Understanding different types of retirement plans
With defined benefit pension plans not as available as they once were, workers are more responsible for saving for retirement. There are several defined contribution plans that enable employees and their employers to contribute to retirement savings.
Individual Retirement Arrangements (IRAs)
An IRA is a retirement plan you establish for yourself outside of your place of employment. With a standard IRA, you can make pre-tax contributions as long as you earn taxable income. The most you can contribute to all of your IRAs is the smaller of your taxable compensation for the year or $5,500 ($6,500 if you’re age 50 or older by the end of the year).
The earnings in your IRA will grow tax-deferred. Any deductible contributions and earnings you withdraw or that are distributed from your traditional IRA are taxable. Withdrawals taken before you turn age 59 1/2 will require a 10 percent tax for early withdrawals unless you qualify for an exception. Regular IRAs impost required minimum distributions beginning at age 70 1/2.
IRAs can be established through a bank or other financial institution, or with a mutual fund or life insurance company.
Savers can also use a Roth IRA. Although contributions do not provide a reduction in taxes, the account holder will be able to take tax-free withdrawals.
A SIMPLE IRA plan (Savings Incentive Match Plan for Employees) allows employees and employers to contribute to traditional IRAs set up for employees. It is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan.
Under a Payroll Deduction IRA, employees establish an IRA (either a Traditional or Roth IRA) with a financial institution and authorize a payroll deduction amount for it. A business of any size, even self-employed, can establish a Payroll Deduction IRA program.
401(k)s
A 401(k) plan is one of the most common types of qualified retirement plan. If an employer offers a 401(k), employees can allocate a percentage of their salaries, on a pre-tax basis, to their retirement account. Employers can also contribute to their employee’s accounts.
The money inside a person’s 401(k) grows tax-deferred, meaning the account holder will not pay taxes if the account increases in value. Instead, income taxes are paid when the account holder withdraws money from the account.
Employees under the age of 50 can contribute a maximum of $18,000 in 2016. Those 50 and older and contribute $24,000.
In general, you cannot withdraw money from your 401(k) until:
You die, become disabled, or otherwise have a severance from employment.
The plan terminates and no successor defined contribution plan is established or maintained by the employer.
You reach age 59½ or incur a financial hardship.
Making a withdrawal before one of the above events will result in a tax penalty, in addition to the taxes owed on the income.
If the plan allows, you can loan yourself money from your plan, but must pay it back within a certain timeframe.
Roth 401(k)s are available, in which you can take tax-free withdrawals from the account but do not get a tax deduction for contributions.
Simplified Employee Pension (SEP)
A SEP is a retirement plan established by businesses to contribute to their employees’ retirement. It’s often used by the owners of small companies to set aside money for their own retirement, but employers can set up accounts for employees as well.
What differentiates SEPs from other types of retirement plan is that employees cannot make contributions; only the employer can. They have less startup and administrative cost than other employer-provided retirement plans.
SEPs allow an employer to contribute the lesser of $53,000 or 25 percent of the employee’s compensation to the plan.
Government retirement plans
There are two main types of retirement plans available to certain government workers. Employee contribution limits are the same as those on 401(k) plans. The combined limit of employee and employer contributions is the lesser of the employee’s compensation for the year or $53,000 in 2016. If allowed by the employer, catch-up provisions are also available.
The two types of plans include:
403(b) plans. A 403(b) plan (also called a tax-sheltered annuity or TSA plan) is a retirement plan offered by public schools and certain 501(c)(3) tax-exempt organizations.
457 plans. These plans are available for certain state and local governments and non-governmental entities tax exempt under IRC Section 501.
Profit-sharing plans
Employers can set up profit-sharing plans to make discretionary contributions to their employees’ retirement accounts. Employees cannot make contributions to a profit-sharing plan.
These type of plans allow the employer to make a certain size contribution to employees accounts one year, and a different amount another year. There can be years the employer does not make contribution at all. The main requirement is that the plan cannot discriminate against certain employees or groups of employees. The limit per employee is the lesser of 25 percent of compensation or $53,000 in 2016.
Money-purchase plans
Money purchase plans have required contributions. The employer is required to make a contribution each year for the plan participants based on the contribution percentage stated in the plan. For example, if a money purchase plan requires a contribution of 5 percent of each eligible employee’s pay, the employer will need to make a contribution of 5 percent of each eligible employee’s pay to their separate account. The contribution limit is the same as with profit-sharing plans.