Planning for retirement is one of the most significant financial decision that you will make in your life. It is an aspect that will come to your aid when you need it the most – in the last part of your life. Having a secure plan for that time requires you to be aware of what your options are today. You must know what you are planning, why and how, and to be able to do that successfully, it is time to be aware.... specially if you happen to be in United States.
Retirement plans in United States can be classifiedin three forms: Defined benefit vs defined contribution; funded vs unfunded; and qualified vs non-qualified. These are the basic characteristics by which almost every plan, by whatever name it is called, can be described.
Defined Benefit Vs. Defined Contribution Plans
Defined benefit plans provide for a benefit that is defined and assured right from the beginning, irrespective of the amount of contribution and the rate of return on investments. On the contrary, defined contribution plans define a specified contribution which is invested in the plan and the benefits are defined by the returns on assets in which the contributions are invested.
Earlier, defined benefits plans were more common. Today they are common only with Government agencies or very large corporate, where the benefits are linked with the years of service rendered and the last pay received. The advantage with these plans is that they provide for an assured income in the retirement period. The negative side is the risk. If the employer goes bankrupt, there may be no retirement benefits at all.
The defined contribution plans have now more or less become the norm, especially in the private sector. The advantage with these plans is that one's contribution is maintained in a separate account, the 'INDIVIDUAL RETIREMENT ACCOUNT' or IRA. Mostly, the individual has a choice of deciding where she wants her contributions to be invested, e.g.. stocks, debt, employer stocks, or a mixture of these. The returns on the investment are deposited back in the account, and the final retirement benefits depend on these returns.
Funded Vs. Unfunded
The defined contribution plans are usually funded, as the contributions are maintained in individual IRAs. Funding may be by the employee or the employer, or both. Often the employer provides a matching contribution in some way to promote retirement saving. In some cases, it could be only on account of employer contribution.
The unfunded plans are the defined benefit plans, also known as 'pay as you go' plans, common mostly in Government and large corporate. They continue in the Government mainly because the Government has very little probability to go bankrupt, though high pension outgo is taking dangerous proportions in most countries with aging societies, and also a significant source of fiscal deficit. The pensions are paid from the fresh receipts or revenue, and no individual contributions are collected.
Qualified Vs. Non Qualified
The word 'qualified' here refers to qualification for income tax benefit on saving for retirement. The tax benefits associated with these plans are available in two forms. One is 'exemption from tax of pre-tax contributions' that is generally available for the defined contribution plans that fulfill all the norms prescribed by the IRS for this purpose. In such cases, the contributions are taxed as 'income' at the time of their withdrawal. The other tax benefit is available in the form of 'exemption from taxation at the
Those plans that do not qualify for the tax benefits are known as 'non qualified' plans. These plans are mostly consisting of flexible contributions or benefits, deferred payments, and lesser restrictions on vesting and withdrawals from the accounts. These are usually tailor-made plans for the highly paid executives.
There are many common plans that fall within the above categories. Some of the most common plans are described hereunder.
401 (k) PLANS - These are defined contribution plans with tax benefits provided by the section 401 (k) of the Internal Revenue Code. In these plans, individual retirement accounts or IRA are maintained for each individual. The contributions are exempt from tax, and invested in the form of stocks, debt or other securities. The returns on these investments as well as the contributions are taxed as income at the time of withdrawal. But there are several rules imposed. There is a 10% tax on premature withdrawals before the age of 59 1/2 years. These plans are protected in case of employer bankruptcy and they are backed by insurance through the Pension benefit guarantee corporation.
ROTH 401 (k) PLANS - These are defined contribution plans where qualified distributions can be made tax free. However, the limits for maximum contributions are small, only $ 5000 (or $ 6000 if you are over 50 years), which get further reduced if one is making contribution to traditional plans.
457 PLANS - These are tax advantaged retirement plans that is available for governmental and certain non governmental employers in United States. In these plans, the compensation is deferred on a pre-tax basis. They are actually similar to 401 (k) except that there is no penalty of 10% for withdrawal before 59 1/2 years.
403 (b) PLANS - These are tax advantaged retirement saving plan available for educational and certain non profit institutes. It also has a tax treatment similar to the 401 (k) plan.
CASH BALANCE PLAN - These are typical HYBRID plans incorporating features of both defined contribution and defined benefit plans. They involve a defined contribution on the basis of an expected rate of return on the investments, and also assure a defined benefit. The risk relating to returns is borne by the sponsor of the retirement plans, which may be the employer.
SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN - It is a non-qualified plan for high compensation employees, that provides flexibility and serves as additional benefits. The negative side is that it is not protected from employer bankruptcy.