Retirement Plan FAQ
Quick answers to common questions about retirement plans, including 401(k) plans, IRAs, Keoghs and SEPs.
A qualified plan is simply one that is described in Section 401(a) of the Tax Code. The most common types of qualified plans are profit sharing plans (including 401(k) plans), defined benefit plans and money purchase pension plans. In general, your contributions are not taxed until you withdraw money from the plan. Most retirement plans that you obtain through your job are qualified plans.
401(k) plans are popular with employers because they are less expensive than other types of retirement plans. Contributions constitute the biggest expense for an employer. But in the case of a 401(k) plan, the bulk of the contribution is typically made by the employee -- through salary reductions. The employee diverts into the plan a portion of the salary he or she would otherwise receive in cash.
401(k) plans are popular with employees because the plan allows them to save for retirement while simultaneously reducing their current income tax bill. Employees don't pay income tax on salary deferrals until the money comes out of the 401(k) plan, some time in the future. And employers usually allow employees to change the amount of salary deferred into the plan as the employees' circumstances change. Also, employees are often permitted to make their own investment decisions, and are frequently given access to their retirement funds through loans or hardship withdrawals.
A Keogh plan is a qualified plan for self-employed individuals. The term Keogh is not a tax term, and you won't find any reference to it in the Tax Code. It's just a bit of retirement planning jargon that refers to the special restrictions placed on qualified plans when they are established by self-employed individuals.
The most onerous restriction is the following: Contributions to retirement plans are often determined by taking a percentage of compensation, but compensation for self-employed individuals is defined differently than it is for employees of corporations. The revised definition often produces a lower contribution limit for a Keogh.
If you are vested in your retirement plan, you can take it with you when you leave the company. If you are 50% vested, you can take 50% of it with you when you go. In the case of a 401(k) plan, you are always 100% vested in the salary you defer into the plan.
An IRA, or Individual Retirement Account, is indeed a retirement plan. However, it's not a qualified plan. Instead, IRAs are described in Section 408 of the Tax Code and have their own set of rules. One significant difference between qualified plans and IRAs is that qualified plans are established by businesses, while certain types of IRAs -- traditional or Roth IRAs -- are established by individuals. That means you can set up a traditional or Roth IRA for yourself, whether or not your employer has established a qualified plan for you at work.
Other types of IRAs, known as SEPs and SIMPLE IRAs, are for businesses and must be established by an employer. For example, the employer might be a corporation, a sole proprietor or a partnership. SEPs and SIMPLE IRAs permit larger tax deductions than do traditional or Roth IRAs.
I work for a company and also have a small business of my own. Can I set up a retirement plan for my business even if I'm covered by a plan at work?
Generally, yes. The restrictions on contributions you can make to a retirement plan are applied to each employer separately. If you work for a company, the company is an employer. If you are self-employed, you are a separate employer, and can have a separate retirement plan for your business. But be careful. If both you and your employer establish some type of salary reduction plan, you might run up against an overall limit on contributions.
The most common types of salary reduction plans are 401(k) plans, tax-deferred annuity or 403(b) plans (these generally cover university professors and public school teachers), and 457 plans (sponsored by state and local governments and other tax-exempt organizations). A SIMPLE IRA is also a salary reduction plan.
Although the amount of your salary or compensation you can defer into each of these plans is limited, the law also puts a limit on the total amount you can defer into all such plans, if you happen to be covered by more than one. The overall limit depends on the type of plan you participate in.
Most employer plans are safe from creditors, thanks to the Employee Retirement Income Security Act of 1974, commonly known as ERISA. ERISA requires all plans under its purview (generally, qualified plans) to include provisions that prohibit the assignment of plan assets to a creditor. The U.S. Supreme Court has also ruled that ERISA plans are even protected from creditors when you are in bankruptcy.
Unfortunately, Keogh plans that cover only you -- or you and your partners, but not employees -- are not governed or protected by ERISA. Neither are IRAs, whether traditional, Roth, SEP or SIMPLE.
But even though IRAs are not automatically protected from creditors under federal law, many states have put safeguards in place that specifically protect IRA assets from creditors' claims, whether or not you are in bankruptcy. Also, some state laws contain protective language that is broad enough to protect single-participant Keoghs, as well.