To ensure a financially secure retirement, it is essential to set up a plan early in life or immediately if you have not already. You can do it by investing a percentage of your income in a tax-advantaged retirement savings plan. Your wealth may increase enormously, allowing you to reach financial security throughout your so-called golden years. However, this article compiled many types of pension or retirement plans. As a result, you can easily plan your financial for retirement.
List of Contents
- The Definition of a Pension Plan
- Defined Benefit Plans
- Types of Defined Benefit Plans
- Defined Contribution Plans
- Types of Defined Contribution Plans
The Definition of a Pension Plan
A pension plan is an employee benefit in which the company aims to make monthly contributions to a pool of money put aside to finance payments. The purpose is to qualify employees once they retire. However, pension plans are becoming more scarce in the private sector of the United States. They have mostly been supplanted by less expensive retirement benefits for companies such as the 401(k) retirement savings plan. According to the Bureau of Labor Statistics, approximately 15% of private employees in the United States are now covered by a defined-benefit plan. Pension plans are classified into two main types: defined benefit and contribution plans.
Defined Benefit Plans
A defined benefit plan is an employer-sponsored retirement plan that guarantees retirement income for eligible employees. It is an alternative to a defined contribution plan, which provides employees greater flexibility over account contributions. Since defined benefit plans are more expensive for businesses, they have fallen out of favor. However, they can still be found in public organizations, government positions, and a few for-profit businesses.
Types of Defined Benefit Plans
Genuinely, there are several varieties of defined benefit plans. They consist of Pensions and Cash Balance Plans.
These plans give income for retirement based on a predetermined formula. Typically, the calculation considers your overall wages and the number of years you have worked for the company. Once employees reach the plan-specified retirement age, they normally begin receiving payments that continue until their downfall. Moreover, some pensions also provide the transfer of payments to a spouse or other beneficiary upon the employee’s death.
2. Cash Balance Plans
Rather than a monthly wage, these provide employees with a lump sum upon separation from their employment. Typically, an employee’s compensation is based on the length of service to the employer.
Defined Contribution Plans
A defined contribution plan requires the employer to make a particular contribution for each employee covered by the plan. Employee contributions might match this. Importantly, the employee’s final benefit is determined by the plan’s investment performance. When the total contributions are depleted, the company’s responsibility ceases. However, although the word “pension plan” is often used to refer to the classic defined-benefit plan, the 401(k) plan is a type of this plan. A company can afford to sponsor a defined-contribution plan since the long-term expenses are impossible to predict. They also made the company liable for any shortages in the fund.
Types of Defined Contribution Plans
Genuinely, there are several types of defined contribution plans other than 401(k) such as 403(b) plans, 457(b) plans, thrift savings plans, employee stock ownership plans, and profit sharing plans. You can read more details as follows.
1. 401(k) Plans
A 401(k) is a retirement savings plan. An employer offers it to help you plan for the future. Moreover, it also provides you with significant tax benefits. Employees who participate in a 401(k) plan can direct a certain portion of their income to be automatically deducted from each paycheck and placed in their retirement savings account. Significantly, employers offer a wide variety of retirement plans, including the following.
Traditional 401(k) Plans
Inside a traditional plan, employees contribute a part of their pre-tax salary to their 401(k). However, before deducting the employee’s 401(k) contribution, withhold Social Security and Medicare (also known as FICA tax) from the employee’s gross income. In addition, some companies match a percentage of an employee’s 401(k) contributions under this scheme. Employer matching and nonelective contributions are exempt from FICA and federal income tax.
Safe harbor 401(k) Plans
A safe harbor 401(k) plan is a form of a retirement plan that passes the nondiscrimination test. In contrast to a regular 401(k) plan, you are not required to pass an ADP and ACP exam annually. Importantly, small companies choose safe harbor 401(k) plans as they save employers the time and money required to pass annual nondiscrimination exams. However, you are obligated to contribute to each employee’s safe harbor retirement plan. Nonetheless, with a safe harbor plan, you are required to contribute to an employee’s 401(k), regardless of their position, salary, or length of service.
SIMPLE 401(k) Plans
With 100 or fewer employees, a SIMPLE 401(k) plan is appropriate for small company owners and self-employed professionals. This plan type is a streamlined version of the regular 401(k) plan. It combines the characteristics of a conventional plan with the ease of a SIMPLE IRA. Additionally, no nondiscrimination tests are required with a SIMPLE 401(k).
Under a SIMPLE 401(k) plan, contributions are irrevocable as soon as they are made. However, participants in a SIMPLE 401(k) plan are ineligible for contributions and accruals from other employer-sponsored retirement plans.
Roth 401(k) Plans
A Roth 401(k) plan is comparable to a standard 401(k) plan. With a Roth 401(k), contributions are deducted after taxes, not before. Before deferring an employee’s gross pay to a 401(k) plan, withhold taxes from the employee’s compensation. Withdrawals from standard 401(k) funds are taxed at ordinary income rates upon retirement. However, distributions are normally tax-free.
Solo 401(k) Plans
The important point of these plans is that you cannot offer your workers a solo 401(k) plan. A solo 401(k) plan has only one participant: you. It is a standard 401(k) plan created for company owners and self-employed individuals with no workers other than their spouses and business partners. The plans permit both employer and employee contributions from the employer. This enables company owners to optimize their contributions to retirement plans and corporate deductions. All payments you make are tax-deductible.
2. 403(b) Plans
A 403(b) plan is a retirement account created for some public school and other tax-exempt organization workers. Teachers, school administrators, academics, government professionals, nurses, physicians, and librarians may participate. The 403(b) plan is similar to the more popular 401(k) plan. It permits members to save for retirement through payroll deductions while enjoying certain tax advantages. Optionally, the company may match a portion of the employee’s contribution.
A Traditional 403(b) Plan
A traditional 403(b) plan permits the employee to have pre-tax funds withdrawn from each paycheck and deposited into a personal retirement account. The employee has set aside funds for the future while also reducing the gross revenue and income taxes owed for the year. This money will not be subject to taxes until the employee withdraws it.
A Roth 403(b)
A Roth 403(b) requires after-tax dollars to be deposited into the account. There are no immediate tax benefits. However, when the money is taken, the employee owes no further taxes or the interest it accrues.
3. 457(b) Plans
If you are an employee of a state or local government, such as a teacher or a police officer, you might likely be qualified to join a 457(b) plan. Nevertheless, eligibility requirements vary from state to state.
4. Thrift Savings Plans (TSP)
The best method to ensure that your retirement income will meet your needs is to begin saving in the Thrift Savings Plan (TSP) at the outset of your federal employment and to continue doing so throughout your career. It is an investing and retirement savings plan for government employees. The TSP is designed to provide retirement income through savings and tax-deferred benefits, which many private companies offer to their employees.
5. Employee Stock Ownership Plans (ESOP)
ESOP plans are methods of employee pay that give workers a stake in the company. It is also known as an employee stock purchase plan (ESP) or an employee stock option plan (ESOP). In other terms, an ESOP plan is a benefit program for employees comparable to a profit-sharing plan. However, ESOP plans are divided into five categories as follows.
Options on employee shares are a fairly common type of employee ownership. In this form, employees have the right, but not the responsibility, to acquire company shares. They accomplish this by offering them the opportunity to purchase firm shares below the current market price.
Employees’ Stock Purchase Plan (ESPP)
With ESPPs, employees get a specific amount of firm shares at a discount to their Fair Market Value (FMV). Most ESPPs endure a certain period. It stipulates that workers must retain their shares for a specified period after acquiring them. By issuing employee shares through ESPPs, corporations can reduce their portion of an IPO’s costs.
Restricted Stock Units (RSU)
Restricted Stock Units are employee rewards based on a particular company’s or employee’s total incentive scheme success. It is a sort of ESOP scheme in which employees get stock upon satisfying specific requirements. For example, if your company’s stock performs well, the RSU plan would reward your employees with shares of stock if it reaches a certain price or value.
Stock Appreciation Rights (SARs)
SARs enable employees to earn income depending on the appreciation of their company’s shares over a predetermined time. It grants employees ownership without exposing them to downside risk. SARs are not eligible for the same tax advantages as conventional ESOPs. However, they are advantageous for employees with a long-term perspective of their organization and who wish to profit from corporate stock appreciation.
Phantom stock is a kind of long-term deferred compensation in which an employee gets business shares without the actual transfer of ownership. This program tries to link employees with company owners by allowing them to gain the same advantages without giving up stock.
6. Profit Sharing Plans
This kind of plan provides a win-win situation for both employees and employers. It motivates employees to put up their best efforts in the business, which generates more earnings and increases the company’s wealth. As a result, both sides benefited from higher earnings.
After each year or quarter, employees covered by this plan are rewarded cash or shares in the organization or corporation. Consequently, individuals receive immediate feedback on their contributions to the company. The biggest downside of this sort of plan is that the employees’ increased income is taxed as normal income.
Profit-sharing is channeled into a specialized fund known as the trust fund, which pays incentives to employees at a later period, generally at retirement. As a result, a deferred plan avoids immediate taxes on the employee’s earnings. Furthermore, the qualifying investment plan offers employees a variety of investment options. In addition, when contributions rise, so does the retirement compensation.
As the name implies, this plan is a hybrid of the two previously described plans, with a portion of the contribution paid in cash regularly and a portion deferred into a trust fund to be paid at retirement.
To summarize, even though there are many types of retirement plans, you still have to protect your financial future by setting aside the maximum annual amount. The sooner you begin saving for your future, the faster your money will be able to compound. As a result, these tax benefits can help you create wealth even more rapidly as you won’t be burdened by taxation.
Read more: Retirement Planning