Types of Retirement Plans

If you've recently started a business, you may be considering setting up a tax-favored retirement plan for yourself and your employees. There are several types of plans that can qualify for the tax advantages of a qualified plan—a current deduction from income to the employer for contributions to the plan, tax-free buildup of plan investments and the deferral of income (augmented by investment earnings) to the employees until distribution of the funds.

There are two basic types of plans—defined benefit pension plans and defined contribution plans. A defined benefit plan provides for a fixed benefit at retirement, based generally upon years of service and compensation. Adoption of a defined benefit plan is a commitment to fund the plan. These plans will often provide the greatest current deduction from income, and the greatest retirement benefit, where the owners of the business are older and nearing retirement.

A defined contribution plan is a plan that provides for an individual account for each participant, with benefits based solely on the amount contributed to the participant's account and any investment income, expenses, gains and losses, and any forfeitures (usually from departing employees) that may be allocated to the participant's account. Profit-sharing plans are defined contribution plans.

A 401(k) plan, or cash or deferred arrangement, is a defined contribution plan, with employer contributions made at the direction of the employee under a salary reduction agreement. The employee elects to have a certain amount of pay deferred and contributed by the employer on his or her behalf to the plan. The employer may or may not provide matching contributions to the amount deferred, as provided for in the plan. This type of plan can provide tax-deferred retirement benefits for employees at little cost to an employer beyond the costs of administering the plan.

401(k) plans may also allow participants to make after-tax contributions to the plan, which can be invested tax free.

There are other types of plans within these general categories, including employee stock ownership plans (ESOPs), in which shares of stock in the employer are purchased to fund the plan.

Small businesses may adopt a “simplified employee pension” (SEP), and receive similar tax advantages to “qualified” plans by making contributions to SEP-IRAs on behalf of employees. A business with 100 or fewer employees may establish a “SIMPLE” (savings incentive match plan for employees) retirement plan. Under a SIMPLE plan, an IRA is established for each employee, and the employer makes matching contributions based on contributions elected by participating employees under a qualified salary reduction arrangement. Or, a SIMPLE 401(k) plan may be set up with features similar to a SIMPLE plan, with automatic passage of the otherwise complex nondiscrimination test for 401(k) plans.