There are a variety of employee retirement plans out there, which go by a variety of different names. This article summarizes the typical features of the most common types of plans.
The two main types of plans
Employee retirement plans generally are of one of two kinds: defined benefit plans, and defined contribution plans. Defined benefit plans are what people usually think of as pensions or annuities. The employer pays out a regular retirement benefit that is based on the employee’s salary history and length of service. The employer is responsible for ensuring the plan is fully funded and able to meet its obligations.
Although defined benefit plans are still common in the public sector, fewer private employers are offering them. According to the Bureau of Labor Statistics, only 22 percent of private sector full-time employees are under a defined benefit plan, decreased from 42 percent in 1990. Defined benefit plans are most common among union workers (70%) and employees of large companies (63%). Of companies with fewer than 50 employees, less than 10% of employees had a defined benefit plan.
The more common type of plan is the defined contribution plan. Under this plan, the employee voluntarily elects to have a portion of each paycheck deposited in a savings account; the employer may match all or part of this contribution. There is a statutory limit to the amount that an employee can contribute each year. The plan is typically administered by a professional investment company and offers a selection of mutual funds and other investments for the employee to choose from. The balance in the account depends on the amounts contributed and the performance of the investments in the account.
Below are some common types of defined contribution plans.
401(k) plans are an example of a defined contribution plan. In a typical 401(k), the contributions to the account are pre-tax (i.e. contributions are tax-deductible), and the employee chooses from the investments made available by the employer. The balance in the account grows tax-deferred.
At retirement, the employee can begin taking distributions from the account, which are taxed as income. There is a 10% penalty for taking funds out before age 59 ½, except for certain uses like education or healthcare.
The employee often must work for the company for a certain period before they are “vested” in the plan. Once the employee is vested, they can take the employer’s matching contributions with them if they leave the company; before that, they can only take what they have contributed themselves.
Roth 401(k)s have recently become more popular. Under these funds, contributions are made with after-tax money, but the funds grow tax-free and distributions are not taxable.
403(b) plans are offered by tax-exempt organizations like schools, colleges, universities, state and local governments, and charitable organizations. A 403(b) plan works similarly to a 401(k): contributions are made with pre-tax dollars, the account balance grows tax-deferred, distributions are taxed as income, and there is a penalty for taking funds out before age 59 ½. Although employers can match employee contributions to a 403(b), it is much less common than with a 401(k).
Unlike a typical 401(k) plan, a 403(b) plan offers a variety of investment companies to choose from. Each company offers a range of investments. Therefore, 403(b) plans give the employee a wider range of choices.
The 457 plan is also offered by tax-exempt organizations like schools, universities, local governments, and charities. Like 401(k)s and 403(b)s, contributions to 457 plans are made with pre-tax dollars and grow tax-deferred until retirement. Employers can match contributions to 457s but this is less common than with 401(k)s.
Many employers that are eligible to do so, offer both 403(b) and 457 plans to their employees. The contribution limits are separate for each plan: an employee who has reached the contribution limit for their 403(b) can still contribute the full amount to their 457, or vice versa.
However, the distribution rules are more strict for a 457: an employee who is still working at the organization which sponsors their 457 cannot take distributions before age 70 ½ without incurring a penalty. But if the employee retires or leaves the organization, they can start taking distributions earlier without penalty.
Thrift savings plans
Thrift savings plans (TSPs) are the federal government’s version of 401(k)s, offered to its civilian and military personnel. TSPs function like 401(k)s: contributions come out of pre-tax dollars; a portion is matched by the government; the plan offers a range of investment options to choose from; distributions are taxable; and there is normally a penalty for taking funds out before age 59 ½.
Roth TSPs started being offered in 2012. With a Roth TSP, contributions are made with after-tax dollars and distributions are not taxable.
Besides the types described above, there are other types of retirement plans. These include Savings Incentive Match PLan for Employees (SIMPLE) IRA and Simplified Employee Pension (SEP) plans. These enable smaller companies that don’t offer a retirement plan to contribute to employees’ Individual Retirement Accounts.
For additional information
For more information about Thrift Savings Plans see the official TSP website.