29 January 2016

Five Traits of Retirement Plans

For many people, an interest in a retirement plan, such as a profit-sharing plan, 401(k) plan, or individual retirement account (IRA), is their most significant asset. Planning for these assets is a real challenge.

The complexity in this area is monumental. There are many different types of retirement plans. The retirement plan that we are focusing on is sometimes called a “qualified defined contribution plan” or, popularly, a profit sharing plan or 401(k) plan. An IRA is a similar type of plan for purposes of discussing distributions from the plan. Note, however, that a Roth IRA is subject to a different set of rules than what is set out below.

These qualified defined contribution plans, including profit sharing plans, 401(k) plans and IRAs, are different from pensions. With a pension, a person gets a certain amount per month for the rest of his or her life—the future benefit is set. With a qualified defined contribution plan, the plan beneficiary has a right to a sum of money now based on contributions—however, the future benefit is not set; it may go up or down.

Qualified defined contribution plans are different from nonqualified defined contribution plans. A typical nonqualified defined contribution plan would be a bonus plan, where the employer or employee defers payment of the bonus until some later time.

A big difference between qualified and nonqualified defined contribution plans is how they are treated under the Tax Code. A retirement plan is a “qualified plan” if it meets certain requirements in the Tax Code. With a qualified plan, the employer gets a deduction for contributions to the plan when the contribution is made. This happens even though the employee does not realize income until she later withdraws the money from the retirement plan.

Qualified defined contribution plans have become increasingly popular in the last fifty years. There are many of these plans around, and a person can accumulate a sizable balance in one of them.

The Five Traits

There are five general traits to keep in mind when thinking about these plans. There are exceptions and permutations to these traits. However, the traits have broad enough applicability that they will help us think about potential alternatives for distributions from these qualified defined contribution plans.

Here are the five traits of qualified defined contributions plans:

  1. Plan income grows tax free.
  2. Plan distributions carry an income tax liability.
  3. There are required plan distributions.
  4. There are restrictions on transferring interests in these plans.
  5. The plan owner has ultimate responsibility for plan distributions and transfers.

Next week we’ll discuss the first two traits. Stay tuned …