Company retirement plans come in two flavors--defined benefit (based on an ultimate benefit to be paid upon retirement) and defined contribution (based on the amount that gets put into the plan today). These are both referred to a "qualified plans" because they qualify for tax deductible contributions under section 401 of the Internal Revenue Code.
No matter what type of plan pertains to you, at least 10 years prior to retirement, make an estimate of the income you need using the retirement planning calculator and determine what portion of your retirement needs the company retirement plan will provide.
In a defined benefit plan, the benefit is spelled out such as a retired employee receives a specific amount based on salary history and years of service, and in which the employer bears the investment risk. For example, upon retirement, the employee receives from the company retirement plan 2% of their final year's salary times the number of years with the company. So if they had 20 years tenure, they would retire with a benefit equal to 40% (2% x 20) of their final year's salary. The employee, the employer, or both may make contributions.
Defined contribution plans are more common in the US and allow the employer and/or employee to make contributions, so that the final benefits depend on how much was in the account and the rate earned by the account's investments. An individual accounting must be set up for each participant in the plan although the funds can be one large pool. The federal government does not guarantee a participant's pension benefits; instead, the plan is "participant-directed", meaning that the employee makes the investment decisions based on the employer's options. Contributions have a limit of $46,000 for 2008 or 25% of the participant's total compensation. The different defined contribution company retirement plans are:
Profit sharing plan--they have nothing to do with sharing of profit so don't get excited. They should be called "discretionary plans" because management makes a discretionary decision how much to put into the plan each year. Once the amount to be contributed to the company retirement plan is decided, the formula to allocate amongst employees may be very simple, such as a percentage of salary. An employer alone makes contributions based on an employee's current-year compensation. If the employer also wants the employee to have the opiton to contribute, this is now a 401k plan.
Stock bonus plan: A type of profit sharing plan, where contributions are made in the form of company stock.
Money purchase pension plan: a company retirement plan with fixed-percentage compensation by the employers. Unlike profit sharing plans, these contributions are mandatory every year, regardless of profits or other factors. Such a plan may simply be an annual contribution by the company such as 3% of pay.
In all cases, the government allows the employer to exclude from the company retirement plan part time employees (those working less then 1000 hours annually). Additionally, those under age 21 can be excluded. Even after attaining 2 years of full time work, the plan can have only vested benefits. This means that whatever amount has been placed into the company retirement plan, it may not be fully vested to the employee until after 6 years. For example, if the employee leaves the company after 2 years, he would get 20% of what the company had contributed for him and leave the rest behind (the forfeited amount gets allocated to the remaining employees in the plan).
Employers may also have company retirement plans that are different than the above or discriminate in favor of highly compensated employees or management. These non-qualified retirement plans do not meet the IRC or ERISA requirements. These plans are funded by employers and are more flexible but they do not have the tax benefits qualified plans do. Benefits are paid at the retirement age in the form of annuities, which are taxed as ordinary income tax, or in lump sum payments, which cannot be rolled over into IRAs. One can use the fixed annuity calculator to determine if the amount paid by the company will be better or if a lump sum should be taken for purchase of an individual annuity contract.
Post provided by Javelin Marketing