Tax-Qualified Plans
Tax-qualified retirement plans come in two types: defined benefit plans and defined contribution plans.
A defined benefit plan is a qualified plan where the employer promises to pay the employees a specific benefit for life, starting at retirement. The most common example of the defined benefit plan is the pension plan. These plans are typically funded and managed by the company or organization that employs the participant, so all the investment decisions are made by the employer, and it is the employer’s responsibility to make sure enough money is set aside for the employees’ retirement.
Defined benefit plans usually rely on actuarial models that calculate the amount of benefit based on an employee’s age, earnings, and years of service. Employees accrue benefits as time passes, and if they leave a company before retirement, they are entitled to their vested benefit. Vesting is the process by which employees accrue ownership of their retirement benefit, such that the longer they work for the company, the greater percentage they own. An employee is fully vested when he owns 100% of the assets.
Typically, vested benefits are held in a trust for the employee until retirement. Then they are paid out as a lifetime annuity. Withdrawals are taxed at an ordinary income rate.
A defined contribution plan is a qualified retirement plan in which the contribution is defined but the ultimate benefit to be paid out is not. In this kind of plan, participants contribute a portion of their paycheck to the plan; participants have their own individual accounts and choose from several different investment options. Employers may match all or part of the employee’s co