Types of Retirement Savings Plans

There are four principal types of retirement savings plans:

Individual Managed Plans (Content coming soon)

The IRS defines two principal types of employer-sponsored retirement savings plans:

  1. Defined Contribution Plans
  2. Defined Benefit Plans

Defined Contribution Plans

Defined Contribution Plan is a retirement plan in which the employee and/or the employer contribute to the employee’s individual account under the plan. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans and profit-sharing plans.

The amount in the account at distribution includes the contributions and investment gains or losses, minus any investment and administrative fees. Generally, the contributions and earnings are not taxed until distribution. The value of the account will change based on contributions and the value and performance of the investments.


401(k) Plans

401(k) Plan is a defined contribution plan where an employee can make contributions from his or her paycheck either before or after-tax, depending on the options offered in the plan. The contributions go into a 401(k) account, with the employee often choosing the investments based on options provided under the plan. In some plans, the employer also makes contributions such as matching the employee’s contributions up to a certain percentage. SIMPLE and safe harbor 401(k) plans have mandatory employer contributions.

401(k) plans were created as a provision of the Revenue Act of 1978.  In 1981, the IRS issued new rules that allowed employees to fund their 401(k) through payroll deductions. This kickstarted the 401(k)’s popularity. Within a couple of years, nearly one-half of all large companies were offering 401(k)s to their employees.

Safe Harbor 401(k) Plan is similar to a traditional 401(k) plan, but the employer is required to make contributions for each employee. The safe harbor 401(k) eases administrative burdens on employers by eliminating some of the rules ordinarily applied to traditional 401(k) plans.

Employee Stock Ownership Plan (ESOP) is a type of defined contribution plan that is invested primarily in employer stock.

Profit-Sharing 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 may include a 401(k) feature.

How 401(k) Plans Work - If your employer offers a 401(k) and you meet the plan’s eligibility requirements, you can enroll in the plan and begin making contributions via payroll deductions.

401(k)s come in two distinct flavors: Traditional and Roth. Although at their heart they aim to achieve the same purpose — to encourage Americans to save more for retirement by offering tax incentives — they do this in drastically different ways. Here are the main ways they differ.

Traditional 401(k) - Your contributions are made before Federal and State income taxes were withheld from your income.  Over the years your retirement money compounds and grows tax-deferred. This means the contributions you make help lower your taxable income now, and you won’t pay any Federal or State income taxes on either your contributions or investment earnings until you begin making withdrawals in retirement. At that point, the money will be taxed as ordinary income.

Roth 401(k) - Your contributions are made after Federal and State income taxes were withheld from your income. However, your retirement money compounds and grows tax-free for life. Because you already paid the income taxes up front, when you withdraw money during retirement, you won’t have to pay any additional income taxes on the amount invested nor on the investment earnings.  The Power of Compounding a substantial sum of money tax-free over one’s lifetime is a very attractive retirement savings feature – one that should be pursued diligently!

The Roth 401(k) is a retirement savings plan which represents a unique combination of features of the Roth IRA and a traditional 401(k) plan.  Roth 401(k)s were created as a provision of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. In 2006, U.S. employers were allowed to amend their 401(k) plan documents to allow employees to elect Roth IRA type tax treatment for a portion or all their retirement plan contributions.

Which one you choose will depend on several factors, including whether your company offers both (Roth 401(k)s are not as commonly offered as traditional 401(k)s) and whether you want a tax break now or later.

Employer Matching Contributions - If your employer offers a matching contribution benefit, it’s a great idea to try to contribute at least enough to meet 100% of your employer’s match, as this is “free money” for you. A company might, for instance, match half of the contributions you make on the first 6% of your salary, or match 100% of what you contribute up to a certain dollar amount or percentage of your salary. In some rare cases, your employer might even match what you put in dollar for dollar.


403(b) Tax-Sheltered Annuity (TSA) Plan

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.

403(b) plans had their origin in 1958, when Congress approved a tax-deferred savings device for employees of certain 501(c)(3) organizations by adding Section 403(b) to the Internal Revenue Code. In 1961, Congress extended IRS 403(b) to employees of educational institutions including colleges and public universities, with investments limited to annuities. Mutual funds held in custodial accounts were added in 1974. The program was intended to be a relatively simple way for employees to supplement retirement savings by using their own voluntary pre-tax dollars. Supplementing retirement savings has become increasingly important with widespread reductions in benefits being made to the state retirement system plans for those employees.

The same change in law (see “Roth 401(k)”, above) allowed Roth IRA type contributions to 403(b) retirement plans.
 

401(k) and 403(b) Plan Contribution Limits

Tax Year

Contribution Limits

Under Age 50

Age 50 or Older

2022 20,500 27,000
2021 19,500 26,000
2020 19,000 25,000

 


Defined Benefit Plan

The Defined Benefit Plan, more commonly known as a traditional Pension Plan, promises the participant a specified monthly benefit at retirement. Often, the benefit is based on factors such as the participant’s salary, age and the number of years he or she worked for the employer. 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.

Pension plans were offered by most employers well into the 1990s. However, as the popularity of 401(k) and 403(b) plans continued to grow, and employers wrestled with the ever-increasing costs of funding and managing their pension plans, most private-sector pension plans were phased out or converted into 401(k) or 403(b) plans. Today, it is rare to find a private-sector employer who offers a pension plan benefit. It seems that only Federal, state and municipal government agencies still offer pension plans.

Self-Employed Plans (Content coming soon)

Inherited retirement savings plans (“Inherited Plans”) are retirement plan funds that one received from the settlement of the estate of a person who had passed away – usually a parent or other relative, but sometimes a friend.

Inherited Plans are distributed only in the form of Traditional IRAs or Roth IRAs, depending upon the original character of the Plans when they were established by the deceased owner.

Employer-Sponsored plans such as Defined Benefit Plans (i.e., 401(k) plans, 403(b) plans, etc.) or Defined Benefit Plans (i.e., pension plans) are not eligible to be directly distributed to the recipients as the recipients were not the participants in such Plans.  Instead, the Executor of the estate instructs each Plan’s fiduciary to convert that Plan’s assets into a Traditional IRA or Roth IRA first, depending upon the original character of each Plan when they were established, and then distribute the assets of each converted Plan to the beneficiaries according to the terms of the deceased owner’s will.

Distribution Requirements

Prior to 2020, Inherited Plan recipients had to start taking withdrawals from their Inherited Plans in the year immediately after the decedent’s death.  The amount of the withdrawals, known as Required Minimum Distributions (RMDs) were determined by size of the Inherited Plan’s assets and by the IRS’ actuarial life expectancy tables that extend all the way out to age 115.

A nonspousal beneficiary of an IRA could “stretch” the receipt of these RMDs over his or her remaining actuarial life expectancy.  This estate planning strategy allowed one to extend IRA distributions over future generations while the IRA continued to grow tax-deferred.  Under this scenario, the younger the beneficiary, the better, as the RMD would be smaller, and the account could grow tax-deferred for a longer period of time.  Younger beneficiaries have longer actuarial life expectancies, resulting in smaller RMDs taken in the beginning, growing larger over time.  The “stretch IRA” strategy minimized the amount that must be withdrawn from the IRA each year and avoided a large, taxable, lump-sum distribution to the beneficiary.

SECURE Act of 2019

Under the "Setting Every Community Up for Retirement Enhancement Act of 2019,” also known as the “SECURE Act”, individuals who inherit an IRA after December 31, 2019 are required to withdraw all IRA plan assets within 10 years of the original account holder’s death.  There are no RMDs during the 10-year period, as long as the entire IRA balance is withdrawn within 10 years of the date of death.  §401 of the SECURE Act essentially eliminated “stretch” IRAs that could be stretched over the life of the beneficiary and grow tax-deferred for an extended period.  §401 of the SECURE Act does not apply to account holders who died prior to December 31, 2019, and in this scenario, a beneficiary may still “stretch” distributions over his or her own lifetime. It is important to review client estate plans as the 10-year payout rule will come as a surprise to many and could undermine the original intent of the estate plan.

§401(a)(2) of the SECURE Act does allow for a few exceptions to the 10-year payout rule.  Spouses, account holder’s children who have not reached the age of majority, beneficiaries less than 10 years younger than the account holder, and chronically ill or disabled beneficiaries are NOT subject to the 10-year distribution rule and are considered “eligible designated beneficiaries.”  These individuals are eligible to withdraw inherited IRAs over their life expectancy as was customary prior to 2020, bypassing the 10-year rule.  Designated beneficiaries include any person (i.e., not an entity or institution) subject to the 10-year rule.

Tax Tip

If the Inherited Plan is in the form of a Traditional IRA, you should consider taking 10 equal distributions annually over the required 10-year period to avoid a large, taxable, lump-sum distribution to the beneficiary at the end of the 10-year period.

However, if you don’t need these funds to supplement your operating budget, consider a Roth Conversion.  Yes, you will still have to pay the income tax liabilities incurred because you received these Inherited Traditional IRA distributions.  However, now these funds can capitalize on The Power of Compounding and grow tax-free for the rest of your lifetime.

Tax Tip

If the Inherited Plan is in the form of a Roth IRA, you should consider deferring the entire Inherited Plan distribution until the very end of 10-year period in order to capitalize on
The Power of Compounding and allowed these funds to grow tax-free during the 10-year period.

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