There are two types of employer-sponsored retirement plans: basic and supplemental. The basic plan calls for automatic employee participation after a certain term of employment, such as one year. The supplemental plan is a voluntary program that enables employees to increase the amount of money being set aside for their retirements. Although the supplemental plans are the most common, we also touch on basic plans, so that you are familiar with them as well.

Basic Plans

Basic plans have participation requirements that employers institute to help keep their costs down. For the most part, employers have decreed that in order to be eligible for the retirement plans, you must meet at least age (such as 21) and years-of-service requirements. Often times, there is also an income-level requirement. This is because employers feel that there is a higher turnover ratio for those people who are newly hired and younger. To help keep their administrative costs low, they’ve sought to disallow those categories of employees from participating. Of course, the belief is that once those newly hired, younger people are with the company longer, they are more apt to stay, and so they merit the retirement plan.

Employer pension plans are a type of basic plan. However, you may find that you are expected to contribute to your own pension plan. There are both noncontributory and contributory pension plans. Under the noncontributory type, the company will pay for the entire cost of an employee’s benefits. But, under a contributory plan, both the employee and employer share the cost. More often than not, companies have instituted contributory plans, where the cost to the employee ranges between 3 and 10 percent of annual income. The employer then generally matches what the employee has put in.

But, what if you leave the company? The ability and willingness to change jobs, and even careers, is higher now than it ever has been. So what do you do when you have money in a contributory pension plan and you leave that company for another one? You are legally entitled to at least the amount of money that you put in, adjusted for any profit or loss. Whether you qualify for the amount that your employer contributed is determined by the company’s policy. You can take the benefits as a lump-sum amount ( it being taxable plus a 10percent penalty if you are younger than 591/2), you can roll it over into an IRA, or you can take it as monthly income once you are retired. Of course, the amount that is transferred may be more or less than the initial investment.

Companies also have established vesting rules  (which occur when employees have a nonforfeitable right to their pensions). This gives some employees an added incentive to work longer. Prior to 1974, companies usually had vesting rules that  stated  that  the employees had to be employed at the company for at least 25 years, or they received no pension benefits. The Employee Retirement Income Security Act of 1974 (ERISA) helped fix that by regulating the amount of time that the companies could set for vesting. Those rules were again updated in 1986 with the Tax Reform Act, which greatly benefited employees. Now, employers must choose between two vesting schedules. The first is called cliff vesting, and dictates that an employee is fully vested after no more than 5 years of service, but the employee receives no vesting privileges until that time. Once you’re fully vested, you have the right to all the money that has been paid in so far, yours and your employer’s, again adjusted for any profit or loss. The second schedule is a graded schedule. At the minimum, you would begin vesting at your third year of employment at 20 percent. Each year, you would be vested by an additional 20 percent until you reached 100 percent after 7 years on the job. These rules apply to an employer’s contributions. You are always 100-percent vested in any contribution you make on your behalf.

DEFINED BENEFITS VERSUS DEFINED CONTRIBUTION PLANS.  The two most commonly used methods to calculate retirement benefits are the defined contribution and defined benefits plans. With the defined benefits plan, employees will know exactly how much they will receive in retirement benefits before they retire. This is because the way the benefits are paid out and calculated are expressly defined in the plan’s provisions. This also means that no matter how well or poorly the underlying investments do, the employer must pay out the benefits. There will be no deviation from the formula. Usually, the formula includes the number of years of service and the amount of money the employee was making. For example, you worked for XYZ Company for 25 years. They based their defined benefits plan on the average of your final (and usually, highest) 3 years of income, which works out to $78,000. Their formula stipulates that you will receive three percent of your salary average for each of your years of service. Your annual benefit would be $58,500.

Under a defined contributions plan, the plan provisions detail the amount of contribution that the employee and employer must make. Then, at retirement, the employee is granted whatever monthly benefit those contributions will afford. While this type of plan also takes age, years of service, and income level into consideration, the most important factor is the investment return on the contributions. A defined contribution plan guarantees the employee nothing in the way of benefits except for what the fund managers have been able to obtain, which can lead to a lot of volatility. However, there is a standard that the fund managers must follow, so that the contributing employees don’t find all their money gone at retirement.

As the employee, your main concern is the amount of money you will receive in the form of benefits once you have retired. Generally, a pension plan is considered good when employees receive between 70 and 80 percent of their net preretirement pay. However, ascertaining how much you will receive will become more difficult to do as more companies shy away from the defined benefits plan and towards the defined contribution plan. From an employer’s perspective, the move is an easy decision because the economic future is unknown. Employers simply don’t want to find themselves responsible for paying out benefits that they don’t have the funds for. Unfortunately, for the employees, this means that you are required to take an additional part in your retirement funding.

TAX IMPLICATIONS.   Employer-sponsored retirement plans are often referred to as qualified plans. This means that the plans qualify for important tax benefits under the Internal Revenue Code. For the employer, these benefits include a current tax deduction on the payments. For the employee, the benefits include deferral of income tax on the employer contributions. Finally, earnings accumulate on a taxdeferred basis. Most distributions from qualified plans are also eligible for tax-free rollovers to IRAs and other retirement plans.

Special note: Some employees have decided to forego making their pension plans qualified. These nonqualified pension plans receive no special tax treatment, nor do any contributions made to them. Any contributions made by an employee to a contributory pension plan that is nonqualified is still fully taxable and treated as ordinary income received.

Supplemental Plans

Supplemental plans are voluntary for employees. These plans offer employees the chance to increase the amount of funds set aside for their  retirements,  as  well as shelter some of their income from income tax. There are three types of supplemental plans: profit-sharing, thrift and savings, and salary reduction plans.

PROFIT-SHARING PLANS.   As the name implies, profit-sharing plans allow a company’s employees to share in the company’s earnings. Proponents of profit-sharing plans argue that these plans give an added incentive to employees to work harder. They reason that if the employees work harder, the firm will be more profitable, with the earnings flowing back into the employees’ pockets. Whether or not this actually happens is unknown. However, both employees and employers like the benefits of this type of plan. For one, a profitsharing plan may be tax qualified, and enjoy the same favorable tax treatment that a qualified pension or IRA would. Second, there is no contribution requirement for the employer. The company will simply contribute a percentage of its profits. Therefore, when there is a good year, the contribution may be larger than that of a poor-earnings year. A company will set certain minimum and maximum contribution percentages, so that the employees have a general idea of how big (or small) a given contribution will be.

Many times, a firm will contribute its own company’s stock to an employee’s profit-sharing plan. This doesn’t mean, though, that an employee’s contributions must be invested in that company’s stock. Generally, there is a number of investment options, such as stock and bond funds.

When investing in your employer’s company stock, there are some things to consider. First, if the company has a good year and is very profitable, you will benefit in two ways: Your employer’s contribution may be greater, and the value of that stock may increase. However, heavily investing in your employer’s company stock is generally frowned upon. While you may feel that your company is very strong, that doesn’t mean that it will always remain that way. Should the company have a poor year, you may face a declining value in your profit-sharing plan, as well as uncertainty at work. If you can diversify your profit-sharing account’s portfolio, you’ll be better off in case something does happen.

Consider the predicament of the many employees of Enron Corporation. For the past few years, Enron’s stock has been going strong. It’s been trading in the $70-$80 range, hitting $89.625 on September 18, 2000. For those employees who had sunk a considerable portion of their retirement money in the company’s stock, it looked like they had made a profitable decision. Unfortunately, things didn’t stay so rosy. Enron’s stock began to slide in February of 2001. Although it came back a little in April of that year, the stock price continued to go down. It hovered in the $50 range from March to early June of 2001, but things just got worse. By December of 2001, the stock price was less than $1 per share. Imagine your retirement money doing that. So think very carefully before you invest 100 percent of your retirement money in your company’s stock. Investing a portion of your contribution, say 5 to 10 percent, is perfectly healthy. Plus, if your employer offers a match of your contribution with company stock, you really shouldn’t add to that amount by investing your contribution in company stock. Even the best companies can have problems with their stock prices. You just don’t want to be on the receiving end of these problems. By diversifying your retirement plan, you won’t be.

Interestingly, nonprofit corporations can sponsor profit-sharing plans. At one time an employer could only make contributions to a profit-sharing  plan  if  it  had  either  current-year  or  prior-year retained  profits.  This  was  not  a  major  limitation  unless  the employer had consistently been unprofitable. The profit requirement was eliminated from the Internal Revenue Code several years ago. It would be more precise to call these plans discretionary defined contribution plans, but the term profit-sharing plan has been used for many years.

THRIFT AND SAVINGS PLANS.  Thrift and savings plans offer the same type of tax treatment that other types of qualified plans do, with  one  exception.  Although  any  contributions  made  by  the employer are not included in an employee’s gross income for the year in which they were made, any contributions made by the employee are still counted in his or her gross income for that year. So any money you put into your thrift and savings account will still be considered as income, and you will face ordinary income tax on those amounts.

An employer who makes contributions to an employee’s plan will do so in a set proportion of the employee’s contribution up to a maximum percentage. The money contributed will then be deposited with a trustee, who will it them in various types of securities, such as stock and bond funds and the stock of the employing company. These plans also offer a much more liberal vesting period than other plans do. Typically, an employee is 100-percent vested in the employer’s contributions as soon as the contribution is made. Thrift and savings plans also have looser policies regarding withdrawal of funds and cessation of participation. Be careful, though, because there is usually a waiting period to reenter the program once you have stopped participating.

For example, you participate in your company’s thrift and savings program. Your annual salary is $60,000 and you put 10 percent, or $6000, per year into your plan. Your employer will match any contribution you make at 75 ¢ on the dollar up to 6 percent of your salary. Your employer’s contribution to your plan would

Although the fact that an employee’s contribution is counted as part of his or her annual income remains a disadvantage of the thrift and savings plans, if you have access to one at your work, I would advise that you participate. Most thrift and savings plans require the employer to make contributions on behalf of the employees, and the account will accumulate much faster since you won’t be the only one contributing.

SALARY REDUCTION PLANS.  The most common form of employersponsored retirement account is the salary reduction plan, or the 401 (k). The term 401(k) refers to the IRS code that establishes these accounts. 401(k) plans are available to those employees in for-profit, private business. There are similar plans for people who work for public schools, universities, colleges, and nonprofit hospitals; these are known as 403(b) plans. Employees of state and local governments, as well as some tax-exempt organizations, will participate in 457 plans.
401 (k) plans are a type of defined contribution plan, and as such, many employers will contribute to their employees’ 401(k) accounts. Sometimes an employer will match 50 ¢ for every dollar contributed by the employee up to a certain percentage of salary, but sometimes an employer will match dollar for dollar up to a percentage of salary. Employer contributions are not counted as part of the employee’s gross income, and so the employees aren’t taxed on that until they begin to take distributions from their plans. Plus, any contribution made by an employee is taken out of the employee’s gross income and sheltered until distributions begin. All earnings grow tax-deferred. Most employers offer a wide range of different types of investments that the employees may invest their 401(k) money in. The advantages to the 401(k) plans are quite beneficial to the employee. While the tax treatment for  403(b) and 457 participants is the same as for the 401 (k), many employers do not match for 403(b) plans, and matching for 457 plan participants is almost nonexistent

403 (b) plans are subject to a variety of special rules, and they are limited to investing in annuities and mutual funds. The plans are subject to fewer discrimination rules than 401(k) plans and are more flexible than 401(k) plans in many ways. Any salary reduction contributions you made to a 403(b) plan will reduce the contribution you make to a 401(k) plan. However, any contributions made to a 457 plan (beginning in the year 2002), do not limit the amount that may be contributed to a 401(k).

There are some other characteristics of 457 plans that should be considered. First, these plans don’t offer the same safeguards that 401 (k) and 403(b) plans do. Qualified plan assets are segregated from the employer’s assets. If the employer becomes bankrupt, your benefits are still safe. Assets of governmental 457 plans must also be held in a separate trust for the participants’ benefit. But a tax-exempt organization cannot set up a separate trust. For this reason, you should be very certain that your tax-exempt organization is financially sound before contributing to its 457 plan, Finally, assets in a 457 plan sponsored by tax-exempt organization cannot be rolled over to IRAs when you leave employment. A governmental 457 plan can be rolled over. Let’s consider how participating in a 401(k) can be beneficial, not just for planning for your retirement, but also for decreasing your current income tax due. John Client has been working for the same company for about 20 years. As a result, his salary is quite high, and so he feels that he can contribute the full amount ($11,000 for the year 2002) to his 401(k) plan at work. Unfortunately for John, his employer doesn’t offer any type of match. With John’s salary of $125,000, he finds that he is in the 30% (using year 2002 tables) tax bracket. By diverting $11,000 from his salary into his 401(k), he is saving himself $3300 in taxes ($11,000 _ 30%) since he is reducing his income to $114,000. Therefore, it could be said that he is contributing $7800 to his 401(k) while the IRS is contributing $3300 because of the tax savings.

The more you are able to contribute, the faster your account will accumulate. Add in any match that your employer provides, and that will just increase the amount of saving going on for your retirement. Participating in a 401(k), 403(b), or 457 is an excellent way to beef up your retirement nest egg, while enjoying some tax savings in the meantime. Don’t worry if your employer doesn’t offer any matching contribution. Just because they may not match now, doesn’t mean they won’t match in the future.

All employer-sponsored retirement plans have the same tax treatment. Gains and interest accrue on a tax-deferred basis, and there are no taxes due until the participant begins to take distributions. At that time, the participant will face ordinary income tax on the portion withdrawn. However, there will be a 10-percent early-withdrawal penalty imposed for those people who are younger than 591/2.3