Qualified Retirement Plan

A qualified retirement plan is one that is designed to observe all of the requirements of the Retirement Income Security Act (ERISA), as well as all related IRS rulings. By observing these requirements, an employer can immediately deduct allowable contributions to the plan on behalf of plan participants. Also, income earned by the plan is not taxable to the plan. In addition, participants can exclude from taxable income any contributions they make to the plan, until such time as they choose to withdraw the funds from the plan. Finally, distributions to participants can, in some cases, be rolled over into an Individual Retirement Account (IRA), thereby prolonging the deferral of taxable income. There are two types of qualified retirement plans, which are as follows:

Defined Contribution Plan. This is a plan in which the employer is liable for a payment into the plan of a specific size, but not for the size of the resulting payments from the plan to participants. Thus, the participant bears the risk of the results of investment of the monies that have been deposited into the plan. The participant can mitigate or increase this risk by having control over a number of different investment options. The annual combined contribution to this type of plan by both the participant and employer is limited to the greater of $35,000 or one-fourth of a participant's compensation (though this is restricted in several cases—see the following specific plan types). Funds received by participants in a steady income stream are taxed at ordinary income tax rates, and cannot be rolled over into an IRA, whereas a lump-sum payment can be rolled into an IRA. Some of the more common defined contribution plans are as follows:

401(k) plan. This is a plan set up by an employer into which employees can contribute the lesser of $11,000 or 15 percent of their pay, which is excluded from taxation until such time as they remove the funds from the account. All earnings of the funds while held in the plan will also not be taxed until removed from the account. Employers can also match the funds contributed to the plan by employees, and contribute the results of a profit sharing plan to the employees' 401(k) accounts. The plan typically allows employees to invest the funds in their accounts in a number of different investment options, ranging from conservative money market funds to more speculative small cap or international stock funds; the employee holds the risk of how well or poorly an investment will perform—the employer has no liability for the performance of investments. Withdrawals from a 401(k) are intended to be upon retirement or the attainment of age 59 1/2, but can also be distributed as a loan (if the specific plan document permits it) or in the event of disability or death.

Example. The Humble Pie Company matches the contributions of its employees for the first 3 percent of pay they contribute into a 401 (k) plan. Sally Reed elects to have 8 percent of her pay contributed to the 401 (k) plan each month. Her monthly rate of pay is $3,500. Accordingly, the company deducts $280 from her pay, which is 8 percent times $3,500. The company then adds $105 to her contribution, which is 3 percent times $3,500. Consequently, the total contribution to her 401(k) plan is $385, which is composed of $280 contributed by Ms. Reed and $105 contributed by the company.

403(b) plan. This is similar to a 401 (k) plan, except that it is designed specifically for charitable, religious, and educational organizations that fall under the tax-exempt status of 501(c)(3) regulations. It also varies from a 401(k) plan in two other ways: participants can only invest in mutual funds and annuities, and contributions can exceed the limit imposed under a 401 (k) plan to the extent that participants can catch up on contributions that were below the maximum threshold in previous years.

Employee stock ownership plan (ESOP). The bulk of the contributions made to this type of plan are in the stock of the employing company. The employer calculates the amount of its contribution to the plan, based on a proportion of total employee compensation, and uses the result to buy an equivalent amount of stock and deposit it in the ESOP. When an employee leaves the company, he or she will receive either company stock or the cash equivalent of the stock in payment of his or her vested interest.

Money purchase plan. The employer must make a payment into each employee's account in each year that is typically based on a percentage of total compensation paid to each participant. The payments must be made, irrespective of company profits (see next item).

Profit sharing plan. Contributions to this type of plan are intended to be funded from company profits, which is an incentive for employees to extend their efforts to ensure that profits will occur. However, many employers will make contributions to the plan even in the absence of profits. This plan is frequently linked to a 401(k) plan, so that participants can also make contributions to the plan.

Defined Benefit Plan. This plan itemizes a specific dollar amount that participants will receive, based on a set of rules that typically combine the number of years of employment and wages paid over the time period that each employee has worked for the company. An additional factor may be the age of the participant at the time of retirement. Funds received by participants in a steady income stream are taxed at ordinary income tax rates and cannot be rolled over into an IRA, whereas a lump-sum payment can be. This type of plan is not favorable to the company, which guarantees the fixed payments made to retirees, and so bears the risk of unfavorable investment returns that may require additional payments into the plan in order to meet the fixed payment obligations. Some of the more common defined benefit plans are as follows:

Cash balance plan. The employer contributes a pay credit (usually based on a proportion of that person's annual compensation) and an interest credit (usually linked to a publicly available interest rate index or well-known high-grade investment such as a U.S. government security) to each participant's account within the plan. Changes in plan value based on these credits do not impact the fixed benefit amounts to which participants are entitled.

Target benefit plan. Under this approach, the employer makes annual contributions into the plan based on the actuarial assumption at that time regarding the amount of funding needed to achieve a targeted benefit level (hence the name of the plan). However, there is no guarantee that the amount of the actual benefit paid will match the estimate upon which the contributions were based, since the return on invested amounts in the plan may vary from the estimated level at the time when the contributions were made.

A plan that can fall into either the defined contribution or defined benefit plan categories is the Keogh plan. It is available to self-employed people, partnerships, and owners of unincorporated businesses. When created, a Keogh plan can be defined as either a defined contribution or defined benefit plan. Under either approach, the contribution level is restricted to the lesser of 25 percent of taxable annual compensation (or 20 percent for the owner) or $35,000. It is not allowable to issue loans against a Keogh plan, but distributions from it can be rolled over into an IRA. Premature withdrawal penalties are similar to those for an IRA.

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Qualified Retirement Plan

Qualified Retirement Plan