What is a Qualified Retirement Plan?
If it meets certain criteria, a qualified retirement plan is permitted to take advantage of special tax treatment. One key requirement for qualification is that the plan must not discriminate in favor of the employer's key employees. The special tax benefits include the following:
- The employer may take a tax deduction for contributions made to the plan
- Employees may take a tax deduction on their own contributions to the plan
- Earnings on all contributions are tax deferred until withdrawn
There are two types of qualified plans: defined benefit and defined contribution plans.
Defined Benefit Plans
Defined benefit plans are traditional pension plans, where benefits are based on a specific formula. Most formulas use the number of years of service times a salary factor (often an average of the highest three, or highest five, years of salary history). An age factor is used as well, so a worker retiring at 65 receives a higher monthly benefit than one retiring at 62.
- Employer makes all contributions
- Employer makes all investment decisions and bears the risk if investments perform badly
- Less popular since the rise of defined contribution plans
Defined Contribution Plans
Rather than basing plan benefits on a specific formula as defined benefit plans do, defined contribution plans allocate money to plan participants based on a percentage of each employee's earnings. The longer the employee participates in the plan, the higher the account balance grows, based on the amounts contributed and the investment earnings.
Most defined contribution plans allow employees to choose their own investment mix from the specific funds made available through the employer.
Types of Plans:
- Profit-sharing plan - this allows the employer to contribute a percentage of salary each year, but the percentage can vary each year based on corporate profits. However, contributions can be made even when there are no profits, at the employer's discretion.
- 401(k) plan - this form of profit-sharing plan allows employees to reduce their taxable income by deferring a percentage of their salary into the plan. For 2007, the contribution limit is $15,500, with an additional catch-up contribution of up to $5,000 allowed for workers 50 and over.
- 403(b) plan - these plans are also known as tax-sheltered annuities.
- Money purchase pension plan - this requires the employer to contribute a set percentage of salary each year regardless of corporate profits.
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 nonprofit organizations. They are analogous to corporate 401(k) plans.
If you are interested in learning more about the different types of retirement plans, the tutorial, Introductory Tour Through Retirement Plans will walk you through them.
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