Question

1. Qualified pension plans offer important tax benefits. What is the special tax treatment and what qualifies a pension plan for these benefits?
2. Evaluate this statement: The excess of the actual return on plan assets over the expected return decreases the employer’s pension cost.

Answer 1

iThe ipool iof ifunds iis iinvested ion ithe iemployee's ibehalf, iand ithe iearnings ion ithe iinvestments igenerate iincome ito ithe iworker iupon iretirement.

In iaddition ito ian iemployer's irequired icontributions, isome ipension iplans ihave ia ivoluntary iinvestment icomponent. iA ipension iplan imay iallow ia iworker ito icontribute ipart iof ihis icurrent iincome ifrom iwages iinto ian iinvestment iplan ito ihelp ifund iretirement.

Types iof iPension iPlan

1. Defined-Benefit iPlans

In ia idefined-benefit iplan, ithe iemployer iguarantees ithat ithe iemployee ireceives ia idefinite iamount iof ibenefit iupon iretirement, iregardless iof ithe iperformance iof ithe iunderlying iinvestment ipool. iThe iemployer iis iliable ifor ia ispecific iflow iof ipension ipayments ito ithe iretiree i(the idollar iamount iis itypically idetermined iby ia iformula, iusually ibased ion iearnings iand iyears iof iservice), iand iif ithe iassets iin ithe ipension iplan iare inot isufficient ito ipay ithe ibenefits, ithe icompany iis iliable ifor ithe iremainder iof ithe ipayment.

2. Defined-Contribution iPlans

In ia idefined-contribution iplan, ithe iemployer imakes ispecific iplan icontributions ifor ithe iworker, iusually imatching ito ivarying idegrees ithe icontributions imade iby ithe iemployees. iThe ifinal ibenefit ireceived iby ithe iemployee idepends ion ithe iplan's iinvestment iperformance.1

3. Defined-Contribution iPlans

In ia idefined-contribution iplan, ithe iemployer imakes ispecific iplan icontributions ifor ithe iworker, iusually imatching ito ivarying idegrees ithe icontributions imade iby ithe iemployees.  iThe icompany’s iliability ito ipay ia ispecific ibenefit iends iwhen ithe icontributions iare imade

Pension iPlan: iAre iThey iTaxable?

Most iemployer-sponsored ipension iplans iare iqualified, imeaning ithey imeet iInternal iRevenue iCode i401(a) iand iEmployee iRetirement iIncome iSecurity iAct iof i1974 i(ERISA) irequirements. iThat igives ithem itheir itax-advantaged istatus.

Employers iget ia itax ibreak ion ithe icontributions ithey imake ito ithe iplan ifor itheir iemployees. iSo ido iemployees. iContributions ithey imake ito ithe iplan icome i"off ithe itop" iof itheir ipaychecks—that iis, iare itaken iout iof itheir igross iincome

That ieffectively ireduces itheir itaxable iincome, iand, iin iturn, ithe iamount ithey iowe ithe iIRS icome iApril i15. iFunds iplaced iin ia iretirement iaccount ithen igrow iat ia itax-deferred irate, imeaning ino itax iis idue ion ithem ias ilong ias ithey iremain iin ithe iaccount. iBoth itypes iof iplans iallow ithe iworker ito idefer itax ion ithe iretirement iplan’s iearnings iuntil iwithdrawals ibegin, iand ithis itax itreatment iallows ithe iemployee ito ireinvest idividend iincome, iinterest iincome, iand icapital igains, iwhich igenerate ia imuch ihigher irate iof ireturn ibefore iretirement.

Upon iretirement, iwhen iyou istart ireceiving ifunds ifrom ia iqualified ipension iplan, iyou imay ihave ito ipay ifederal iand istate iincome itaxes

If iyou ihave ino iinvestment iin ithe iplan ibecause iyou ihave inot icontributed ianything ior iare iconsidered ito inot ihave icontributed ianything, iyour iemployer idid inot iwithhold icontributions ifrom iyour isalary ior iyou ihave ireceived iall iof iyour icontributions i(investments iin ithe icontract) itax-free iin iprevious iyears, iyour ipension iis ifully itaxable.

iYou idon't iowe itax ion ithe ipart iof ithe ipayment iyou imade ithat irepresents ithe ireturn iof ithe iafter-tax iamount iyou iput iinto ithe iplan. iPartially itaxable iqualified ipensions iare itaxed iunder ithe iSimplified iMethod.

A iqualified iretirement iplan imeets ithe irequirements iof iInternal iRevenue iCode iSection i401(a) iof ithe iInternal iRevenue iService i(IRS) iand iis ithus ieligible ito ireceive icertain itax ibenefits, iunlike ia inon-qualified iplan. iAn iemployer iestablishes isuch ia iretirement iplan ion ibehalf iof iand ifor ithe ibenefit iof ithe icompany’s iemployees. iIt iis ione itool ithat ican ihelp iemployers iattract iand iretain igood iemployees.

Qualified iplans icome iin itwo imain itypes: idefined ibenefit iand idefined icontribution, ithough ithere iare ialso isome iother iplans ithat iare ihybrids iof ithe itwo, ithe imost icommon iof iwhich iis icalled ia icash ibalance iplan. iDefined ibenefit iplans igive iemployees ia iguaranteed ipayout iand iplace ithe irisk ion ithe iemployer ito isave iand iinvest iproperly ito imeet iplan iliabilities. iA itraditional iannuity-type ipension iis ian iexample iof ia idefined-benefit iplan.

Under idefined icontribution iplans, ithe iamount iemployees ireceive iin iretirement idepends ion ihow iwell ithey isave iand iearn ithrough iinvestment ion itheir iown ibehalf iduring itheir iworking iyears. iA i401(k) iis ithe imost ipopular iexample iof ia idefined icontribution iplan. iOther iexamples iof iqualified iplans iinclude ithe ifollowing:

· Profit-sharing iplans

· 403(b) iplans

· Money ipurchase iplans

· Defined ibenefit iplans

· Employee istock iownership i(ESOP) iplans

· Salary iReduction iSimplified iEmployee iPension i(SARSEP)

· Simplified iEmployee iPension i(SEP)

· Savings iIncentive iMatch iPlan ifor iEmployees i(SIMPLE)

Qualified iRetirement iPlan iand iInvesting

iIncreasingly, ialternative iinvestments ilike ihedge ifunds iand iprivate iequity iare ibeing iconsidered ifor idefined icontribution iplans. iSome iare ialready iavailable, ipackaged iinto itarget-date ifunds.

Qualified iRetirement iPlan iand iTaxes

Qualified iretirement iplans igive iemployers ia itax ibreak ifor ithe icontributions ithey imake ifor itheir iemployees. Workers imay itake idistributions ifrom iqualified iplans ibefore iretirement iage ior ibefore ione iof ithe iother itriggering ievents ioccurs, ibut ithe idistributions iwill ibe isubject ito itaxes iand ipenalties ithat ioften imake iit iunwise ito itake ian iearly idistribution.

Some iplans ialso iallow iemployees ito iborrow ifrom ithe iplan iunder istrict irules iabout ihow ithe iloan iis irepaid. iFor iexample, iplan irules imay irequire ithat ithe iloan ibe irepaid iwithin ia icertain inumber iof iyears, ithat ithe iworker ipays iinterest i(which igoes iback iinto ithe iplan) ion ithe iloan, iand ithat ithe iloan iis irepaid iimmediately iif ithe iemployee ileaves ithe ijob ito iwhich ithe iqualified iretirement iplan iis itied.