8.2.10. Retirement Accounts
A qualified retirement plan is one that satisfies the requirements of the Internal Revenue Code. A qualified plan allows the participant (the employee) and the sponsor (the employer) to make allowed deductions from federal income taxes.
Qualified employer-sponsored 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 each eligible employee a specific periodic (usually monthly) 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. Therefore, all the investment decisions are made by the employer, and it is the employer’s responsibility to make sure that enough money is set aside for its 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. If an employee leaves a company before retirement, she is entitled to her vested benefit. Vesting is the process by which an employee incrementally accrues ownership of her retirement benefit, such that the longer she works for the company, the greater percentage she owns. An employee is fully vested when she owns 100% of the assets in her account.
Typically, vested benefits are held in a trust for the employee until retirement or until a specified age if the employee leaves the company before retirement. The vested benefits are then paid out as a lifetime annuity. Withdrawals are taxed at an ordinary income rate.
A defined contribution plan is a retirement plan in which the contribution is defined but the ultimate benefit to be paid out is not. More and more, companies are moving to defined contribution plans to avoid the high costs of pensions. In a defined contribution plan, inves