Qualified Retirement Plan Overviews
Qualified Plans are retirement arrangements that satisfy requirements of the Internal Revenue Code and, as a result, are eligible to receive certain tax benefits. Generally, by satisfying the qualification rules, contributions to Qualified Plans can be tax deductible and the investment earnings grow tax deferred. There are two types of Qualified Plans:
- Defined Contribution Plans
- Defined Benefit Plans
Defined Contribution Plans
Retirement plans where contributions are made by the employer, employee, or both. Separate accounts are maintained for each participant. The final payout to the participant depends on how much is invested and the financial outcome of the investments.
Named after a section of the 1978 Internal Revenue Code where it first apeared, this type of plan allows participants to make voluntary plan contributions, up to certain limits. 401k plans let employees save for retirement easily and conveniently through automatic payroll deductions. Depending on the provisions, employees may contribute on a Pre-Tax, Roth, or After-Tax basis. Employee contributions may be matched by the employer. Generally, employees may have control over investment options within the plan.
Money Purchase Pension Plan
Plan that requires employers to contribute a set annual amount, which is generally expressed as a percentage of participant pay. Continued qualification under Internal Revenue Codes requires that employers make an annual contribution. Generally, an employer's annual contribution budget is easily predictable.
Plan that bases employer contributions on business profits or a percentage of pay. “Discretionary profit sharing” plans generally allow employers to decide each year whether to contribute.
Target Benefit Plan
Employer contributions are calculated to provide hypothetical projected benefits at retirement, based on actuarial assumptions. Similar to a Defined Benefit Plan (below), the annual contribution is calculated as the amount necessary to fund for a projected benefit at retirement, and similar to a money purchase plan (above), contributions are allocated to individual participant accounts. The actual retirement benefit is based upon a participant's account balance at retirement age. The investment experience (gains/losses) will not result in any increase or decrease in employer contributions. Instead, such experience will increase or decrease the benefit payable to the participant.
Defined Benefit Plans
The Defined Benefit plan is designed to pay a fixed benefit amount upon retirement. The benefit amount is based on the formula outlined in the plan document. The contributions are actuarially determined on the anticipated benefit at retirement. The factors that determine the total contribution are current compensation, earnings on contributions, age and years of service. The contribution is the amount necessary each year to provide sufficient funds to pay the promised benefit. Money is paid into the plan for all participating employees, but some will not qualify for, and therefore will not get, benefits.
The employer assumes the investment risk in that if the assets fail to earn the rate of return that was used in the actuarial assumption, a greater contribution may be required the following year. Or, conversely, if the investments outperform expectations, the plan will have an actuarial gain, which may reduce future contribution requirements.