With so many options for retirement savings, it can be tempting to throw up your arms in defeat. However, doing so causes you to miss out on valuable tax breaks for retirement saving. Understanding the different categories of retirement savings plans can help you make wise decisions in your financial planning.
Qualified and Nonqualified
Qualified plans offer the greatest tax benefits for saving for retirement. Qualified plans must meet a range of qualifications under the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code, including funding requirements and nondiscrimination requirements. Nonqualified plans don't have the same restrictions, but the tax code isn't nearly as generous to those participating in such plans. Nonqualified plans are usually set up to offer highly paid employees extra deferred compensation. If the nonqualified plan isn't carefully written, you could end up being taxed on the money long before you actually receive it.
Defined Benefit and Defined Contribution
Defined benefit plans promise you a specified amount at retirement based on a predetermined formula. For example, your employer might promise that you will receive 2 percent of your last year's salary multiplied by the number of years you worked for the company. Your employer might also require that you pay in a certain amount from each paycheck. These plans place the market risk on the employer, because if the market does poorly, the employer is still responsible for paying the promised benefit. Defined contribution plans put in a certain amount on your behalf and then at retirement, you get however much is in the account. If the account does very well, you could end up with a much larger retirement fund, but if it performs poorly, you could end up having to work several more years than you planned.
Pretax and Roth
For many years, the only option for retirement savings plans were pretax accounts. These accounts allow a deduction when you contribute to the plan, but tax all of your distributions. Examples of pretax accounts include 401(k) plans, 403(b) plans and traditional IRAs. Decades later, Roth accounts gave the option of saving on an after-tax basis, which means the contributions don't receive a tax deduction, but all the distributions are tax-free.
Individual and Employer-Sponsored
Employers may make contributions only to certain types of retirement plans. These include all 401(k) plans and 403(b) plans, simplified employee pension IRAs and savings incentive match plans for employees. Only the account holder may make contributions to traditional IRAs and Roth IRAs. Generally, employer-sponsored plans have much higher contribution limits than individual plans. As of 2012, annual contributions to IRAs were limited to $5,000, while annual contributions to 401(k) plans were limited to $17,000 from the account holder and up to $50,000 total between employee contributions and employer contributions.
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