Employer-sponsored plans are a staple of retirement income for most individuals. There are two main types of plans: defined benefit plans and defined contribution plans. Defined benefit plans are traditional pensions, which typically offer retirement benefits based on salary and length of service. These plans have become less popular in recent years. Retirement income from defined contribution plans depends on the amount of money contributed and the investment performance of the account.
Because employees are often responsible for taking the initiative to participate and fund defined contribution plans, tax planning is key. If you are employed by a company that offers matching contributions, take advantage by contributing at least enough to get the full match. In addition to lowering your current taxable income, your contributions have the potential for tax-deferred growth. Let's take a look at some popular defined contribution plans.
401(k) plans are qualified retirement plans offered by many employers, including tax-exempt organizations. As an employee, you can contribute a certain percentage of your salary, as defined by the plan, or up to the contribution dollar limit, whichever is less.
The limit for elective salary deferrals is $18,000 in 2016. Those age 50 and older can contribute an additional $6,000. You do not pay taxes on contributions until you receive money from the plan, which is usually when you retire and are probably paying taxes at a lower rate.
Some employers match a portion of employee contributions and may also make additional contributions on behalf of employees. These company contributions may be distributed according to the plan's vesting schedule. So, if you leave employment before you are fully vested, you may not receive all of the company's contribution. You will, however, always be 100% vested in the funds you have contributed and their earnings.
Self-employed taxpayers may also make deductible matching contributions to their 401(k) plans.
A Roth option may be available to those participating in traditional 401(k) plans. Like the Roth IRA, contributions to a Roth 401(k) are made with after-tax dollars, and earnings and distributions are tax free, provided you have owned the account for five years and are at least 59½ when you make withdrawals. However, unlike the Roth IRA, Roth 401(k)s have no income restrictions, and they are subject to the more generous elective salary deferral limits that apply to conventional 401(k)s — $18,000 for taxpayers under the age of 50 and $24,000 for older workers in 2016.
You may choose to designate all or part of your elective 401(k) contributions as Roth contributions. However, matching contributions made by an employer must be invested in a traditional account, not a Roth. Participants in 401(k), 403(b), and 457(b) plans are permitted to roll over funds into Roth accounts within their plans, if available. Because contributions to traditional 401(k)s are made on a pre-tax basis, any funds transferred from traditional to Roth 401(k) accounts are taxed in the year of conversion.
Savings Incentive Match Plans for Employees (SIMPLEs) can be adopted by companies with 100 or fewer employees who earned at least $5,000 last year. The plan must be made available to every employee who made at least $5,000 in each of the previous two years, and owner-employees are allowed to participate.
SIMPLE programs can be designed as either an IRA plan or a simplified 401(k) plan. With certain required contributions, these plans are not subject to nondiscrimination rules.
Employees can contribute up to $12,500 to a SIMPLE in 2016. Participants age 50 or older may make additional contributions of $3,000.
The employer must match the contribution dollar for dollar, up to 3% of the employee's compensation, or make an overall 2% contribution to every eligible participant. All contributions to a SIMPLE account are immediately fully vested.
To see how SIMPLE and 401(k) plans stack up against each other, click here.