Types of Employer-Sponsored Retirement Plans

1. Types of Employer-Sponsored Retirement Plans

Many companies offer retirement plan benefits to employees. These plans may be qualified or nonqualified. Let’s examine the differences between the two.

1a. Qualified Plans

The primary difference between qualified employer-sponsored plans and nonqualified plans is the way they are treated for tax purposes. Qualified plans receive more favorable tax treatment because they meet the requirements of both of the following:

• IRC §401(a). IRC §401(a) states, “A trust created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall constitute a qualified trust under this section.”
• The Employment Retirement Income Security Act of 1974 (ERISA). This federal law set minimum standards for private industry retirement and health plans that are mostly voluntarily established. It was created to provide protection to the individuals participating in these plans.

1b. Nonqualified Plans

A nonqualified plan is basically the opposite of a qualified plan. Nonqualified plans do not meet the requirements of IRC §401(a) and ERISA and do not qualify for favorable tax treatment.

Nonqualified plans are:

• Usually designed to meet specialized retirement needs of key executives and other select employees.
• Exempt from the discriminatory and top-heavy testing that qualified plans are subject to.

Unlike qualified plans, contributions to nonqualified, employer-sponsored plans are generally made with the employee’s after-tax dollars. However, employees have the benefit of being able to defer taxes on accrued earnings until taking distributions, typically in retirement. Employees who contribute to nonqualified plans may also be able to contribute a larger percentage of their compensation. At retirement, distributions from a nonqualified plan are usually made in the form of an annuity.

did you know

Nonqualified retirement plans may also be part of a larger benefit package used to retain executives and other key employees. These packages are sometimes referred to as “golden handcuffs” because they typically include restrictions designed to encourage employees to stay with the company for a specified number of years. For example, both parties might agree to terms stating that the employee would have to forfeit certain benefits, such as the employer’s matching contributions to the retirement plan, if the employee fails to meet the conditions both parties agreed to.

Employers are generally not eligible to deduct contributions to nonqualified plans until the employee takes a withdrawal.

We do not cover nonqualified plan contributions in this course.

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2. Qualified Plans

Qualified plans offer several tax advantages. Employers who offer qualified plans to their employees benefit by being able to deduct the annual allowable contributions they make for each plan participant.

Participating employees enjoy the following tax benefits:

• The amount of income contributed to the plan is tax-deferred until withdrawn.
• Earnings on contributions are also tax-deferred until withdrawn.
• When the employee retires or changes jobs, they may be able to defer paying taxes on the funds even longer by transferring, or “rolling over,” the funds into an individual retirement arrangement (IRA). This is commonly referred to as a “rollover,” which is defined later in this chapter. We will cover IRA accounts later.

EXAMPLE

Bertha contributes $1,000 during the year to her employer’s qualified retirement plan. The $1,000 she contributed will not be included in her taxable income. Rather, the income will be taxed when she starts to withdraw money from the retirement plan, so the tax on the $1,000 income is deferred, i.e., tax-deferred.

Let’s say that, in 20 years, Bertha’s initial $1,000 contribution grows to $4,500. The growth of $3,500 ($4,500 current value – $1,000 initial contribution) will not be taxed until she withdraws funds from the qualified retirement plan. So the growth, or increase in value, will not be taxed until it is withdrawn, making it also tax-deferred.

There are two kinds of qualified plans—defined benefit and defined contribution.

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3. Defined Benefit Plans

A defined benefit plan is a retirement plan in which the employee receives a predetermined, formula-based benefit at retirement. The most common type of defined benefit plan is a pension, in which the retirement benefit is calculated using a formula based on the number of years worked, the taxpayer’s age, and the taxpayer’s history of earnings with the employer. Another type of defined benefit plan is an annuity. An annuity is a series of payments under a contract, made at regular intervals over a period of more than one year. The taxpayer can buy the annuity contract alone or with the help of their employer. Annuities are often purchased from life insurance companies. For these types of retirement accounts, generally, the employer or employee makes payments to fund the pension or annuity.

terms to know

Defined Benefit Plan

An employee benefit plan that provides a fixed, predetermined benefit for employees at retirement. The most common type of defined benefit plan is a pension plan.

Pension

Defined periodic payments made over a specified period (usually life) from an employer-maintained plan to workers who have met the stated requirements. The primary purpose of a pension is to provide retirement income.

Annuity

A fixed sum payable to a person at specific intervals for a specific period of time or for life. Payments represent a partial return of capital and a return on the capital investment. Once the cost in the investment has been recovered, all payments are then included in gross income.

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4. Defined Contribution Plans

A defined contribution plan (also called a deferred compensation plan) is a retirement plan in which the employee or employer makes pretax contributions into a retirement account where the contributions and earnings grow tax-deferred until the money is withdrawn. The most commonly known type of deferred compensation plan is a 401(k). The following information provides more details about 401(k) plans and other common types of deferred compensation plans.

term to know

Defined Contribution Plan

An employee benefit plan that provides a separate account for each person covered and pays benefits based on account earnings. The employee and/or the employer may contribute to the account. Examples include §401(k) plans and profit-sharing plans.

4a. 401(k) Plans

The 401(k) plan takes its name from IRC §401(k), which governs its existence. As a qualified plan, the 401(k) offers the tax-deferred advantages mentioned above.

In addition to the contributions the employee makes, the employer can also contribute to the employee’s account.

4a.i. Employer-Matching Contributions

The employer may opt to match all or part of the employee’s contributions to the account.

This may be done by:

• Making an additional contribution to the account on behalf of the employee.
• Offering a profit-sharing contribution to the plan.

EXAMPLE

Ted’s employer offers its employees a 401(k) plan. The employer offers a matching contribution for each percent the employee contributes, up to 5%, of their annual salary to the plan.

If Ted earns $50,000 during the year and contributes 10% of his annual salary to the plan, he will contribute $5,000 [$50,000 x 0.10 = $5,000].

Ted’s employer will make an additional contribution of $2,500 [$50,000 x 0.05 = $2,500] on his behalf.

This means Ted is actually saving $7,500 [$5,000 + $2,500 = $7,500] for his retirement, or 15% of his annual salary [$50,000 x 0.15 = $7,500]. Yet his out-of-pocket expenditure is only $5,000.

big idea

Taking advantage of any employer-matching contribution is a fantastic way to help build retirement savings. Depending on the taxpayer’s available cash flow, it is always advantageous for the taxpayer to make the minimum contribution to the retirement plan required to receive the employer’s maximum matching contribution. From the employee’s perspective, the employer’s matching contribution is “free” money the year it is contributed.

4b. 403(b) Plans

A 403(b) plan is a tax-advantaged retirement savings plan available for employees of the following types of organizations:

• Public education.
• Some nonprofits.
• Cooperative hospital service.

Employee contributions to a 403(b) plan are tax-deferred, and so are earnings.

Note: Technically, 403(b) plans are not qualified plans. However, their main features are identical to those of qualified plans. For our purpose, we are going to treat 403(b) plans the same as a qualified plan.

4c. 457 Plans

457 plans are tax-advantaged, deferred compensation retirement plans available primarily to government employees. These 457 plans are not qualified plans, but their primary features are identical to qualified plans. Contributions to the plan, and earnings on those contributions, are tax-deferred until the employee receives distributions from the plan.

4d. Contribution Limits

As wonderful a deal as a deferred compensation plan is, employees are not allowed to contribute an unlimited amount to their plan. The IRS sets annual maximum limits on the amount that can be contributed. These amounts are indexed for inflation and generally rise each year. Taxpayers who exceed retirement contribution limits may be subject to penalties if the excess amount is not withdrawn by April 15th of the following tax year.

For 2022, the maximum annual allowable contribution is $20,500. Taxpayers aged 50 or older are allowed an additional “catch up” contribution of $6,500, for a maximum annual allowable contribution of $27,000.

Allowable contributions to plans are generally set as a percentage of an employee’s salary. Therefore, the maximum amount any one taxpayer can contribute is a function of both the maximum annual limit and the allowable percentage of salary that may be contributed.

EXAMPLE

John Connor’s annual salary is $225,000. John is 47 years old. His employer sponsors a 401(k) plan, which allows each employee to contribute a percentage of their annual salary up to the IRS annual contribution limit. John wants to contribute 10% of his annual salary. His contribution will be limited since 10% of his annual salary is more than the $20,500 maximum allowable contribution ($225,000 × 10% = $22,500).

4e. Identifying Contributions to a Deferred Compensation Plan

Many contributions to deferred compensation plans are reported on the Form W-2 in box 12a.

The following illustration shows John Connor’s Form W-2 (from our earlier example). Notice the difference between the amount in box 1 and the amounts in boxes 3 and 5. The difference in box 3 is due to the limit on wages subject to Social Security tax, which in 2022 is $147,000. The $20,500 difference in box 5 is the amount John contributed on a tax-deferred basis to his 401(k) plan. The $20,500 401(k) contribution is reported in box 12 with the code D, and the retirement plan box is marked on John’s Form W-2.

See the list below of the box 12 codes. Note that codes D through H are all deferred compensation plans.