Workplace plans

We’ll cover the following workplace plans in this chapter:

• Qualified defined benefit plans
• Qualified defined contribution plans
• Non-qualified plans

Qualified defined benefit plans

Defined benefit plans are a type of qualified plan involving varying employer contributions and a specific retirement benefit that is “defined.” The most common form of a defined benefit plan is a pension. Over the past several decades, pensions have fallen in popularity due to the burden they place on the employer. Organizations offering pensions are typically obligated to pay their retired employees until death. 20 years or more of service is typically required for an employee to gain access to their pension.

Qualifying employees usually receive benefits based on their salary during their working years. For example, some organizations offer retirement benefits equal to 70% of the average of their employees’ top three years of earnings. If an employee’s top three years of earnings average at $100,000, their employer will pay them $70,000 (70%) every year until they die. Additionally, many pensions provide an annual cost of living adjustment for inflation purposes. Due to this structure, defined benefit plans are most beneficial for employees with large salaries.

When the employee retires, they begin collecting payments from their former employer. The pension payments must be made, regardless of the employer’s financial status. Even if the organization has a bad business year, it must still pay retirees. Because of this, many corporations do not offer pensions today. However, government-sponsored organizations like the military and police continue to offer this type of retirement plan.

To ensure pension payments can be made, employers must set aside and invest significant amounts of money for future payouts. The amount required depends on the combined salaries and ages of their workforce. The employer sets aside more money when employees have higher salaries and are nearing retirement. Future projections consider the growth of their investments and the life expectancy of their retirees to determine the amount of money the organization will be required to pay.

An unfunded pension liability exists when the projection of future payouts is more than the amount set aside. For example, an organization projects $1 million in payouts in 2030, but only expects $800,000 in the pension fund at that time. If the problem isn’t fixed, the employer will eventually bankrupt itself. Most organizations maintain insurance backing their pensions to ease the anxiety of their retirees. If bankruptcy occurs, the insurance takes over the required payouts.

Defined benefit plan payouts are 100% taxable to the retiree as ordinary income.

Qualified defined contribution plans

Defined contribution plans maintain specific “defined” contributions and an unknown retirement benefit. Meaning, participating employees know what they put into these plans, but do not know how much they’ll have at retirement. Most plans allow employees to contribute a specific amount (e.g., 7% of salary) and invest their contributions. Additionally, employers can make contributions on behalf of employees (e.g., matching contributions up to 5% of the employee’s salary). Depending on their investments’ success, the retirement benefit can vary. All of the plans discussed in this section maintain the same general tax structure:

• Pre-tax (deductible) contributions
• Tax-deferred growth
• Distributions taxable as ordinary income

401(k) plans

The 401(k), which is named after section 401(k) of the internal revenue code, is arguably the most well-known and popular qualified retirement plan. Only available to private (non-government) for-profit companies, 401(k)s allow employees to save pre-tax money for retirement. Additionally, employers may match their employee’s contributions, encouraging faster growth of retirement assets.

Current employees generally cannot pull money out of their 401(k), but can apply for a hardship withdrawal if facing financial problems. However, standard distribution rules apply. If the employee is under 59 ½, they are subject to a 10% early withdrawal penalty and additional ordinary income taxes. Once the employee is terminated (quits, is fired, or retires), they gain access to 401(k) funds, although taxes and some penalties may apply.

The 2024 employee contribution limit for 401(k) plans is $23,000.

403(b) plans

A 403(b) plan is similar to a 401(k), but is utilized by non-profit organizations, public school systems, and religious organizations. Sometimes referred to as a tax-sheltered annuity, 403(b) plans offer their employees a few options at retirement. The retiree can take their money from the account, roll it over to another retirement account, or turn it into an annuity that will pay them until death.

The 2024 employee contribution limit for 403(b) plans is $23,000.

Keogh (HR-10) plans

HR-10 plans, also known as Keogh (pronounced key-o) plans, are created for smaller professional practices (like a dentist’s office or law firm). The employer (e.g., the dentist that owns their practice) has a 2024 contribution limit of $69,000 or 25% of their income, whichever is less. When the employer makes a maximum contribution to their own plan, they must make a matching contribution to their employees’ plans (e.g., the dental hygienists in a dental practice) equal to 25% of their (the employee’s) income.

Profit-sharing plans

Profit-sharing plans are exactly what they sound like. Businesses offering these plans provide extra incentives for employees to perform well in their roles as a specified percentage of profits is pledged to be shared annually with employees. For example, a company commits 10% of its profits to its employees’ profit-sharing plans. Employees do not contribute to these plans, and employers are not obligated to contribute themselves. Obviously, there will be no profits to share if the business is unprofitable. Even if the company is profitable, the employer can refuse contributions in any given year. This structure provides flexibility to the employer if they face financial difficulties while incentivizing employees to remain productive.

Money purchase plans

Money purchase plans are similar to profit-sharing plans, with two exceptions. First, contributions to money purchase plans are not based on the company’s profitability. Second, contributions must be made every year. For example, a company contributes an amount equal to 4% of its employees’ salaries annually. Some money purchase plans allow employees to contribute on top of the employers’ funds, but those that do typically require employee contributions to be made annually.

SEP & SIMPLE IRAs

Later in this unit, you’ll learn about individual retirement accounts (IRAs). IRAs are not always employer-sponsored, but SEP IRAs and SIMPLE IRAs are. Simplified Employee Pension (SEP) IRAs and savings incentive match for employees (SIMPLE) IRAs are structured specifically for smaller companies. They are similar to Keogh plans, but with insignificant differences that you won’t need to know for the exam. You shouldn’t expect specific test questions on their contribution limits, but you may need to know that they are larger than traditional and Roth IRA contribution limits (discussed later).

Non-qualified plans

Non-qualified plans are not governed by the Employee Retirement Income Security Act (ERISA), meaning they are not required to conform to the rules discussed in the previous chapter. One of the benefits of not being ERISA governed is the ability to discriminate, allowing employers to pick and choose who they offer them to. While qualified plans must be provided to every full-time employee, employers can offer non-qualified plans only to their executives, officers, directors, or whoever they wish.

Deferred compensation plans

A common type of non-qualified plan is a deferred compensation plan. These plans offer money to employees in the future and are typically only provided to higher-up employees of a company with large salaries. If an employee makes $500,000 annually, they could defer $100,000, invest the funds, and distribute the basis (amount invested) and growth in retirement. The employee only pays taxes on the compensation once they receive it later, reducing their tax burden in the year they defer their salary.

457 plans

A 457 plan is another type of non-qualified plan that is only available to government and certain non-profit organization employees. It is a unique non-qualified plan as it allows tax-deductible contributions and tax-deferred growth. Unlike all other retirement plans, early withdrawal penalties do not apply to 457 plans.

The 2024 contribution limit for 457 plans is $23,000.

Rollovers

When retiring or quitting a job with a qualified plan, many investors roll their retirement plan assets into IRAs. Funds transferred from one retirement account to another (known as a rollover) are not subject to taxation. Investors generally have 60 days from receiving a distribution to roll it over tax-free into another plan.

Rollovers allow investors to keep their assets tax-sheltered and provide additional investment options. Most qualified plans place limitations on the types of investments they allow. IRAs are only prohibited from short sales, margin, and some option strategies* with unlimited risk potential.

*In particular, an investor cannot sell uncovered (naked) options due to the significant risk involved.