We sometimes think of employer-sponsored retirement plans as something almost generic. But there are actually several different types of plans, many of which are low cost and can help you save for retirement much faster. Which one you should choose depends on the type and size of your employer, as well as the economic sector that they are involved in.
What Is an Employer-Sponsored Retirement Plan?
Employer-sponsored retirement savings plans are useful for both employees and employers, as they present benefits like savings directly deducted from your paycheck, tax breaks and, in some cases, an employer matching of your contributions. (Hello, free money!)
Here are seven types of employer-sponsored retirement plans.
1. Defined Benefit Pension Plans
Often referred to as traditional retirement plans, defined benefit pension plans used to be the most common type of employer-sponsored retirement plan, at least until the 1970s. Today they are fairly rare, as most have been replaced by defined contribution plans.
A defined benefit pension plan is exactly what the name implies. The employee will receive a fixed monthly benefit at retirement and will not be responsible to make any contributions to the plan.
All contributions will be supplied by the employer, who will base the monthly benefit on your income and years of service. All investment decisions will be made by the employer, not the employee. And since the plan is entirely administered by the employer, the employee will have no control over the funds upon reaching retirement age.
2. 401(k) Plan
This is the most common employer-sponsored retirement plan today. They are primarily offered by large, for-profit businesses. It is a defined contribution plan funded primarily by the employee but often comes with at least a partial employer match. The employee chooses which investments in the 401(k) plan to put his or her funds into and will have complete control over the money upon reaching retirement.
In addition, the employee contributions are tax deductible in the year they are made. Investment earnings will accumulate on a tax-deferred basis. Once the employee retires and begins taking distributions, those distributions will be taxable as ordinary income.
Should the employee withdraw the funds prior to retirement, those funds can be rolled over either into a traditional IRA or into the 401(k) plan of another employer — without incurring taxes or early withdrawal penalties.
Any funds withdrawn, but not rolled over into another qualified plan, will be subject to ordinary income taxes as well as a 10% early withdrawal penalty.
Annual contributions are limited to $18,000 for 2016. If the employee is age 50 or older, there is a catch-up provision allowing additional contributions of $6,000 for 2016.
3. Roth 401(k) Plan
Some employers are also offering Roth 401(k) plans. These provide the benefits of a regular Roth IRA, but the employee contributions are the same as those for a regular 401(k) plan.
Like a Roth IRA, contributions into a Roth 401(k) are not tax-deductible. Investment earnings accumulate on a tax-deferred basis. However, distributions from the plan are tax free, as long as the employee is at least 59½ and has been in the plan for at least five years.
If distributions are taken earlier, the investment income portion of the withdrawals will be subject to regular income tax, as well as a 10% early withdrawal penalty.
An employer can offer a partial match on a Roth 401(k), however the employer contribution must be placed into a regular 401(k).
The employee contribution limit is the same as it is for a 401(k) plan — which is much more generous than for a Roth IRA. However, the combination of contributions to both a 401(k) plan and a Roth 401(k) cannot exceed the maximum contribution to a 401(k) plan.
Be aware that Roth 401(k) plans are subject to the IRS-required minimum distribution (RMD) rule. That rule requires that a retirement plan begin making distributions once the employee reaches age 70½.
If distributions are taken early, they can be rolled over into only either a Roth IRA or another Roth 401(k) plan.
4. 403(b) Plan
The 403(b) plan is virtually identical to a 401(k) plan, except that it’s designed for nonprofit organizations. This includes public schools systems, hospitals, home health service agencies, welfare service agencies, churches, and conventions and associations of churches.
The plans are funded primarily by employees, and those contributions are tax deductible when made. Employers can match contributions up to a certain percentage. Investment earnings accumulate on a tax-deferred basis, and contribution limits are identical to those of 401(k) plans.
5. 457 Plan
457 plans are basically 401(k) plans for state and local government employees. They work the same way as 401(k) plans and have identical contribution limits. There’s one significant difference, however, between a 457 plan and a 401(k) plan.
Should an employer offer both a 457 plan and a 401(k) plan, the employee can fully contribute to both plans, allowing for contributions that double the limit for a 401(k) plan.
That would enable a participant to contribute $18,000 to each, for a total of $36,000 in 2016.
6. SIMPLE Plan
SIMPLE stands for Savings Incentive Match Plan for Employees, which is an IRA plan offered by an employer. These plans are generally offered by smaller employers who do not offer more complex retirement plans.
The employee makes tax-deductible contributions to the plan, and an employer must make either matching contributions (up to 3% of the employee‘s salary) or nonelective contributions. The maximum contribution to a SIMPLE IRA is $12,500 in 2016. An employee age 50 or over can also make catch-up contributions of $3,000 for 2016.
If the employee participates in other retirement plans, total contributions — including those made to a SIMPLE IRA — are limited to $18,000 in 2016.
7. SEP Plan
A SEP is a Simplified Employee Pension plan that allows small businesses to have a simple method of administering a retirement plan for their employees. Like a SIMPLE plan, SEP plans are based on IRAs and are typically known as SEP-IRA plans.
This has the same investment, distribution and rollover requirements as traditional IRAs; however, the contribution limits are much more generous.
Contributions are limited to the lesser of:
- 25% of compensation (though through a complicated formula, it actually works out to be effectively 20%), or
- $53,000 for 2016 (the maximum any employee can contribute to all retirement plans combined)
These are seven of the most common employer-sponsored retirement plans available, and if you participate in a program, it’s likely to be one of these.
Be sure to research the company to find out which plan is the best for your situation and what kind of investment options they offer.