In the US various types of retirement plans exist. If you understand your retirement plan options, you will be better equipped to detail your benefits and actually achieve the type of retirement plans you want. Do you want to know more about key retirement plans? Discover the different types of retirement plans and their tax advantages and disadvantages of all the retirement plans that help you save. Read through as we take you to step by step…
Key Retirement Plans, What is a Retirement Plan?
According to Wikipedia, a retirement plan is a financial arrangement designed to replace employment income upon retirement. These plans may be set up by employers, insurance companies, trade unions, the government, or other institutions. Congress has expressed a desire to encourage responsible retirement planning by granting favourable tax treatment to a wide variety of plans. Federal tax aspects of retirement plans in the United States are based on provisions of the Internal Revenue Code and the plans are regulated by the Department of Labor under the provisions of the Employee Retirement Income Security Act (ERISA).
From the definition above, We can easily understand that:
- Retirement plans provide tax advantages to individual households working in both public and private establishments and also encourage them to save for retirement.
- There are different types of retirement plans. As such, each varies in the kind of tax benefit they provide, as well as in contribution limits and withdrawal rules.
- Some retirement plans are designed for employees, others for business owners or self-employed people—and some are available to anyone.
Individually, we all know we should save for retirement. To inspire us to do so, organizations both private and the government provide tax incentives that encourage us to sock away money in a variety of different types of retirement plans. But here is the fact, Understanding the different types of retirement plans can be challenging, particularly since they have confusing names, like 401(k), SEP, and IRA.
Key Retirement Plans
If you are still a student or you are still building your career, retirement may not be top of mind at this point in your life. But someday, if you are lucky and save on a regular basis, it will be.
To help ensure you have financially secure retirement plans, it is wise to create a plan early in life or right now if you have not already done so. Start, by diverting a portion of your monthly income into a tax-advantaged retirement savings plan, by doing that, your wealth can grow exponentially to help you achieve financial stability and peace of mind during your old age
Unfortunately, just two-thirds of current employees find it easy to understand the retirement benefits offered to them, according to a survey from the Employee Benefit Research Institute two years ago.
However, there is no uniform benefit formula for retirement plans. According to David Littell, who is a retirement planning expert and professor emeritus of taxation at The American College of Financial Services. To him, one company’s benefit formula may not be as generous as others,” “It’s really important that you read the summary plan description that is provided to all participants so that you can understand the design of the plan.”
By understanding your retirement plan options, you will be better equipped to detail your benefits and actually achieve the retirement goals you want.
Types Of Retirement Plans In The US
Retirement plans in the US are classified into different types, depending on how benefits are determined. They are as follows:
- Defined contribution plans.
- Defined benefit plans.
- Hybrid and cash balance plans. Others are
- IRA plans.
- Solo 401(k) plan.
- Traditional pensions.
- Guaranteed income annuities (GIAs)
- The Federal Thrift Savings Plan.
- Cash-value life insurance plan.
- Nonqualified deferred compensation plans (NQDC)
Explaining Key Types Of Retirement Plans
- Defined Contribution Plans:
According to US Internal Revenue Code Section 414, a defined contribution plan is an employer-sponsored plan with the personal account of each participant. Here, the accrued benefit from such a plan is solely attributable to the contributions made into the participant’s personal accounts and investment gains on those funds, less any losses and expense charges.
The contributions are invested in the US stock market, and the returns on the investment are credited to or deducted from the participant’s account. Upon retirement, the participant’s account is used to provide retirement benefits, often through the purchase of an annuity. Defined contribution plans have become more widespread over recent years and are now the most dominant form of retirement plan in the US private sector. However, there is a rapid uprising in the number of defined contribution plans in the US now, as more employers see pension funding as a financial risk they can avoid by freezing the defined benefit plan and instead offering a defined contribution plan.
Examples of defined contribution plans include individual retirement accounts (IRAs), 401(k), and profit-sharing plans. In such plans, the participant is responsible for selecting the types of investments toward which the funds in the retirement plan can be invested. The participant may decide to choose one of a small number of pre-determined mutual funds to select stocks or other securities. Most self-directed retirement plans are characterized by certain tax advantages. The funds in such plans may not be withdrawn without penalty until the investor reaches retirement age, which is typically the year in which the taxpayer reaches 59 years of age.
Note: Money contributed can be from employee salary deferrals, employer contributions, or employer matching contributions. Defined contribution plans are subject to Internal Revenue Code Section 415 limits on how much can be contributed. As of 2021, the total deferral amount including the employee and employer contribution is capped at $53,000. The employee-only amount is $27,000 for 2022, but a plan can permit participants who are age 50 or older to make “catch-up” contributions of up to an additional income.
2. Defined Benefit plans:
Commonly referred to as a pension in the US, According to Wikipedia a defined benefit retirement plan pays benefits from a trust fund using a specific formula set forth by the plan sponsor. In other words, the plan defines a benefit that will be paid upon retirement. The statutory definition of defined benefit encompasses all pension plans that are not defined contributions and therefore do not have individual accounts.
While this catch-all definition has been interpreted by the courts to capture some hybrid pension plans like cash balance (CB) plans and pension equity plans (PEP), most pension plans offered by large businesses or government agencies are final average pay (FAP) plans, under which the monthly benefit is equal to the number of years worked multiplied by the member’s salary at retirement multiplied by a factor known as the accrual rate.
At a minimum, benefits are payable in normal form as a Single Life Annuity (SLA) for single participants or as a Qualified Joint and Survivor Annuity (QJSA) for married participants. Both normal forms are paid at Normal Retirement Age (usually 65) and may be actuarially adjusted for early or late commencement. Other optional forms of payment, such as lump sum distributions, may be available but are not required.
Defined benefit plans may be either funded or unfunded. In a funded plan, contributions from the employer and participants are invested into a trust fund dedicated solely to paying benefits to retirees under a given plan. The future returns on the investments and the future benefits to be paid are not known in advance, so there is no guarantee that a given level of contributions will meet future obligations. Therefore, fund assets and liabilities are regularly reviewed by an actuary in a process known as valuation. A defined benefit plan is required to maintain adequate funding if it is to remain qualified.
Also, in an unfunded plan, no funds are set aside for the specific purpose of paying benefits. The benefits to be paid are met immediately by contributions to the plan or by general assets. Most government-run retirement plans, including Social Security, are unfunded, with benefits being paid directly out of current taxes and Social Security contributions. Most nonqualified plans are also unfunded.
3. Cash Balance Plans:
The Hybrid or Cash balance plan is designed to combine the features of defined benefit and defined contribution plan designs. In general, they are treated as defined benefit plans for tax, accounting, and regulatory purposes. As with defined benefit plans, investment risk is largely borne by the plan sponsor.
As with defined contribution designs, plan benefits are expressed in the terms of a notional account balance, and are usually paid as cash balances upon termination of employment. These features make them more portable than traditionally defined benefit plans and perhaps more attractive to a highly mobile workforce. A typical hybrid design is the cash balance plan, where the employee’s notional account balance grows by some defined rate of interest and annual employer contribution.
In the United States, conversions from traditional plans to hybrid plan designs have been controversial. This is because, Upon conversion, plan sponsors are required to retrospectively calculate employee account balances, and if the employee’s actual vested benefit under the old design is more than the account balance, the employee enters a period of wear away. During this period, the employee would be eligible to receive the already accrued benefit under the old formula, but all future benefits are accrued under the new plan design.
Eventually, the accrued benefit under the new design exceeds the main amount under the old design. To the participant, however, it appears as if there is a period where no new benefits are accrued. Hybrid designs also typically eliminate the more generous early retirement provisions of traditional pensions.
Today, younger workers have more years in which to accrue interest and pay credits than those approaching retirement age, critics of cash balance plans have called the new designs discriminatory.
On the other hand, the new designs may better meet the needs of a modern workforce and actually encourage older workers to remain at work since benefit accruals continue at a constant pace as long as an employee remains on the job. As of 2021, the courts have generally rejected the notion that cash balance plans discriminate based on age, while the Pension Protection Act of 2006 offers relief for most hybrid plans on a prospective basis.
Although a cash balance plan is technically a defined benefit plan designed to allow workers to evaluate the economic worth of their pension benefit in the manner of a defined contribution plan.
The target benefit plan is a defined contribution plan designed to express its projected impact in terms of lifetime income as a per cent of the final salary at retirement. For example, a target benefit plan may mimic a typically defined benefit plan offering 1.5% of salary per year of service times the final 3-year average salary. Actuarial assumptions like 5% interest, 3% salary increases and the UP84 Life Table for mortality are used to calculate a level contribution rate that would create the needed lump sum at retirement age. The problem with such plans is that the flat rate could be low for young entrants and high for old entrants.
While this may appear unfair, the skewing of benefits to the old worker is a feature of most traditional defined benefit plans, and any attempt to match it would reveal this backloading feature.
4. The Federal Thrift Savings Plan:
The Thrift Savings Plan (TSP) is a lot like a 401(k) plan on steroids, and it is mostly available to government workers and members of the uniformed services.
Participants choose from five low-cost investment options, including a bond fund, an S&P 500 index fund, a small-cap fund and an international stock fund. Plus a fund that invests in specially issued Treasury securities.
On the other hand, federal workers can choose from among several lifecycle funds with different target retirement dates that invest in those core funds, making investment decisions relatively easy.
The good news: Federal employees can get a 5 per cent employer contribution to the TSP, which includes a 1 per cent non-elective contribution, a dollar-for-dollar match for the next 3 per cent and a 50 per cent match for the next 2 per cent contributed.
“The formula is a bit complicated, but if you put in 5 per cent, they put in 5 per cent,” says Littell. “Another positive is that the investment fees are shockingly low – four-hundredths of a percentage point.” That translates to 40 cents annually per $1,000 invested – much lower than you will find elsewhere.
The bad news: As with all defined contribution plans, there is always uncertainty about what your account balance might be when you retire.
5. Guaranteed income annuities (GIAs):
GIAs are generally not offered by employers, but individuals can buy these annuities to create their own pensions. You can trade a big lump sum at retirement and buy an immediate annuity to get a monthly payment for life, but most people aren’t comfortable with this arrangement. More popular are deferred income annuities that are paid into over time.
An example of a GIAsplan is that, at 50 years of age, you can begin making premium payments until 65 years of age if that is when you plan to retire. “Each time you make a payment, it bumps up your payment for life.
You can also buy these on an after-tax basis, in which case you will owe tax only on the plan’s earnings. Or you can buy it within an IRA and can get an upfront tax deduction, but the entire annuity would be taxable when you take withdrawals.
In addition, annuities are complex legal contracts, and it can be difficult to understand your rights and rewards for signing up for an annuity. You will want to be fully informed about what the annuity will and won’t do for you.
A 401(k) plan is a tax-advantaged plan that offers a way to save for retirement. With a traditional 401(k) an employee contributes to the plan with his or her pre-tax wages, meaning contributions are not considered taxable income. The 401(k) plan allows these contributions to grow tax-free until they are withdrawn at retirement. At retirement, distributions create a taxable gain, though withdrawals before age 59.5 may be subject to taxes and additional penalties. With a Roth 401(k) an employee contributes after-tax dollars and gains are not taxed as long as they are withdrawn after age 59.5
The good news is that a 401(k) retirement plan can be an easy way to save for old age because you can schedule the money to come out of your paycheck and be invested automatically. The money can be invested in a number of high-return investments such as stocks, and you won’t have to pay tax on the gains until you withdraw the funds or ever in a Roth 401(k). In addition, many employers offer you a match on contributions, giving you free money and an automatic gain just for saving, there encouraging and calling for more participants.
The bad news is that in 401(k) plans you may have to pay a penalty for accessing the money if you need it for an emergency. While many plans do allow you to take loans from your funds for qualified reasons, it is not a guarantee that your employer’s plan will do that. Your investments are limited to the funds provided in your employer’s 401(k) program, so you may not be able to invest in what you want to.
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