRA plans are always 100 percent vested.
Should you borrow money from your
retirement plan?
Some
retirement plans, such as the
401(k) plan, may allow you to borrow money from the plan under certain
conditions. Typically, the interest charged on such a loan will be less than
that of an unsecured bank loan. When you pay the money back, you're really
paying the money to yourself. Therefore, borrowing money from your 401(k) plan
may be the cheapest source of funds you can find for a loan.
When
you take a loan from your 401(k) plan, the funds you borrow are removed from
your plan account until you repay the loan. While removed from your account,
the funds aren't continuing to grow tax deferred within the plan. So the
economics of a plan loan depend in part on how much those borrowed funds would
have earned if they were still inside the plan, compared to the amount of
interest you're paying yourself. This is known as the opportunity cost of a
plan loan, because you miss out on the opportunity for more tax-deferred
investment earnings.
Also,
while the interest you pay on a loan is usually deposited into your plan
account, the benefits of this perk are somewhat illusory. To pay interest on a
plan loan, you first need to earn money and pay income tax on those earnings.
With what is left over after taxes, you pay the interest on your loan. When you
later withdraw those dollars from the plan, they are taxed again because plan
distributions are treated as taxable income. In effect, you are paying income
tax twice on the funds you use to pay interest on the loan.
What are some of the more popular
employer-sponsored retirement plans, and how do they work?
There
are several plans; each has its own advantages and disadvantages. Along with
the traditional pension plan (the defined benefit plan), there are 12
retirement plans that are most often offered by businesses:
·
401(k)
plan
·
Age-weighted
profit-sharing plan
·
Employee
stock ownership plan (ESOP)
·
Keogh
plan
·
Money
purchase pension plan
·
New
comparability plan
·
Profit-sharing
plan
·
SIMPLE
401(k)
·
Simplified
employee pension plan (SEP)
·
Target
benefit plan
·
Thrift
savings plan
In
addition, there are two nonqualified retirement plans that are especially
popular with tax-exempt organizations:
·
Section
403(b) plan
·
Section
457(b) plan
401(k) plan
A
401(k) plan, sometimes called a cash or deferred arrangement, is a defined
contribution retirement plan that allows employees to elect either to receive
their compensation paid currently in cash or to defer receipt of the income
until retirement. If deferred, the amount deferred is pretax dollars that go
into the plan's trust fund; these dollars will be invested and then eventually
be distributed (with investment earnings) to the employees. The employee is
taxed when money is withdrawn or distributed to him or her from the plan.
Often, employers make contributions matching some or all of employee deferrals
in order to encourage employee participation. The business can deduct these
employer contributions, subject to certain limitations. 401(k) plans can also
permit Roth contributions. Roth 401(k) contributions are made on an after-tax
basis, just like Roth IRA contributions. This means there's no up-front tax
benefit, but if certain conditions are met, your Roth 401(k) contributions and
all accumulated earnings are tax-free when distributed from the plan.
Age-weighted profit-sharing plan
An
age-weighted profit-sharing plan is a defined contribution plan in which
contributions are allocated based on the age of plan participants as well as on
their compensation, allowing older participants with fewer years to retirement
to receive much larger allocations (as a percentage of current compensation) to
their accounts than younger participants.
Employee stock ownership plan (ESOP)
An
employee stock ownership plan (ESOP), sometimes called a stock bonus plan, is a
defined contribution plan in which participants' accounts are invested in stock
of the employer corporation. The employer funds the plan. When a plan
participant retires or leaves the company, he or she receives the vested
interest in the ESOP in the form of cash or employer securities.
Keogh plan
A
Keogh plan (sometimes called an HR-10 plan) is another name for any qualified
retirement plan adopted by self-employed individuals. Only a sole proprietor or
a partner may establish a Keogh plan; an employee cannot. Keogh plans may be
set up either as defined benefit plans or as defined contribution plans. A
Keogh plan allows you to contribute pretax dollars to the retirement plan (providing
a tax deferral to you).
Money purchase pension plan
A
money purchase pension plan
is a defined contribution plan in which the employer makes an annual
contribution to each employee's account in the plan. The amount of the
contribution is determined by a set formula, regardless of whether the employer
is showing a profit. Typically, the employer's contribution will be based on a
certain percentage of each participating employee's compensation.
New comparability plan
A
new comparability plan is a variant of the traditional profit-sharing plan. By
dividing up plan participants into two or more classes, the new comparability
plan allows businesses to maximize plan contributions to higher-paid workers
and key employees and minimize allocations to other employees.
Profit-sharing plan
A
profit-sharing plan is a defined contribution plan that allows for employer
discretion in determining the level of annual contributions to the retirement
plan; in fact, the employer can contribute nothing at all in a given year if it
so chooses. As the name suggests, a profit-sharing plan is usually a sharing of
profits that may fluctuate from year to year. Generally, an employer will
contribute to a profit-sharing plan in one of two ways: either according to a
set formula or in a purely discretionary manner.
SIMPLE 401(k)
A
savings incentive match plan for employees 401(k), or SIMPLE 401(k), is a
retirement plan for small businesses (those with 100 or fewer employees) and
for self-employed persons, sole proprietorships, and partnerships. The plan is
structured as a 401(k) cash or deferred arrangement and was devised in an
effort to offer self-employed persons and small businesses a tax-deferred
retirement plan without the complexity and expense of the traditional 401(k)
plan. The SIMPLE 401(k) is funded with voluntary employee pre-tax or Roth
contributions, and mandatory, fully vested, employer contributions. The annual
allowable contribution amount is lower than the annual contribution amount for
regular 401(k) plans.
SIMPLE IRA
A
savings incentive match plan for employees IRA (SIMPLE IRA) is a retirement plan
for small businesses (those with 100 or fewer employees) and self-employed
persons that is established in the form of employee-owned individual retirement
accounts. The SIMPLE IRA is funded with voluntary employee pre-tax
contributions and mandatory, fully vested, employer contributions. The annual
allowable contribution amount is significantly higher than the annual
contribution amount for regular IRAs.
Simplified employee pension plan (SEP)
Self-employed
persons, including sole proprietors and partners, can sometimes set up
simplified employee pension plans (SEPs) for themselves and their employees. A
SEP is a tax-deferred qualified retirement savings plan that allows
contributions to be made to special IRAs, called SEP-IRAs, according to a
specific formula. Except for the ability to accept SEP contributions (i.e.,
allowing more money to be contributed and deducted) and certain related rules,
SEP-IRAs are virtually identical to regular IRAs. Employer contributions are
fully vested.
Target benefit plan
A
target benefit plan is a hybrid of a defined benefit plan and a money purchase
pension plan. It resembles a defined benefit plan in that the annual contribution
is determined by the amount needed each year to accumulate a fund sufficient to
pay a specific targeted benefit amount. It is like a money purchase plan in
that the actual benefit received by the participant at retirement is based on
his or her individual balance.
Thrift savings plan
A
thrift savings plan is a defined contribution plan that is similar to a
profit-sharing plan but has features that provide for (and encourage) after-tax
employee contributions to the plan. This means that the employee must pay tax
on his or her money before contributing to the plan. Typically, a thrift
savings plan would provide after-tax employee contributions with matching
employer contributions. Most thrift plans have been converted to 401(k) plans.
Section 403(b) plan
A
403(b) plan, also known as a tax-sheltered annuity or a tax-deferred annuity,
is a special type of retirement plan under which certain government and
tax-exempt organizations (including religious organizations) can purchase
annuity contracts or can contribute to custodial accounts for eligible
employees. Employees are not taxed on contributions made to the plan on their
behalf until they receive their benefits. Section 403(b) plans generally fall
into one of two types of plans: a salary reduction plan or an employer-funded
plan. A 403(b) plan is not a qualified plan, but it is subject to many of the
same rules, and salary reduction 403(b) plans are similar to 401(k) plans in
many respects. Like 401(k) plans, 403(b) plans can also permit Roth contributions.
Roth 403(b) contributions are made on an after-tax basis, just like Roth IRA
contributions. This means there's no up-front tax benefit, but if certain
conditions are met, your Roth 403(b) contributions and all accumulated earnings
are tax-free when distributed from the plan.
Section 457(b) plan
A
Section 457(b) plan is a nonqualified deferred compensation plan for
governmental units, governmental agencies, and nonchurch-controlled tax-exempt
organizations; it somewhat resembles a 401(k) plan. Unlike a 401(k) plan, a
Section 457(b) plan for a tax-exempt organization must be structured so that
it's not subject to the strict requirements of ERISA. Like 401(k) plans, 457(b)
plans can also permit Roth contributions. Roth 457(b) contributions are made on
an after-tax basis, just like Roth IRA contributions. This means there's no
up-front tax benefit, but if certain conditions are met, your Roth 457(b)
contributions and all accumulated earnings are tax-free when distributed from
the plan.
Jared Daniel may be reached at www.WealthGuardianGroup.com or
our Facebook page.
IMPORTANT
DISCLOSURESBroadridge Investor Communication Solutions, Inc. does not provide
investment, tax, or legal advice. The information presented here is not
specific to any individual's personal circumstances.To the extent that this
material concerns tax matters, it is not intended or written to be used, and
cannot be used, by a taxpayer for the purpose of avoiding penalties that may be
imposed by law. Each taxpayer should
seek independent advice from a tax professional based on his or her individual
circumstances.These materials are provided for general information and
educational purposes based upon publicly available information from sources
believed to be reliable—we cannot assure the accuracy or completeness of these
materials. The information in these
materials may change at any time and without notice.
No comments:
Post a Comment