What is a 401(k) Plan?
As part of the Revenue Act of 1978, Congress enacted IRS Section 401(k), which authorized employees to defer part of their salary to a qualified plan for tax purposes.
401(K) Plans have emerged as the primary retirement plan today. As an employer, you have the option to make that 401(k) a part of your Discretionary Defined Contribution Plan or as a stand-alone employee deferral-only plan which features no required contributions by the corporation or partnership. However, the sponsoring entity would have the option to match a certain percentage of the employee’s deferral. Such a contribution would increase the employee’s incentive to defer for their retirement security.
Why would an employee want to contribute?
Elective employee deferrals to a 401(k) Plan provide the participant with a number of tax advantages not available through alternative types of tax deferral vehicles. The primary advantages of a 401(k) Plan are the employee’s ability to defer taxation on money that otherwise would be subject to taxation and ease the challenge of saving for a well-financed retirement.
Beyond that, any interest earned on the contribution is tax deferred. The contribution limits that are available to the participant are far more generous than any alternative deductible or pre-tax arrangement available. In addition to the employee’s elective deferral, an employer may voluntarily make matching contributions that are also tax-deferred accumulations.
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How does a Discretionary Defined Contribution Plan operate?
A Discretionary Defined Contribution Plan provides employers with the opportunity to share company profits with their employees. The employer has the flexibility to choose a vesting schedule, which requires the employees to remain with the company for up to six years. A Discretionary Defined Contribution Plan provides the employer with a key employee retention tool and a flexible retirement plan option.
How does a Defined Benefit or Cash Balance Plan operate?
A Defined Benefit/Cash Balance Plan defines a benefit for an employee upon that employee’s retirement. A simple example is a plan that provides $100 per month for every year an employee works for a company: with 30 years of employment, that participant would receive $3,000 per month payable for their lifetime. The benefit in a defined benefit pension plan is determined by a formula, which can incorporate the employee’s pay, years of employment, age at retirement and other factors. In large part, it is driven by age.
For those desiring the maximum retirement contribution, these plans provide significant contributions to fund impressive pensions at retirement.
Description of Combination Plans:
- Discretionary Defined Contribution/401(k) Plans: The plan offers similar tax deferral opportunities and provides the employees with tax-deductible savings accounts. Companies can design the plan to reward specific employees or employee groups with special company contributions. The plan can annually select employees based upon specific company criteria. Properly constructed, the plan provides for maximum contribution allocation of $54,000, or $60,000 for those 50 years of age or older.
- 401(k) Plans: 401(k) Plans have evolved to become today’s primary retirement plan. Participants may defer up to $18,000, plus $6,000 if 50 years of age or older.
- Defined Benefit Pension/Cash Balance Plans: These plans can generate large contributions to fund maximum benefits for the owner(s) and key employees of the company. Specialized plan designs can generate contributions in excess of $100,000 for targeted participants. The Defined Benefit Pension Plan/Cash Balance Plan offers maximum deduction opportunities for those in need of large tax savings to fund retirement benefits commensurate with present income levels.