Employer-Based Retirement Plans

Are you one of the lucky few whose employer provides a retirement plan? If yes, go ahead and embrace it wholeheartedly. Workplace retirement plans are one of the most effective means to save for the future. According to the Employee Benefits Research Institute, low-to-moderate income workers are 20 times more likely to save when covered by an employer-based retirement plan. Not only do you save, but you also benefit from the tax advantages.

There are two basic types of employer-based retirement plans – Defined benefit (DB) plans and Defined Contribution (DC) plans.

Defined Benefit (DB) plan

A Defined Benefit pension plan comes with an employer guarantee that you will receive a specific amount of money at retirement. The pension amount is related to the number of years you have worked at the organization and your highest earnings on the job. This amount is handed over at retirement in the form of a lump sum or monthly checks as long as you live. The Federal Government protects your DB pension benefits. Even if your employer goes bankrupt, you receive your benefits.

A DB plan begins paying your benefits when you reach retirement age and stop working. You can decide whether the plan covers you alone, or you and your spouse. If it’s the latter, your spouse receives the checks after your death.

The problem with a DB plan is that the employer alone contributes to the pension. Several companies struggle and end up with underfunded DB pension plans. When they go bankrupt, the Pension Benefit Guarantee Corporation (PBGC) takes over and pays out substantially reduced amounts to the pensioners.

Defined Contribution (DC) plan

To lessen their burden, a number of employers have shifted to the Defined Contribution plan in recent years. Here the employees take a more active role in managing their retirement income. They are responsible for investing the money during their working years.

A Defined Contribution plan comes with some risks that one needs to be aware of. It does not promise any returns, unlike a Defined Benefit plan. While the Federal Government does not guarantee the amount accumulated in your account, it protects the account assets from misuse. The total sum in your account depends on the amount invested over the years, the investment vehicles chosen and performance of those investments. Since the responsibility of retirement planning is shifted onto your shoulders, it is critical that you contribute regularly once eligible and that you choose your investments wisely.

The 401(k) plan is one of the popular types of DC plan. It is a payroll deduction plan that lets you save part of your salary for retirement. In some cases, the employer contributes to the 401(k) plan, with contributions ranging from 25% to 100% of your savings. There is usually an upper limit to the employer’s contribution into their employees’ 401(k). Occasionally employers put in company stock in lieu of cash. A plan with overloaded stock should be avoided. In the case of Enron, the company matched employees’ savings with company stock. When the company went under, the value of the employees’ retirement accounts plummeted because the Enron stock price nosedived.

Types of Defined Contribution Plans

• 401(k) plan – This is one of the most popular DC plans. It is usually offered by large organizations. The employer often matches the employee contribution.

• 403(b) Tax Sheltered Annuity plan – It is like a 401(k) but is eligible for employees of schools, churches, hospitals and certain non-profit organizations.

• Savings Incentive Match Plans for Employees of Small Employers (SIMPLE) – Businesses with 100 or fewer employees can establish SIMPLE plans, where employees allocate part of their salary into an Individual Retirement Account (IRA) and the employer matches the contribution. The employees decide on the investment options.

• Simplified Employee Pension (SEP) plan – This is designed for small businesses, that do not have other pension plans, and the self-employed. SEPs are tax-deferred retirement accounts.

• Profit sharing plan – Company profits are shared with the employees, based on their salaries.

• Employee Stock Ownership plan (ESOP) – It is similar to the profit-sharing plan except that it invests primarily in company stock. Employees share in the company ownership.

Tax Incentives

Although you, as an employee, are responsible for funding a DC plan, there are some tax breaks that make it very attractive. The money that you invest in the plan and the earnings from the DC plan are both eligible for tax deferment. This means that you do not pay income tax on the amount till you withdraw at, and hopefully not before, retirement. How does a tax deferment help? Postponing taxes means that the amount you invested in the plan and the earnings from it makes the nest egg grow faster. Add the power of compounding and the amount is substantially high. The larger the base amount available, a compound rate of interest balloons the total amount to significant proportions. A tax deduction upfront would have reduced the size of the base amount itself and consequently the final amount in the DC plan. Even though the withdrawals are taxed, the larger size of the nest egg, because of tax deferment, more than makes up for the taxes paid.

Let us say you wish to contribute $100 to your DC plan, and you fall in the 15% tax bracket. If you do not contribute to the DC plan, you pay a tax of $15 on the $100 that is part of your income. You get a net of $85 as take-home pay. On the other hand, if you do contribute $100, the entire amount goes into your DC plan and you postpone the taxes. In effect, your $100 contribution reduces your take-home pay by just $85 and not the entire $100. Meanwhile your nest egg, enhanced by your $100 contribution, grows faster and is only taxed when you withdraw.

Vesting

When an employer contributes to your DC plan, you do not have the right to withdraw the amount anytime it suits you. Until you spend a certain number of years at the company, you cannot access the money. Once you cross that period, the money becomes “vested”. You can withdraw it whenever you wish. This is called “cliff vesting”, which means that you are not entitled to the money until you complete a specified number of years at employment, but can withdraw after you do. A 401(k) plan vests after a 5-year period. No employer can force you to work longer than 7 years before you become vested in the pension benefits.

Some employers have a graduated vesting schedule. Here a certain percentage of your money gets vested each year you remain employed, until the amount is 100% vested. Some DC plans like the SIMPLE and SEP vest immediately. You can access the employer’s contribution the very day it is deposited.

Borrowings and early withdrawals

DC plans permit you to borrow money from the account, with a loan limited to half the vested amount in your account. In most cases, the loan needs to be repaid within 5 years. Borrowing can drastically reduce your nest egg, so try to avoid it.

If you wish to withdraw early from the account before retirement, you get levied a 10% penalty on the amount plus taxes. There are a few factors that allow you to avoid the penalty. Again an early withdrawal is highly avoidable.

In the event of a financial emergency, most DC plans allow you to withdraw money without incurring penalties. Unlike a loan, you do not have to repay the withdrawal. However there are a few stringent conditions to be fulfilled in order to qualify for an emergency.

Make the most of the DC plan by contributing the maximum amount possible, or as much as you can stretch yourself. Since an employer matches 25% to 100% of your contribution, the more you contribute, the faster your retirement fund grows. If you are over 50, you can put extra money in your retirement account in addition to regular contributions. Make informed investment decisions and you are well on your way to meeting your goals.

Original: http://www.advisorworld.com/2009/01/09/employer-based-retirement-plans/