Retirement and College Savings Plans - Qualified Employer-Sponsored Retirement Plans
Under a qualified employer-sponsored retirement plan, all contributions grow tax-deferred. Employees are not taxed on income, dividends or capital gains within the plan until they begin taking distributions from it. In addition, an employer may deduct all contributions it makes to the plan on behalf of its employees.
Qualified employer-sponsored retirement plans can be established as either defined-benefit plans or defined-contribution plans.
Defined Benefit vs. Defined Contribution
Defined-Benefit Plans: Defined-benefit plans are rare today. A defined-benefit plan is designed to provide the employee with a fixed monthly income at retirement. The monthly amount is calculated according to the employee's length of service, age and annual salary. The employer is responsible for financing the plan and bears all of the investment risk if its assumptions fall short of the mark, as it is obligated to pay the employee's defined benefits no matter how successfully it has financed the plan.
- Defined-Contribution Plans: Defined-contribution plans have become the norm in the last decade. Employees who contribute to this type of plan bear all of the investment risk. As such, the employee's retirement benefits will depend upon the amount that he or she has contributed to the defined-contribution plan and the performance of the chosen investments within his or her plan account.
Let's look at three of the most common defined-contribution plans: 401(k) plans, 403(b) plans and profit-sharing plans.
- 401(k) Plans: This is the most common defined-contribution plan. The 401(k) plan allows an employee to make before-tax contributions from his or her paycheck into the plan. The employee decides what investment choices to make from a list of possible mutual funds or employer stock, and these contributions grow tax-deferred until the employee starts taking distributions from the account. While employees are always fully vested in their own contributions, the employer has the option to establish a vesting schedule for matching contributions within a 401(k) plan.
401(k) plans also contain annual contribution limits. For 2013, they may add $17,500 to their 401(k) plan , the contribution amount is indexed for inflation.
403(b) Plans: 403(b) plans are similar to 401(k) plans, only they are restricted to employees of certain nonprofit organizations with tax-exempt status, such as public schools, state colleges and universities, churches, hospitals, and so on. 403(b) plans are synonymous with tax-sheltered annuity plans (TSAs). TSAs have the same tax advantages and eligibility requirements as 401(k)s.
- Profit-Sharing Plans: Profit-sharing plans are established to reward employees for their role in making a business profitable. An employer has the option to contribute to the plan, depending on how well the business is doing. In bad years, the employer might not make a contribution to the plan, whereas, in a profitable year, she will contribute a certain percentage, as determined at the plan's inception. For example, the owner of a business has a profitable year and decides to contribute 15% of her receptionist's salary to the plan. If the receptionist makes $35,000 a year, he would receive a contribution of $5,250. Employers may deduct any contributions made up to a maximum of 25% of the employee's salary or $51,000, per year, whichever is less.
- 403(b) Plans: 403(b) plans are similar to 401(k) plans, only they are restricted to employees of certain nonprofit organizations with tax-exempt status, such as public schools, state colleges and universities, churches, hospitals, and so on. 403(b) plans are synonymous with tax-sheltered annuity plans (TSAs). TSAs have the same tax advantages and eligibility requirements as 401(k)s.
Read more about qualified plans such as defined benefit, defined contribution, and profit sharing within the following tutorial: 401(k) and Qualified Plans.
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