Qualified plans that have tax advantages are often known as employer-sponsored retirement plans. These tax-advantaged qualified plans qualify for special tax treatment under Section 401 (a) of the Internal Revenue Code. Basically, the two main categories these plans fall under are defined benefit plans and defined contribution plans or profit-sharing plans.
A defined benefit plan is also known to most as the traditional pension plan. This plan is funded by employer contributions alone, and provides the beneficiary with specified level of retirement benefits. The employees salary and service are generally the determining factors of one’s benefits in the defined benefit plan. Whereas the defined contribution plans such as 401k or profit-sharing plans are funded by the employer along with employee contributions. The investment performance and the amount contributed to these plans will dictate the benefits the employee will receive from the defined contribution plan.
Pension plans or defined benefit plans can also be subcategorized as three different plans: defined benefit plans, target benefit plans and money purchase plans. The money purchase pension plan decides or specifies how much the participant contributes by the formula of the plan. Another pension plan is the target benefit plan. This plan is also referred to as a hybrid because although it starts out as the benefit being determined by the defined benefit, after the benefit is calculated or assessed, this type of pension plan then converts to a money purchase plan. The defined benefit plan is where a plan formula determines the retirement benefit. Usually, this formula is calculated by the amount of years of service the contributor of the defined benefit plan has invested.
Defined contribution plans or profit-sharing plans are generally not a required tax-advantaged qualified plan but remain an option as a benefit plan or an additional benefit plan. 401 (k) plans are still the most popular type of defined contribution plans. However, other examples of the defined contribution plans include profit sharing plans, employee stock ownership plans, and 403 (b) plans. As of 2008, the annual deferral limit is $15,500. However, the 401 (k) does include a catch-up provision for those who are 50 years old and older.
There are advantages and disadvantages to both the defined benefit plans and defined contribution plans. The advantages of the defined benefit plans is that there is no investment risks, not dependent on participant’s ability to save, there is a cost-of-living adjustment and this is a guaranteed income for workers. The advantages of the defined contribution plans are the tax-deferred retirement savings, participants choose how much to save, and these plans can be funded through payroll deductions.
The disadvantages to the defined benefit plans is that they can be difficult to understand and are not beneficial to employees leaving before retirement. Whereas the disadvantages of the defined contribution plans is that the participants have an investment risk and for the older employee they can be difficult to build.
Although the rules and limits may sometimes vary among these tax-advantaged qualified plans, they generally share key features. Generally, these plans are on pre-tax basis. The beneficiary does not usually pay taxes on these plans until they begin actually withdrawing the funds during retirement or whenever the funds are withdrawn. This also applies to all of the plans that use the words “tax-deferred growth.” Pretax contributions and tax-deferred growth are basically saying the same thing. When the plan involves employees contributing to them, often times the employee must be vested prior to being eligible to receive them. This is something that one must check with his or her employer about. Another feature that can be seen as an advantage to most of these plans is that they are usually protected from creditors. In other words, if one does have debts, creditors generally do not have access to the funds from these various qualified plans.
So basically, the various kinds of qualified plans that have tax advantages include pension plans, 401(k) plans and plans equivalent to the 401(k) in other industries such as 457s, and 403(b)s. In taking in account of one’s age, investment history along with what one wants from their tax-advantaged qualified plan these can all help in determining the best choices these plans can provide.
(No author given). (2008). Defined Benefit and Contribution Pension Plans.
Retrieved May 14, 2008, from http://retireplan.about.com/cs/retirement/a/aa_defined_a5.htm
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