Demystifying the Law: Retirement Plans Overview

Posted May 5, 2011 in Demystifying the Law by

IRA, 410(k), pensions, annuities, Social Security…welcome to the world of retirement plans! It can be a confusing topic, but today’s blog will try to demystify retirement plans.

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Retirement Plans Defined

A retirement plan is a financial account or agreement that provides monetary benefits after a person retires or reaches a certain age. Retirement plans fall into a few categories, including government-sponsored plans, employer-sponsored plans and personal plans.

Government-Sponsored Plans

The most common government retirement plan is Social Security, which pays benefits to retirees, their spouses, widows and children, and the disabled. There are also other types government retirement plans offered by federal, state and local governments to retired government employees.

Employer-Sponsored Retirement Plans

Broadly speaking, there are two types of employer-sponsored retirement plans: Qualified and non-qualified.

A qualified retirement plan meets certain tax and employee-benefit laws. Typically, there are tax benefits to a qualified plan. Often tax is deferred on contributions and earnings, meaning you don’t pay income tax until you withdraw the funds.

When a qualified retirement plan is created and managed by an employer, it falls under the guidance of the Employee Retirement Income Security Act (ERISA). Employers must provide eligible employees with several documents (or at least have them available) for review. One document is the Summary Plan Description (SPD).

Qualified plans must undergo annual testing to ensure highly compensated employees aren’t over-contributing compared to other employees. Employers generally have fiduciary responsibility to make sure investments are reasonable and plan guidelines are followed.

A non-qualified plan doesn’t have to meet the same legal requirements to qualify for tax benefits. This plan type could be provided to highly compensated employees in addition to a qualified plan.

Although ERISA governs qualified retirement plans, there is no law that requires employers to provide or contribute to company-organized retirement plans.

Many companies, however, choose to offer retirement plans because they offer tax benefits to both the employee and the employer. In time of low unemployment, a good retirement plan can also give an employer a competitive advantage, and help attract and retain employees.

Types of Plans:

  • Pensions: These promise that employees will receive regular payouts after requirement. Pension payments are usually calculated based on the employee’s salary and the length of service with the company.
  • Employee Stock Ownership Plan (ESOP): An ESOP allows a company to contribute some of its corporate stock to employees, who become the stock’s owners.
  • 401(k): A 401(k) plan is a type of deferred-compensation plan that allows employees to contribute a part of their earnings to a savings or investment account. Employers often offer to match a percentage of your contribution. The employee doesn’t pay tax on contributions up front, but does pay tax when withdrawing money. Withdrawals may begin at age 59 1/2 and must begin after the individual turns 70 1/2.

Common Personal Retirement Plans

One of the most popular personal, or individual, retirement plans is the IRA. There are several types of IRAs, including:

  • Traditional IRA: Allows tax-deductible individual contributions, with certain annual limits, into a savings or investment account. Withdrawals may begin at age 59 1/2 and must begin after the individual turns 70 1/2. Earnings on the contributions are taxed when the money is distributed.
  • Roth IRA: Unlike the Traditional IRA, contributions are made with after-tax dollars and no tax is paid when it is withdrawn. Like the Traditional IRA there are annual contribution limits and rules regarding distributions.
  • Rollover IRA: If an employee leaves his job, he can convert some types of qualified retirement plans into an IRA that the individual controls and manages. No additional contributions can be made to the Rollover IRA, but may be made into another qualified retirement account. Tax and distribution rules apply.
  • SEP (or Simplified Employee Pension Plan) IRA: SEP IRAs may be used by the self-employed, but employers may also use these for their employees (different rules apply to each). These plans offer higher contribution limits than a Traditional or Roth IRA. A SEP IRA receives the same tax advantages as an IRA or 401(k).
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Related Resources on Lawyers.comsm

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