What follows is FREE information about various retirement-related tax-favored plans. Bearing in mind that the price charged for this information is very reasonable - you can't beat FREE! - we hope you will not hold us responsible for any problems that may arise. Every effort has been made to present accurate information but you should confirm the actions you decide to take with your CPA or other tax or financial adviser. Also, bear in mind that many of the dollar numbers are indexed and increase from year at Congressional whim; most of the numbers are 2006 numbers and we do not promise the update them every year.
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Tax-favored retirement arrangements may be classified in two broad categories:
First, consider those that don't involve the employment relationship. We say they don't involve the "employment relationship" in the sense that the employer plays no role in the plan but of course they do involve the "employment relationship" in the sense that they generally imply that there is an employer or at least a source of "earned income." The principal tax-favored plans in this category are INDIVIDUAL RETIREMENT ACCOUNTS or IRAs and there are two principal flavors of these:
Consider first the "classic" IRA. In what follows, it is sometimes referred to as "traditional" and sometimes as "classic;" these terms can perhaps be justified as it has been around far longer than the "Roth" and some of the other tax-favored retirement plans discussed here. It has two very attractive features. In the year of contribution, it allows the pzrticipant to get a tax deduction for the amount contributed and certainly that's an attractive tax advantage. It has an even more significant further advantage since it permits the amount contributed to grow free of tax until withdrawn from the plan perhaps many years later. When the amounts contributed to the IRA account are withdrawn, however, both the original contribution to the plan and the earnings that have accumulated on the initial contribution are subject to tax.
Contrast this to the Roth IRA. The Roth gives no tax advantage, no deduction, in the year in which the initial contribution is made. Like the "Classic" IRA, the Roth permits the earnings on the intiial contribution to grow free of tax so it shares this advantage with the "Classic" IRA. It has another significant advantage and this can be very significant: IF CERTAIN REQUIREMENTS ARE MET (essentially if the accumulation is left in the Roth for an extended period of time) THE AMOUNTS WITHDRAWN FROM THE ROTH ARE FREE OF TAX! For a young person planning for retirement many years in the future, this attractive feature can make the Roth IRAsuperior to the Classic IRA.
Just click on the links to learn more about the "Classic" IRAs and the Roth IRA
Now let's talk about plans in which the employer pays a role. These fall in two broad categories:
In a defined benefit plan, the employer makes certain promises to the employee that apply to when the employee retires or leaves the company. These plans are specific and the employee who cares to read the details of the plan can determine what benefits she will receive at a later date, "tomorrow." What isn't known exactly, and this can be troubling to the employer, is what it is costing the employer "today." What sum, for example, could the employer set aside today to take care of that ultimate obligation? Consider this time line:
Today---------------------------------------------Tomorrow
?????---------------------------------------------!!!!!!!!
The employees know what they will get tomorrow; the employer has some difficulty determining what it costs today.
A defined contribution plan reverses the question marks and the exclamation points. The employer knows what it costs today. The employer knows how much it contributes to the plan today and may be unconcerned about what happens to the plan later on. The employer has fulfilled whatever obligation it has when it contributes to the plan. What the employees are able to get from the plan at a later date is of little immediate concern to the employer although of course the employer hopes the plan will fare well and earn a high return so that the employees are well taken of at some later date.
Returning to defined benefit plans, these typically constitute promises made to a large group of employees and they are made to the employees as a group. If Jones stays with the company thirty more years, he will get a pension of $40,000 per year. The employer doesn't know how many employees will stay with the company till they earn retirement benefits and makes no specific promises to a particular employee like Jones.
By contrast, Shirley is covered by a defined contribution plan at her company. An account is opened in her name and certain sums of money are accounted for her in that account. While she may have to work a certain number of years at the company to qualify for the benefits implicit in that account - she may have to work say three years before the benefits "vest" - but given that she works the required time the total amount in her account belongs to her. If she dies, it belongs to her estate.
There is a little more assurance in the case of a defined benefit plan that the benefits will, in fact, be waiting for the employee at the later date. Defined benefit plans are generally regulated by the Pension Benefit Guarantee Corporation (PBGC) which promises, within limits, that if something happens to the employer and it cannot meet its obligations under the plan that the PBGS will step in and pay the benefits. (We didn't learn about Federal guarantees from the the S&L crisis, did we?) Defined contribution plans are not like that. Usually the amounts accumulated in a defined contribution plan go to an independent trustee and the continuing financial health of the employer is irrelevant. But if the trustee has problems it is possible that the employees may have difficulty in collecting the accumulations in their accounts.
Defined benefit plans tend to be those adopted by very large organizations, particularly organizations with a powerful union. While it is difficult for the employer to know exactly how much the plan costs it today, the employer must nevertheless attempt to determine that present cost. Statement of Financial Accounting Standards No. 87 requires most employers to estimate that cost and to reflect it in their financial statements. Determining that expense can cost the employer many dollars of fees paid to actuarial firms and reflecting it in the financial statements will cost something in terms of accounting and audit fees. These uncertainties and the related costs of estimating and reflecting the costs in the financial statements are not present for a defined contribution plan. The employers cost is what it pays into the accounts of the various employees for a particular period of time. What the accounts earn and whether the employees live to collect their benefits is of no concern to the employer other than its compassionate concern for the ultimate welfare of its employees.
Another difference relates to who funds the ultimate benefits to the employees. In a defined benefit plan, typically all funding - all moneys that go into the plan - is provided by the employer. In a defined contribution plan, all the contributions may come from the employee (often as a reduction in their compensation) or may come from a combination of employee and employer contributions.
Here's a very simple and very hypothetical example of how such a defined contribution plan might work. In spite of what was said in the last paragraph - that much, even most, of the money going into a defined contribution plan comes from the employee - we'll assume here for simplicity and to get across the idea of "vesting" that the money comes all from the employer. Assume three doctors run a clinic and that it sets up a plan for their benefit. During the first year the amount contributed by the employer to the plan is $28,000 distributed among the three doctors' accounts as shown.
| Year 1 | Kildare | Gillespie | Kevorkian |
|---|---|---|---|
| Contribution | $9,000 | $10,000 | $9,000 |
| Earnings | 900 | 1,000 | 900 |
| End of Yr 1 | $9,900 | $11,000 | $9,900 |
| Year 2 | |||
| Forfeiture | 5,500 | (11,000) | 5,500 |
| Contribution | 10,000 | 10,000 | |
| Earnings | 2,000 | 2,000 | |
| End of Yr 2 | $27,400 | $27,400 |
CAUTION! The Table and narrative that go with it are purely hypothetical and do not necessarily correspond exactly to any defined contribution plan.
Among the various defined contribution plans are 401(k) plans, Keoghs, SIMPLEs, 403(b) plans and various others. Most of these plans are known as "qualified" plans. The term "qualified" implies that the employer gets a tax deduction for any amounts the employer puts into the accounts of the various employees and it also implies that the employee is able to defer taxes. The employees typically defer the payment of taxes on any amounts they contribute to the account and are not taxed till later on the amount put into the plan by the employer. They pay taxes on these deferred amounts at a later date, perhaps when they retire.
Click the links to learn more about SIMPLEs or 401ks or to get a complete table of contents for this site and please return to this page later to learn more about other aspects of retirement plans.