The Basics of Employer-Sponsored Retirement Plans
Retirement Accounts Offer a Tax-Deferred Advantage
In my previous blog, I talked about retirement plans that could be started by individuals and how they provide a tax-deferred advantage. I compared the Traditional and Roth IRAs and presented the advantages and disadvantages of each. Additionally, I discussed the nuances around withdrawals, contributions and the penalties you should avoid. Finally, I mentioned the two different methods you can use to move an IRA account from one custodian to another.
Employer-Sponsored Plans Defined
Today, I will move on to employer-sponsored plans, which are offered either as a defined contribution plan or a defined benefit plan. The defined contribution plan aims at contributions an employer and/or employee can make into the plan. A defined benefit plan pledges to assure benefits an employee will receive during retirement.
The Defined Contribution Plans
Many companies offer a 401(k) plan that is sponsored by the employer for the benefit of its employees. Typically, employees agree to contribute a certain amount from their paychecks, known as an elective deferral, into their 401(k) account. In this account they select from a list of investment options for their retirement portfolio.
The Advantages of a 401(k)
The portion of your salary that goes into a 401(k) is tax-deferred, just like your money that goes into an IRA. Additionally, employers generally make matching contributions up to a certain percentage of your compensation. While this is not a requirement, it is often done for salaried employees. This is extra money your employer is willing to pay towards your retirement and too few people take advantage of this generous offer.
Even if you don’t get a matching contribution from your employer, you still get certain benefits for participating in a 401(k). This includes higher maximum contribution limits vs. a Traditional or Roth IRA. In 2019, employees can contribute up to $19,000 towards their 401(k) and up to $26,000 if they are 50 or over. Total employer plus employee contributions are $56,000 (add another $6,000 if you are 50 or older. Compare this to the $6,000 individual IRA contribution limit (add another $1,000 if you are 50 or older). Some 401(k) plans offer participants the option of investing directly in stocks and bonds. From the owner’s perspective, a 401(k) plan can be created where employer contributions can be subject to a vesting schedule. One point to keep in mind however, is that if the 401(k) benefit becomes too top heavy, meaning they primarily benefit key executives, this could lead to unpleasant tax complications. Hence the plan needs to benefit all employees in an equitable manner. Additionally, their could be some limitations for highly compensated employees and business owners with 401(k) plans.
The 403(b) Plan and the 457 Plan
Non-profit organizations, such as schools or hospitals, offer their employees 403(b) plans. As with 401(k) plans, employees defer a portion of their paycheck to a 403(b) account, which offers the same type of tax-deferral benefit. However, 403(b) plans, which are also referred to as Tax Savings Annuities (TSAs), offer only annuities and mutual funds as investment options. As with the traditional 401(k), contributions go in pre-tax but come out taxed when the participant takes distributions. State and local governments have begun to utilize a similar type of defined contribution plan for their employees, known as 457 plans. These plans are also tax-deferred and use the same contribution limits as those of the 401(k) and 403(b) plans.
These are defined contribution plans that don’t require an employee contribution. Instead, the company makes a contribution based upon a predetermined formula when it has a profitable year. Such plans can use a higher contribution limit when compared to the 401(k), 403(b) and 457 plans but contributions need to adhere to the predetermined formula to ensure fairness among the employees.
Money Purchase Plans
These plans are less flexible and require the employer to make an annual, mandatory contribution to each employee’s account, based on salary. Such a plan is mandatory on part of the employer and discretionary for the employee.
Employee Stock Ownership Plan
Many companies like to reward key employees with employee stock options. These are free call options that allow employees to buy their company’s stock at a set exercise (strike) price. These options are typically awarded on a vesting schedule that is designed to incentivize the employee to stick with the company and work hard. Referred to as Employee Stock Ownership Plans (ESOPs), these plans allow employees to purchase company stock at a discount through payroll deductions. The stock and any gains generated grow tax-deferred, as with a 401(k) plan.
Retirement Plans for Sole Owners/Small Business
The Keogh Plan
Self-employed individuals or those working for a sole proprietorship with a Keogh plan in place can contribute some of their income into the Keogh plan. In this plan, owners can put up to 20% of their compensation (and 25% of their employee’s compensation) into the plan, pre-tax.
A small business could have a Simplified Employee Pension (SEP) IRA, which allows the employer to contribute 25% of wages into an Employee’s SEP, up to the current maximum, which is $56,000 in 2019. As in the 401(k) plan, this limit is much larger than the $6,000 contribution limit for an individual IRA ($7,000 for those 50 and older).
While SEP contributions are not mandatory for the business owner, they must be made to all eligible employees according to the plan agreement. One major difference between the Keogh and SEP IRA is that SEPs are simple in structure, similar to individual IRAs in many ways and don’t require the annual reporting requirements that you get with qualified plans. Keoghs, on the other hand, are qualified plans, subject to the Employee Retirement Income Security Act (ERISA) guidelines, which are more complex but can be structured in different ways (for example, as a defined contribution or defined benefit plans). Keoghs are more popular for those who make large sums of money and want to make large, deductible contributions to a defined benefit plan. SEPs are more popular for employers who are looking for a simple way to make retirement plan contributions to eligible employees.
The Simple IRA
Another option is the SIMPLE plan or SIMPLE IRA plan that allows for a simplified method for small employers to match employee contributions and to make contributions to their own retirement. The employers can choose to make matching or nonelective contributions to an IRA account set up for each employee. Unlike that with a 401(k) plan, employees are immediately vested in a SEP-IRA and SIMPLE IRA., meaning that the employer’s contributions belong to the employee as soon as they are made.
The Defined Benefit Plan
The defined benefit plan is typically a pension-funded plan, sponsored by an employer, which offers a defined benefit paid out to the employee in each year of retirement. The retiree’s payments are calculated in relation to years of service and salary earned prior to retirement. For example, a typical annual payout could represent 80% of the average of the last three years of an employee’s salary. A defined pension benefit plan is established as a trust and does not pay tax on the income it generates. In fact, a company can deduct its pension fund contributions from its taxable income. Still, companies try to fund these plans just to meet minimum requirements. Hence, these plans require an actuary to certify that the funding levels are sufficient to meet future pension obligations. In recent decades, employers have opted for defined contribution plans over defined benefit plans. The reason is because the burden of risk in retirement funding is shifted from the employer to the employee as you go from a defined benefit plan to a defined contribution plan. Food for thought. Until next time.