Managing Your Finances
DEFINED BENEFIT PLANS
Also known as pension plans, these plans promise the participant a specified monthly benefit at retirement. Available for all businesses, this retirement plan is usually fully funded by the employer. It has required employer contributions that may vary based on the performance of the plan assets.
- Traditional - The plan may state the promised benefit as an exact dollar amount, or it may calculate a benefit through a plan formula that considers such factors as salary and service.
- Cash Balance - The benefit amount is computed based on a formula using contribution and earning credits, and each participant has a hypothetical account. Cash balance plans are more likely than traditional defined benefit plans to make lump sum distributions.
DEFINED CONTRIBUTION PLANS
Retirement plans in which a certain amount or percentage of money is set aside each year by a company for the benefit of each of its employees. The defined-contribution plan places restrictions that control when and how each employee can withdraw these funds without penalties.
Contributions made to defined-contribution plan may be tax-deferred. In traditional defined-contribution plans, contributions are tax-deferred, but withdrawals are taxable. In the Roth 401(k), contributions are taxable, but withdrawals are tax-free if certain qualifications are met. The tax-advantaged status of defined-contribution plans generally allow balances to grow larger over time compared to taxable accounts.
NON-QUALIFIED DEFERRED COMPENSATION PLANS
An excellent strategy for high income earners
An alternative or supplement to qualified plans (401k, SIMPLE IRA, SEP IRA) is non-qualified deferred compensation. More specifically, compensation that has been earned by an employee, but not yet received from the employer. Because the ownership of the compensation - which may be monetary or otherwise - has not been transferred to the employee, it is not yet part of the employee's earned income and is not counted as taxable income.
NQDCs emerged because of the cap on contributions to government-sponsored retirement savings plans. High-income earners are unable to contribute the same proportional amounts to their tax-deferred retirement savings as average or low-income earners. NQDCs, therefore, are a way for high-income earners to defer the actual ownership of income and avoid income taxes on their earnings while enjoying tax-deferred investment growth.
These programs offer employers a flexible way to reward and retain key employees.