Types of Retirement Plans
Qualified Retirement Plans:
Substantial tax advantages can be gained through retirement plans qualified under the Internal Revenue Code. Most people know these plans as Pension and Profit Sharing Plans. Many different types of plans can be adopted. Most fall in one of two major categories. They are usually either classified as "defined contribution plans" or "defined benefit plans." A defined contribution plan is one which provides an individual account for each participant. A typical example is a profit sharing plan. Another example is a 401(k) plan. A defined benefit plan is one which provides for the payment of definitely determinable benefits to employees over a period of years, usually for life, after retirement. An example is a pension plan providing a benefit of a fixed percentage of average compensation over some time frame such as three (3) percent of average compensation for the high three (3) years.
A pension plan can either be a defined contribution or a defined benefit plan, depending on how it is structured. In order to have a plan "qualified", stringent qualification criteria that are set out in the Internal Revenue Code must be complied with. Nondiscrimination rules, vesting schedules, participation and eligibility rules and many other technical requirements must be followed to obtain this status. Qualified Plans offer substantial benefits. These qualified plans allow the employer to take a current business expense deduction for his contributions even though employees are not currently taxed on them. Certain limitations do exist to employer deductability and employee exclusion from income. The employee would generally have to pay no tax until the benefit is actually distributed. Distribution from these plans may also be eligible for special tax treatment and could enjoy continued deferral by roll over to an individual retirement account, or annuity (IRA) if certain conditions are met. A qualified plan further allows earnings within the plan to accumulate on a tax free basis. A vast amount of wealth has been accumulated within qualified plans because of the tremendous tax advantages.
Individual Retirement Accounts
If you are not an active participant in a qualified plan, you could establish an IRA, or even if you are an active participant, if you are below certain income threshold levels, you could defer taxation on $5,000.00 (indexed for inflation and an increased amount for persons near retirement) in contributions yearly and have the funds grow on a tax deferred basis. Even if you do not qualify for a pre-tax contribution to an IRA, you may still make a contribution on an after tax basis and any income or profits will still be tax deferred. No deduction is allowed for contributions to an IRA made after age 70 1/2 (age before close of the tax year for which contribution is made). There are different types of IRAs, including traditional IRAs and Roth IRAs. These rules change over time and your attorney or financial adviser should be consulted.
Non-Qualified Retirement Plans
Plans that are not qualified are often used to provide additional benefits for key employees. They are not subject to the onerous qualification rules and can provide benefits to a select group of persons. However, they also do not enjoy the special tax benefits of qualified plans. They can take many forms which will determine their tax treatment. Since their tax effect can vary dramatically, it is important to make a determination on plan design early in the planning process. Usually this non-qualified plans have substantial business goals as their main focus, with taxation to the employer being of less importance.