Retirement Plan Basics

Traditional pension plans tell you in advance how much your benefits will be at retirement age. Defined contribution plans, such as 401(k)s, help you save for retirement but don’t guarantee a specific benefit. Self-employed people can choose among a variety of ways to invest tax-deferred for retirement.

Retirement plans can seem like a stew of confusing terms, acronyms, and tax rules. “The different retirement accounts are a real alphabet soup, and it’s important to know the differences,” says MSN financial columnist Liz Weston.

Most, but not all, plans work on this principle: Money is taken out of your earnings before it’s taxed, letting your savings grow tax-deferred. You pay taxes when you begin withdrawing money from the accounts. Generally, you can begin taking money out penalty-free at 59 ½, and must start distributions at 70 ½.
The different retirement accounts are a real alphabet soup, but it’s important to know the differences.
Here are the basics on the most common types of retirement plans:
Defined benefit plan (pension)
Better known as a pension, a defined benefit plan guarantees you a monthly check for life. Employers make all the contributions to the plan and they are based on a formula that takes into account age, pre-retirement salary and length of employment with the company.

Defined benefit plans are now rare at large corporations but are gaining popularity with very small business owners age 50 and over as they may require larger contributions that can help accelerate retirement savings.
Defined contribution plan
A defined contribution plan — such as a 401(k), 403(b), or 457(b) plan —doesn’t guarantee payouts at retirement. Instead, employees put aside a percentage of pre-tax salary from each paycheck in investments similar to mutual funds. Employees generally select their investments from a menu of funds chosen by the employer sponsoring the plan. Contributions, plus any earnings, grow tax-deferred.

In 2015, employees can contribute up to $18,000 to a defined-contribution plan if under age 50 – and if you’re 50 and up you may contribute an additional $6,000.

  • 401(k) plans
    Because of their flexibility, 401(k)s are by far the plan most offered by companies with more than 25 employees. To encourage participation, employers often match a percentage of employee contributions up to a certain amount.

    For example, the employer might offer a 50% match, up to the first 6% of salary deferred. On a salary of $100,000, the employee would need to contribute at least $6,000 to get the full matching contribution. If the employee decided to contribute more, say $10,000 (10% of pay), the company will still put in $3,000 (50% of $6,000).

  • 403(b) plans
    These are similar to 401(k)s for public sector employees, such as teachers and nonprofits. The two main differences between 403(b)s and 401(k)s:
    • There’s generally not an employer match.
    • You may be limited to investing in insurance products.

  • 457 plans
    These are offered by governmental entities and municipalities. Unlike a 401(k) or 403(b), you will not be hit with a tax penalty for making an early withdrawal from the plan before age 59 ½.

    Some businesses offer a Roth option within their plan. It works a lot like a Roth IRA: You put in after-tax dollars, the money grows tax- free, and generally you don’t owe taxes when you withdraw the funds in retirement. One key difference is anyone can make Roth contributions to their employer’s plan – unlike the Roth IRA, your eligibility to make contributions is not subject to income limitations.
Retirement plans for small business owners
Small business owners can select among a variety of retirement savings plans such as the Individual 401(k) , SIMPLE IRA and SEP IRA.

  • Individual 401(k)
    This type of retirement plan is for entrepreneurs with no employees. As with a typical 401(k), you can have either a Traditional or Roth 401(k).

    The chief advantage of an Individual 401(k) is that because you can contribute as an employee and an employer, you may be able to maximize retirement contributions.

    For 2015, as an employee, you can put away 100% of your compensation up to $18,000 a year ($24,000 if you’re 50 or older). Then, as the boss, you can contribute even more as a profit sharing contribution: employee plus employer contributions can total up to $53,000 of earnings ($59,000 if you’re 50 or older) in 2015. To see why this can be advantageous if you want to maximize contributions, on compensation of $100,000, between the salary deferrals and profit sharing contributions, you could put away as much as $43,000 ($18,000 + $25,000) in an Individual 401(k) compared to a maximum of $25,000 in a SEP.

    Any business owner can set up a SEP IRA, but you must have fewer than 100 employees for a SIMPLE IRA.

    Two other key differences:

    • Contributions to a SEP IRA are flexible and funded only by the employer to all eligible employees. As the employer, you can put in up to 25% of your compensation in 2015 or $53,000, whichever is less. The advantage of the SEP is that contributions are not required for any given year so you choose the level of funding, if any, based on your cash flow and profitability for your business.

    • A SIMPLE IRA is funded by both employees and employers. The 2014 contribution limit for employee contributions to a SIMPLE IRA is $12,500 ($15,000 if you’re 50 or older). As the employer, you will be required to choose either a match on employees’ contributions dollar-for-dollar up to the first 3% of an employee’s pay or to make a 2% non-elective contribution for each eligible employee.

Key Points:

  • Knowing how the rules vary for tax-advantaged retirement savings plans can help you choose the best plan for your business. Your tax advisor is in the best position to help you decide.
  • With a defined-benefit plan or pension, a formula determines how much you’ll receive in payouts during retirement.
  • Self-employed people can sometimes invest more in their retirement plans than employees.
  • If you are in your 20s, 30s, or 40s the Keys to retirement success video may provide ideas on how to save for retirement.

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