Employer retirement plans overview

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This overview is intended to introduce basic concepts, not provide guidance. Retirement plans are complex and contain many subtleties not described here. There can be penalties if plan withdrawal or contribution limitations are not followed correctly. Please don't hesitate to ask questions in the Bogleheads forum.


Employer retirement plans overview describes retirement plans offered by employers. For individual retirement plans, see Retirement planning in the wiki. US government employees, see Thrift Savings Plan.

Employer retirement plan defined

A pension plan is an employee benefit plan established or maintained by an employer or by an employee organization (such as a union), or both, that provides retirement income or defers income until termination of covered employment or beyond. There are a number of types of retirement plans, including the 401(k) plan and the traditional pension plan, known as a defined benefit plan.

Most private sector pension plans are covered by the Employee Retirement Income Security Act (ERISA). Among other things, ERISA provides protections for participants and beneficiaries in employee benefit plans, including providing access to plan information. Also, those individuals who manage plans (and other fiduciaries) must meet certain standards of conduct under the fiduciary responsibilities specified in the law.[1]

A brief overview

As shown in the IRS table below, implementing an employer retirement plan requires consideration of many factors that affect both the employer and employee. Plan complexity is demonstrated by the fact that the IRS maintains a web site dedicated to nothing more than correcting retirement plans.

Employer Retirement Plan Comparison Table[2]
Type of Plan
  Payroll Deduction IRA SEP SIMPLE IRA Safe Harbor 401(k) 401(k) Profit-Sharing Defined Benefit 403(b) 457(b)
Setting Up and Operating a Plan
May use IRS Model Form as plan document No Yes Yes No No No No No No
Annual return required No No No Yes Yes Yes Yes Yes Yes
Annual nondiscrimination testing No No No Yes Yes Yes Yes Yes1 No
Plan Assets
Invested in IRAs Yes Yes Yes Other2 Other2 Other2 Other2 Other2 Other2
Maximum Contributions
Employee contributions3 Up to $5,500 0 Up to $12,000 Up to $17,500 Up to $17,500 0 0 Up to $17,500 Up to $17,500
Employer contributions3 0 Optional4 Required5 Required5 Optional4 Optional4 Yes6 Optional4 Up to $17,5007
Age 50+ catch-up contributions3 Up to $1,000 0 Up to $2,500 Up to $5,500 Up to $5,500 0 0 Up to $5,500 Up to $17,5008
Accessibility
Loans allowed No No No Yes Yes Yes Yes Yes Yes8
Hardship withdrawals allowed Yes9 Yes9 Yes9 Yes Yes Yes No Yes Yes

1 Only required if plan has employer contributions but never for government plans.
2 Other - Generally, the plan's assets are held in a tax-exempt trust, though they can also be held in custodial accounts and annuity contracts.
3 All Dollar limits are for 2013 and subject to cost-of-living adjustments in future years (except the age 50+ catch-up contributions for Payroll Deduction IRAs).
4 Employer may contribute to an employee's retirement account but the total employer and employee contributions may not for 2013 exceed 100% of the employee's compensation, or $51,000 or more if additional contributions permitted by plan (age 50+ catch-up contributions, 15 or more years of service or 3 years prior to normal retirement age). In a 403(b) plan, compensation means the employee's includible compensation.
5 Required - The amount an employer must deposit into the plan on behalf of an employee must either be a matching contribution that equals a certain portion or percentage of the employee's contributions or a minimum nonelective contibution to all plan participants. The amount of the required employer contributions vary depending on the plan.
6 The amount of an employer's annual contributions are determined by an actuary.
7 The maximum combined employer and employee contributions are for 2013 the lesser of 100% of an employee's includible compensation, or $17,500 or more if additional contributions permitted by plan (age 50+ catch-up contributions or 3 years prior to normal retirement age).
8 Only applies to government plans.

9 Withdrawals may be made at any time, subject to tax

Qualified retirement plan

A qualified retirement plan meets the requirements of Internal Revenue Code Section 401(a) and the Employee Retirement Income Security Act (ERISA) and therefore qualifies for favorable tax treatment. Contributions and earnings are tax-deferred until withdrawn.

The Employee Retirement Income Security Act (ERISA) covers two types of pension plans: defined benefit plans and defined contribution plans.[1]

Defined benefit plan

A defined benefit pension plan is the most administratively complex type of retirement plan. It may be used by businesses of any size. Employers can generally contribute more to a defined benefit plan than to other types of retirement plans.

This fund is different from many pension funds where payouts are somewhat dependent on the return of the invested funds. Therefore, employers will need to dip into the companies earnings in the event that the returns from the investments devoted to funding the employee's retirement result in a funding shortfall. The payouts made to retiring employees participating in defined-benefit plans are determined by more personalized factors, like length of employment.

The most common type of monthly benefit is predetermined by a formula based on the employee's earnings history, tenure of service and age, rather than depending on investment returns. It is 'defined' in the sense that the formula for computing the employer's contribution is known in advance.

Traditional pension

A defined benefit pension plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service — for example, 1 percent of average salary for the last 5 years of employment for every year of service with an employer. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).[1]

Cash balance plan

A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance. In a typical cash balance plan, a participant's account is credited each year with a "pay credit" (such as 5 percent of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer. When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).[1]

Keogh plan

A qualified retirement plan that may either be a defined benefit plan or a defined contribution plan. A Keogh plan is intended for self-employed individuals and partnerships.

Defined contribution plan

A defined contribution plan, on the other hand, does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee's individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually. These contributions generally are invested on the employee's behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.

Payroll deduction IRA

(Employer perspective) This is probably the simplest retirement arrangement that a business can have. It is so easy that, in fact, no plan document is needed under this arrangement.

Under a Payroll Deduction IRA, an employee establishes an IRA (either a Traditional IRA or a Roth IRA) with a financial institution. The employee then authorizes a payroll deduction amount for the IRA.

SARSEP

(Employer perspective) A Salary Reduction Simplified Employee Pension plan (SARSEP) is a Simplified Employee Pension (SEP) plan set up before 1997 that permits contributions to be made through employee salary reductions, referred to as “employee elective deferrals.” Under a SARSEP, employees and employers make contributions to traditional Individual Retirement Arrangements (IRAs) set up for the employees, subject to certain percentage-of-pay and dollar limits.

Employees can play an active role in funding for their retirement by choosing to have the employer contribute part of their pay to their separate IRAs, referred to as SEP-IRAs. SEP-IRAs need to be established for each participant, even those becoming eligible after December 31, 1996, with a bank, insurance company or other qualified financial institution.

No new SARSEPs can be established after December 31, 1996. However, employers who established SARSEPs prior to January 1, 1997, can continue to maintain them and new employees of the employers hired after December 31, 1996, can participate in the existing SARSEP.

SEP

(Employer perspective) A SEP is a Simplified Employee Pension plan. Because this is a simplified plan, the administrative costs should be lower than for other, more complex plans. Under a SEP, employers make contributions to traditional Individual Retirement Arrangements (IRAs) set up for employees (including self –employed individuals), subject to certain limits.

SIMPLE IRA

(Employer perspective) A SIMPLE IRA plan is a Savings Incentive Match PLan for Employees. Because this is a simplified plan, the administrative costs should be lower than for other, more complex plans. Under a SIMPLE IRA plan, employees and employers make contributions to traditional Individual Retirement Arrangements (IRAs) set up for employees (including self-employed individuals), subject to certain limits. It is ideally suited as a start-up retirement savings plan for small employers who do not currently sponsor a retirement plan.

401(k) plans defined

A 401(k) plan is a qualified (i.e., meets the standards set forth in the Internal Revenue Code (IRC) for tax-favored status) profit-sharing, stock bonus, pre-ERISA money purchase pension, or a rural cooperative plan under which an employee can elect to have the employer contribute a portion of the employee’s cash wages to the plan on a pre-tax basis. These deferred wages (elective deferrals) are not subject to federal income tax withholding at the time of deferral, and they are not reflected as taxable income on the employee’s Form 1040, U.S. Individual Income Tax Return.

Employees who would like to change their employer's 401(k) plan, please refer to "How to Campaign for a Better 401(k) Plan" in this wiki.

Traditional 401(k)

A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested.

Designated Roth accounts in 401(k) plans: Beginning in 2006, a 401(k) plan (but not a SARSEP or SIMPLE IRA plan) may permit an employee to irrevocably designate some or all of his or her elective contributions under the plan as designated Roth contributions. The plan must contain language that allows for these Roth contributions.

A designated Roth account is a separate account under a 401(k)plan to which designated Roth contributions are made, and for which separate accounting of contributions, gains, and losses is maintained.

Safe harbor 401(k)s

A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans.

SIMPLE 401(k)

The SIMPLE 401(k) (Savings Incentive Match PLan for Employees) plan was created so that small businesses could have an effective, cost-efficient way to offer retirement benefits to their employees. A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to traditional 401(k) plans. As with a safe harbor 401(k) plan, the employer is required to make employer contributions that are fully vested. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. Employees who are eligible to participate in a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.

Profit sharing

A profit sharing plan or stock bonus plan is a defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution. A profit sharing plan or stock bonus plan can include a 401(k) plan.[1] If you are an S or C corporation, consider the Solo 401(k) plan.[3]

Money purchase plan

A money purchase pension plan is a plan that requires fixed annual contributions from the employer to the employee's individual account. Because a money purchase pension plan requires these regular contributions, the plan is subject to certain funding and other rules.[1]

Target benefit plan

A target benefit plan is a type of pension plan that contains features of a defined contribution plan but is made to appear like a defined benefit plan.

It is similar to defined benefit plan in that the annual contribution is determined by a formula to calculate the amount needed each year to accumulate (at an assumed interest rate) a fund sufficient to pay a projected retirement benefit, the target benefit, to each participant upon reaching retirement. It is similar to a defined contribution plan in that the plan does not guarantee any benefit will be paid. The plan's only obligation is to pay whatever benefit can be provided by the amount in the contributor’s account. The actual earnings on the individual accounts may differ from the estimated earnings used in the assumptions and the investment performance of that account through the years.

403(b) tax sheltered annuity

A 403(b) tax-sheltered annuity (TSA) plan is a retirement plan offered by public schools and certain tax-exempt organizations. An individual’s 403(b) annuity can be obtained only under an employer’s TSA plan. Generally, these annuities are funded by elective deferrals made under salary reduction agreements and nonelective employer contributions.

Designated Roth accounts in 403(b) plans: Beginning in 2006, 403(b) plan (but not a SARSEP or SIMPLE IRA plan) may permit an employee to irrevocably designate some or all of his or her elective contributions under the plan as designated Roth contributions. The plan must contain language that allows for these Roth contributions.

A designated Roth account is a separate account under a 403(b) plan to which designated Roth contributions are made, and for which separate accounting of contributions, gains, and losses is maintained.

Keogh plan

A qualified retirement plan that may either be a defined benefit plan or a defined contribution plan. A Keogh plan is intended for self-employed individuals and partnerships. If you are a sole proprietor, consider the the Solo 401(k) plan.[3]

Non-qualified retirement plan

A non-qualified retirement plan does not meet the requirements of Internal Revenue Code Section 401(a) and the Employee Retirement Income Security Act of 1974 (ERISA) and therefore does not qualify for favorable tax treatment.

In essence, a non-qualified retirement plan is a contract to provide pension benefits. Individuals can create one, but most are created by employers.

Contributors to non-qualified plans don't get the same tax benefits as contributors to qualified plans, such as 401(k)s, do. However, non-qualified plans can be much more flexible in setting benefit amounts and timing payouts.

The contributions made to these plans are usually nondeductible to the employer and are usually taxable to the employee. However, they allow employees to defer taxes until retirement. Non-qualified plans are often used to created to attract and retain highly paid employees.

Deferred compensation plan

Deferred compensation is the term used for future income that would have otherwise been realized in the present.

But when used in context by employers, the name denotes a non-qualified "promise to pay" on the part of the employer. There are many forms, which often include the increased valuation of the company's stock, measures of executive performance, cash value built in life insurance, salary increases/bonuses for the next year not paid by the employer but kept in a company trust, and so on.

Each participating employee needs to understand that the assets set aside in a Deferred Compensation plan are nothing more than the employer's promise to pay them at a future date. This promise is only as good as the employer's ability to keep it, i.e. assets are at risk if the employer fails. This is a different situation than qualified plans, where vested vested account balances are 100% owned by the employee regardless of employer status.

Deferred compensation plans are very hard to describe, as it is at the employer's discretion. It is really about contract law: A written agreement between an employee and employer, and is not subject to the statutory law administered by the DOL and IRS that governs qualified plans.[4]

457(b) deferred compensation plan

Created in 1978, a 457(b) plan is a non-qualified tax-deferred compensation plan similar to qualified plans such as the 401(k) and 403-b. If you work for a state or local government or for a tax-exempt organization, you may be able to participate in a section 457 deferred compensation plan. [5] The 457 plan may be available as an additional voluntary retirement savings vehicle for state or local government or tax-exempt organization employers also offering a public employees pension system. Or they can be offered as a supplemental retirement option for those state or local government or tax-exempt organization employers offering a 401-k or 403-b plan. [6] There are two basic types of 457 plans:

  • Government Plans: Local and state governments are eligible to establish a 457(b) plan for their employees. This type of 457(b) covers employees of a state (including the District of Columbia), a political subdivision of a state, any agency or instrumentality of a state, or political subdivision of a state. These types of employees can include: local and state government workers, fire fighters, police personnel, and public school employees.
Section 1448 of the Small Business Jobs Protection Act of 1996 (SBJPA) added 457(g) of the Code, which requires that 457(b) plans maintained by state or local government employers hold all plan assets and income in trust, or in custodial accounts or annuity contracts (described in 401(f) of the Code), for the exclusive benefit of their participants and beneficiaries.
Contributions to the 457-b plan qualify for the savers credit. [7]
  • Non-Government Plans: Tax-exempt organizations that are non-governmental (hospitals, charitable organizations, unions, among others) must generally limit participation to a select group of management or highly compensated employees. This is due to the rules under Title I of the Employee Retirement Income Security Act of 1974 (ERISA).
ERISA generally requires that a private retirement plan providing benefits to employees be funded by a trust or annuity contract. The rules, however, require that private 457(b) plans be unfunded in order to obtain tax benefits. Therefore, a plan will violate ERISA unless an exception applies. This provision means that the 457 plan assets are the property of the sponsoring employer and are subject to the employer's general creditors, until paid out to plan participants.[8]
  • Please see the 457-b wiki page for the plan details, e.g. combining with other qualified plans, no 10% early withdrawal penalty if..., special 'catch-up' provisions if...
  • Links to 457-b plans, in the wiki

457(b) additional info

  • State and local government plans fall into the "non-qualified" category because they don't pay tax.[9]
  • Government 457(b) plans MUST be funded, as indicated above because the vested account balances are being held "for the exclusive future benefit of the employee". This is the definition of the doctrine of "economic benefit", something unfunded deferred compensation may not have, or it would be income to the employee.[4]
  • Non-profit (excluding churches) organizations may offer a 457(b) plan that CANNOT be funded. This does not mean the employer may not set aside funds in trust with the intent to pay them out to the employee in future years. "Unfunded" simply means there may not be an "economic benefit", which almost always means that the employer must hold them as assets to the non-profit organization, subject to the claims of their creditors. This also generally means that plans balances are not transferable between employers.[4]

Notes

  1. 1.0 1.1 1.2 1.3 1.4 1.5 US Dept. of Labor Retirement Plans, Benefits & Savings
  2. Plan Comparison Table, from the IRS Navigator web site, updated with 2014 values
  3. 3.0 3.1 Solo 401(k) Plan, in the Bogleheads' forum
  4. 4.0 4.1 4.2 Deferred compensation--what is it?, in the bogleheads.org forum
  5. 26 USC § 457 - Deferred compensation plans of State and local governments and tax-exempt organizations, Legal Information Institute, Cornell Law School
  6. 403-bwise. 457 FAQ
  7. Pub 571 savers credit, IRS
  8. 403-bwise. 457 FAQ
  9. Employer Retirement Plans - Is this OK?, in the Bogleheads forum

External links

Types of Retirement Plans, from the IRS
Retirement Plans Frequently Asked Questions (FAQs), from the IRS
Retirement Plans FAQs regarding IRAs, from the IRS
EBRI Databook on Employee Benefits
Retirement Plans and tax deferred investing, the Bogleheads' forum Reference Library
IRS Publication 560: Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans) (for employers)
Fiduciary Focus Scott Simon's monthly column on fiduciary issues with retirement plans.