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 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 on the amount that he or she has contributed to the defined-contribution plan and the performance of the chosen investments within the 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; 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 2006 through 2008, employees may contribute up to $15,000 to their 401(k) plan. After 2008, 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. The 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 $40,000, per year (indexed for inflation), whichever is less.

Look Out!
The main thing to know about the various defined contribution plans is that 403(b) plans are available only to employees of schools, hospitals and certain non-profit organizations. They are analogous to corporate 401(k) plans.

Exam Tips and Tricks
The exam may refer to the employer contribution as $40,000 (indexed for inflation), or may refer to a specific year. For 2005, the correct amount was $42,000. For 2006, the amount is $44,000.

Read more about qualified plans such as defined benefit, defined contribution and profit-sharing within the 401(k) and Qualified Plans tutorial.

Other Qualified Retirement Plans
Related Articles
  1. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  2. Economics

    Explaining Manufacturer’s Suggested Retail Price

    The manufacturer’s suggested retail price (MSRP) is just what it describes – the price manufacturers recommend that retailers charge for their goods.
  3. Economics

    What Happens in a Make-or-Buy Decision?

    A make-or-buy decision happens when a company must choose to either manufacture an item itself, or buy it premade from a supplier.
  4. Insurance

    Explaining Indemnity Insurance

    Indemnity insurance is an insurance policy that protects business owners and employees from losses due to failure to deliver expected services.
  5. Investing Basics

    What Does In Specie Mean?

    In specie describes the distribution of an asset in its physical form instead of cash.
  6. Insurance

    What is a Force Majeure?

    A force majeure clause frees both parties in a contract from fulfilling their obligations in the event of some catastrophic or unexpected occurrence.
  7. Credit & Loans

    Explaining Equated Monthly Installments

    An equated monthly installment is a fixed payment a borrower makes to a lender on the same date of each month.
  8. Economics

    Calculating Days Working Capital

    A company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
  9. Economics

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  10. Economics

    Explaining Corporate Tax

    A corporate tax is a tax levied on the profits a corporation generates.
  1. Unicorn

    In the world of business, a unicorn is a company, usually a start-up ...
  2. Private Equity Real Estate

    A Definition of "Private Equity Real Estate" and how it applies ...
  3. Put-Call Parity

    A principle that defines the relationship between the price of ...
  4. Encumbrance

    A claim against a property by a party that is not the owner. ...
  5. EBITA

    Earnings before interest, taxes and amortization. To calculate ...
  6. Qualitative Analysis

    Securities analysis that uses subjective judgment based on nonquantifiable ...
  1. Can I borrow from my annuity to put a down payment on a house?

    You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
  2. Why is the Cayman Islands considered a tax haven?

    The Cayman Islands is one of the most well-known tax havens in the world. Unlike most countries, the Cayman Islands does ... Read Full Answer >>
  3. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  4. Why is Luxembourg considered a tax haven?

    Luxembourg has been the tax haven of choice for many corporations and mega-rich individuals around the world since the 197 ... Read Full Answer >>
  5. Who decides to print money in Canada?

    In Canada, new money comes from two places: the Bank of Canada (BOC) and chartered banks such as the Toronto Dominion Bank ... Read Full Answer >>
  6. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!