The Internal Revenue Service allows businesses to establish retirement plans for their employees that are tax deductible, provided the plans adhere to IRS Code 401(a) and the Employee Retirement Income Security Act, or ERISA. An employee can determine whether their contribution into their pension plan is deductible by asking their employer if they have received a “Determination Letter” from the IRS to ensure they are covered under a “qualified plan” for tax purposes.
Qualified Plan Requirements
A plan has to be open to all employees who are at least 21 years old and have been with the company for a year. The employee must be allowed to participate either when the plan year starts or within six months of turning 21 or being employed for a year. The plan needs to be operated in strict accordance with plan documents that describe employees covered and the benefits and contributions that will be made. Employees must be 100 percent vested, and a business cannot reduce accumulated benefits. Employee contributions can be made with pre-tax dollars that lower their taxable income for a given year provided the plan documents allow such contributions. Failure to abide by plan documents, or poorly written plans uncovered during an IRS audit, could disqualify the beneficial tax treatments of the contributions made under those plans.
IRS Code 401(a)
The pension plans of federal, state and Indian tribal government employees and the employees of their subdivisions, agencies and instrumentalities are covered under IRS Code 401(a). Employees cannot contribute to this plan and do not receive a tax deduction. Teachers in public schools, hospitals and some 501(c)3 tax-exempt organizations are covered under the 403(b) government pension plan and can contribute and receive a tax deduction.
ERISA was created to protect the employees of private employers that institute a pension plan for their workers. The act established the minimum requirements an employer must meet to establish a pension plan for their employees and gives participants certain rights if the employers do not meet these minimum requirements. The act covers participation requirements, how benefits are accrued, the fiduciary responsibilities of plan managers and the rights of participants if the plan is not operated in accordance with the plan documents. ERISA also allows for payment of some benefits for terminated defined plans through the Pension Benefit Guaranty Corporation.
Types of Retirement Plans Covered
Tax deductions are possible with the following plans: 401(k), Simplified Employee Pension (SEP), Salary Reduction Simplified Employee Pension (SARSEP) – provided the plan was established before 1997, Savings Incentive Match Plans for Employees of Small Businesses (SIMPLE), traditional IRA accounts, 403(b) and 457(b) plans, defined benefit plans and “catch-up” contributions. Tax-deductible contribution limits apply to each plan.
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