Retirement Plans: The Basics

Defined Contribution Plans

A defined-contribution plan is retirement plan that's typically tax-deferred, like a 401(k) or a 403(b), in which employees contribute a fixed amount or a percentage of their paychecks into an account that is intended to fund their retirement. The employer may match a portion of employee contributions as an added benefit to help retain and attract top talent. These plans place restrictions that control when and how each employee can withdraw from these accounts without penalties. There is no way to know how much the plan will ultimately be worth since future account values fluctuate on the basis of investment earnings. The most common defined contribution plans include: 

• Individual Retirement Account (IRA): a type of retirement account that allows individuals to direct pretax income towards investments that can grow tax-deferred. You pay taxes only when you make withdrawals from the account. You may contribute 100% of earned income up to a specified maximum dollar amount each year. Contributions to a traditional IRA may be tax-deductible depending upon the taxpayer's income, tax-filing status and other factors. There is a 10% early withdrawal penalty on withdrawals taken prior to age 59½ if no exceptions apply. In the year you reach age 70½ you are no longer eligible to contribute to a traditional IRA, and must begin the process of taking annual Required Minimum Distributions (RMDs.)
• Roth IRA: An account that allows you to make contributions with money on which you've already paid taxes. You're able to withdraw your contributions tax- and penalty-free at any time, for any reason. Earnings may also be withdrawn tax-free and penalty-free provided that the Roth has been established for at least five years and one of the following conditions is met: age 59½, death, disability, qualified first time home purchase. There are no Required Minimum Distributions (RMDs) and contributions can continue to be made once the taxpayer is past the age of 70½, as long as he or she has earned income. Eligibility for a Roth IRA account depends on income.
• SEP IRA: A retirement savings plan established by employers, including self-employed individuals (independent contractors- sole proprietorships or partnerships) for the benefit of their employees. Contributions are made to each eligible employee's SEP IRA on a discretionary basis. That means that the employer can choose to contribute (or not) each year. However, if the employer does contribute, it must contribute the same percentage of compensation to all employees eligible for the plan, up to the contribution limit. The individual employee accounts are similar to a traditional IRA and are subject to many of the traditional IRA rules.
• Simple IRA: a retirement plan that may be established by employers, including self-employed individuals (sole proprietorships and partnerships), for the benefit of their employees. The SIMPLE IRA allows eligible employees to make pretax contributions to the plan. Employers are required to make either matching contributions – based only on the contributions made by the employees – or nonelective contributions, which are paid to each eligible employee regardless of whether or not the employee participates in the plan. The SIMPLE IRA allows employers and employees a tax deduction for their respective contributions. The individual employee accounts are similar to a traditional IRA and are subject to many of the traditional IRA rules.
• 401(k): a qualified employer-sponsored retirement plan that eligible employees may make salary-deferral contributions on a post-tax and/or pretax basis. Employers offering a 401(k) plan may make contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings in a traditional 401(k) plan accrue on a tax-deferred basis. Earnings in a Roth 401(k) plan accrue tax free. There is a 10% early withdrawal penalty on withdrawals taken prior to age 59½ if no special exceptions apply. You may continue to contribute to a 401(k) plan past age 70½ (avoiding the Required Minimum Distribution) as long as you continue to work for the same employer that sponsors the plan, and do not own 5% or more of the company.
• Solo 401(k): also known as a Self Employed 401(k) or Individual 401(k) is a qualified retirement plan that was designed specifically for employers with no full-time employees other than the business owner(s) and their spouse(s). Those that qualify for the Solo 401(k) can receive the same tax benefits as a general 401(k) plan, but without the employer being subject to the complex ERISA rules.
• 403(b)/ TSA: a retirement plan similar to a traditional 401(k), used by nonprofit companies, religious groups, school districts, and governmental organizations. Participants often include teachers, school administrators, professors, government employees, nurses, doctors and librarians. Employee contributions into the plan are made before income tax is paid and allowed to grow tax-deferred until the money is withdrawn. Participants often have the option of investing in either annuity contracts, bought through an insurance company or purchasing mutual funds directly through a custodial account.
• Thrift Savings Plan (TSP): a retirement plan for United States civil service and function similarly to a 401(k). In a traditional TSP, you make pre-tax contributions and pay tax on withdrawals of your money in retirement. If you elect the Roth option, you would contribute post-tax income and would not pay tax on withdrawals. Different TSP accounts may have some slight differences, depending on if you’re in the military or a civilian government worker:
  • Federal Workers
    
    Federal Employees' Retirement System (FERS): Federal civilian employees who were hired on or after January 1, 1984, are FERS employees. FERS employees hired after July 31, 2010, are automatically enrolled in a traditional TSP, and 3% of their basic pay is deducted and deposited into the account unless you elect to change or stop your contributions. FERS employees hired before August, 1, 2010, have TSPs that get a 1% contribution from their agency, and they can choose to contribute more as well.
    
    Civil Service Retirement System (CSRS): This is the retirement system for federal civilian employees who were hired before January 1, 1984. CSRS employees’ accounts are established by your agency after you make a contribution election.
     
  • Military: Because 80% of uniformed military members don’t remain in the military for the 20 years needed to be eligible for a pension, many were walking away from their service with nothing for retirement. The Blended Retirement System (BRS) was enacted to change that. It allows you to choose a pension, a TSP, or both, and the best option for you depends on your current years of service.
• Profit Sharing Plan: an option that may be added to a normal 401(k) plan, whereby the employer makes discretionary pre-tax contributions to eligible participants’ retirement accounts. The employer has control for determining when and how much the company contributes to the plan, although the allocation amongst employee accounts is usually based on the employee’s salary or level within the organization. A profit-sharing plan is available for businesses of any size, and a company can establish one even if it already has other retirement plans in place. Furthermore, a company has a lot of flexibility in how it can implement a profit-sharing plan, as long as it does not discriminate in favor of highly compensated employees or the owners of the company. Contributions made to a profit sharing plan can have an employee vesting schedule attached.
• Money Purchase Plan: a plan that is similar to a profit-sharing plan but with fixed (not variable) contributions. The employer makes annual contributions according to a required percentage whether or not the business makes a profit. For example, a plan with a contribution of 5% of each eligible employee’s pay means the employer contributes 5% of each eligible employee’s pay to their separate account annually.
  
  An employee with a money-purchase pension plan may participate in additional retirement plans, or contribute to other retirement accounts. As long as contribution amounts remain within annual limits, employer contributions and employee funds remain tax-deferred.
  
  Employers typically adopt a vesting schedule which outlines when an employee may withdraw funds from the plan. After being fully vested, an employee may start taking out funds at age 59½ without a tax penalty. Withdrawals as a lump sum or as minimum annual installments based on life expectancy are taxed as ordinary income and must start by the time the account owner reaches age 70½.
• Health Savings Account (HSA): a tax-advantaged medical savings account for individuals who are covered under a high-deductible health plan to save for medical expenses that the plan does not cover. Pre-tax contributions are made into an HSA account by the individual and are limited to a maximum amount each year. The contributions are invested over time and as long as withdrawals are used to pay for qualified medical expenses, the amount withdrawn will not be taxed. Qualified medical expenses include deductibles, dental services, vision care, prescription drugs, co-pays, psychiatric treatments, and other qualified medical expenses not covered by a health insurance plan. Insurance Premiums usually don’t count towards qualified medical expenses unless the premiums are for Medicare or other healthcare coverage if 65 years or more, for healthcare insurance while unemployed and receiving unemployment compensation, and for long-term care insurance.
  
  If distributions are made from an HSA for reasons other than paying for medical expenses, the amount withdrawn will be subject to both income tax and an additional 20% tax penalty. Individuals who are 65 years old or older will no longer be able to contribute to an HSA, but can withdraw any funds accumulated in the account for any expense without incurring the 20% penalty. However, income tax will still apply to any non-medical usage.

 

Defined Benefit Plans

• Pension Plan / Qualified-Benefit Plans: An employer-sponsored retirement plan that promises the employee a specific monthly benefit payable at the retirement age specified in the plan. Defined benefit plans are usually funded entirely by the employer. The employer is responsible for contributing enough funds to the plan to pay the promised benefits, regardless of profits and earnings.
  
  The plan has a specific formula for determining a fixed monthly retirement benefit. Benefits are usually based on the employee's compensation and years of service which rewards long term employees. Benefits may be integrated with Social Security, which reduces the plan's benefit payments based upon the employee's Social Security benefits. The maximum benefit allowable is 100% of compensation (based on the highest consecutive three-year average) to an indexed maximum annual benefit. A defined benefit plan may permit employees to elect to receive the benefit in a form other than monthly benefits, such as a lump sum payment.
  
  An actuary determines yearly employer contributions based on each employee's projected retirement benefit and assumptions about investment performance, years until retirement, employee turnover and life expectancy at retirement. Employer contributions to fund the promised benefits are mandatory. Investment gains and losses cause employer contributions to decrease or increase. Non-vested accrued benefits forfeited by terminating employees are used to reduce employer contributions.
• Cash Balance Plan: A type of hybrid plan that promises a fixed monthly benefit at retirement that is usually based upon a formula that takes into account the employee's compensation and years of service. A cash balance plan looks like a defined contribution plan because the employee's benefit is expressed as a hypothetical account balance instead of a monthly benefit.
  
  Each employee's "account" receives an annual contribution credit. Employees appreciate this design because they can see their "accounts" grow, but they are still protected against fluctuations in the market. In addition, a cash balance plan is more portable than a traditional defined benefit plan since most plans permit employees to take their cash balance and roll it into an Individual Retirement Account (IRA) when they terminate employment or retire. As in a traditional defined benefit plan, the employer bears the investment risks and rewards in a cash balance plan. An actuary determines the contribution to be made to the plan.