I received a lot of questions about the different types of retirement plans. Yet, it might be very confusing to choose the right one and to understand them properly. Therefore, I provide you with a list of 7 different retirement plans and their definitions to get a better understanding, how it works:
1. Simplified Employee Pension Plan (SEP)
Firstly, a Simplified Employee Pension Plan (SEP) is a relatively uncomplicated retirement savings vehicles. A SEP allows employees to make contributions on a tax-favored basis to individual retirement accounts (IRAs) owned by the employees. SEPs are subject to minimal reporting and disclosure requirements. Under a SEP, an employee must set up an IRA to accept the employer’s contributions. Furthermore, employers may no longer set up Salary Reduction SEPs. However, employers can establish SIMPLE IRA plans with salary reduction contributions. If an employer had a salary reduction SEP, the employer may continue to allow salary reduction contributions to the plan.
2. Profit Sharing Plan (SEP)
A Profit Sharing Plan or Stock Bonus Plan is a defined contribution plan under which the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution. A profit sharing plan or stock bonus plan include a 401(k) plan.
3. & 4. 401(k) and 403(b) Plan (SEP)
A 401(k) Plan is a defined contribution plan that is a cash or deferred arrangement. Employees can elect to save a portion of their salary which is instead contributed, before taxes, to the 401(k) plan. Sometimes the employer may match these contributions. There are special rules governing the operation of a 401(k) plan. For example, there is a dollar limit on the amount an employee may elect to defer each year. An employer must advise employees of any limits that may apply.
In addition, employees who participate in 401(k) plans assume responsibility for their retirement income. They contribute part of their salary and, in many instances, direct their own investments. A 401(k) is usually offered by a for-profit company. However, teachers and other employees of nonprofits may be offered a 403(b) instead.
5. Employee Stock Ownership Plan (SEP)
6. Money Purchase Pension Plan (SEP)
A Money Purchase Pension Plan is a plan that requires fixed annual contributions from the employer to the employee’s individual account. Because this plan requires these regular contributions, the plan requires certain funding and has other rules.
7. Cash Balance Plan (SEP)
A Cash Balance Plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance. In a typical cash balance plan, a participant’s account receives each year a “pay credit” (such as 5 percent of compensation from his or her employer) and an “interest credit” (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate).
Furthermore, increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the employer solely bears the investment risks and rewards on plan assets. When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).
I hope this article is helpful for you and helps you to understand the different types of retirement plans better. If you have any questions, feel free to contact me or subscribe to my newsletter to get access to exclusive content.