What is a Qualified Plan and How Does It Work?

401(k)s & IRAs belong to a class of retirement vehicles called Qualified Plans. By meeting the requirements of Section 401 of the Internal Revenue Code, 401(k)s qualify for certain tax treatment, the most significant being that both employer and employee contributions are tax-deductible in the year they are made, and the employee pays income taxes only when money is withdrawn. Qualified plans include, but are not limited to IRAs, 401(k)s, Thrift Savings Plans (TSP), Tax-Sheltered Annuities (TSA), 403(b)s, 457s, pension, and profit-sharing plans.

There are two types of Qualified Plans; Defined Benefit Plans and Defined Contribution Plans.

A Defined Benefit Plan (traditional pension plans) is a promise to pay a specific monthly benefit upon the participant’s retirement and thereafter to any surviving spouse. It can be stated as a fixed monthly dollar figure such as $1,000 per month, or the plan may use a benefit formula to calculate an amount based on the participant’s salary during a certain time frame and the participant’s years of service. Pensions came to be known as defined benefit plans because the future benefit the participant will receive is defined. What is undefined was how much it would cost the employer to provide this benefit to the participant.

A Defined Contribution Plan is a plan in which an employee’s benefits during retirement depend on the contributions made by the employer, employee, or both, and the investment performance of the assets in his or her account, rather than the employee’s years of service and earnings history. Each plan participant can voluntarily set aside a portion of their pay into their own individual investment account. Since they have not received the money they set aside, they aren’t taxed on it. This reduces their taxable income. And since they haven’t received the profits that grow inside the account, the profits aren’t taxed either (until withdrawn, that is).

Only 1 in 7 Americans (14%) in the private sector (i.e., non-government workers) are covered by a defined benefit pension plan. Only 2 in 5 Americans (42%) in the private sector are covered by a defined contribution retirement plan, e.g., a 401(k) plan (Source: Employee Benefit Research Institute).

Qualified Plan - RocksThe pension plan promises the participant a monthly retirement income, but the cost to the company is unknown. By contrast, the company’s cost to contribute to the 401(k) plan is fixed and the participant is the one who doesn’t know what the account will be worth in the future. Thus, with a 401(k) plan, the cost of the contribution is defined, not the benefit. Thus, 401(k) plans came to be known as defined contribution plans.

Defined Benefit Plans are very hard to come by in this day and age, especially in the private sector. Defined benefit plans were the standard for most of working American’s retirement incomes, but over the last several decades there has been a trend to replace them with Defined Contribution Plans. In other words, companies have intentionally and proactively shifted the burden of providing retirement security from the company to their workers.

Let me illustrate with an example:

Assume Max started at a job years ago earning $20,000 per year and gets a 3% annual raise. By the time he retires in 30 years, he’s earning $47,131. If his pension is equal to 70% of his highest pay, Max will get a pension of $32,992 each year. If Max lives 30 years after retiring, his company will pay a total of $989,758.

But if the company instead offers Max a 401(k) plan and contributes 5% of Max’s salary to it each year, the company will pay a total of $47,575.

No wonder companies are abandoning pension plans in favor of 401(k)s!

Relatively few of today’s workers will receive an employer or union pension in retirement and most everyone expects Social Security benefits to be lower in the future. If you don’t prepare for your own retirement, no one else will do it for you. Retirement security is almost entirely up to you.

If you’re interested in learning more about qualified plans download our FREE report entitled “Is Your IRA/401(k) a Ticking Time Bomb?” We also encourage you to contact us to schedule a time to talk about your specific circumstances.


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