CONTRIBUTION & BENEFIT LIMITS
|401k Plan Limits for Year|
|401k Elective Deferrals||$19,500||$19,000||$18,500||$18,000||$18,000||$18,000||$17,500|
|Annual Defined Contribution Limit||$57,000||$56,000||$55,000||$54,000||$53,000||$53,000||$52,000|
|Annual Compensation Limit||$285,000||$280,000||$275,000||$270,000||$265,000||$265,000||$260,000|
|Catch-Up Contribution Limit||$6,500||$6,000||$6,000||$6,000||$6,000||$6,000||$5,500|
|Highly Compensated Employees||$130,000||$125,000||$120,000||$120,000||$120,000||$120,000||$115,000|
|Non-401k Related Limits|
|403b/457 Elective Deferrals||$19,500||$19,000||$18,500||$18,000||$18,000||$18,000||$17,500|
|SIMPLE Employee Deferrals||$13,500||$13,000||$12,500||$12,500||$12,500||$12,500||$12,000|
|SIMPLE Catch-Up Deferral||$3,000||$3,000||$3,000||$3,000||$3,000||$3,000||$2,500|
|SEP Minimum Compensation||$600||$600||$600||$600||$600||$600||$550|
|SEP Annual Compensation Limit||$285,000||$280,000||$275,000||$270,000||$265,000||$265,000||$260,000|
|Social Security Wage Base||$137,700||$132,900||$128,400||$127,200||$118,500||$118,500||$117,000|
This data was sourced from 401khelpcenter.com
Highlights of Changes for 2020
The contribution limit for employees who participate in 401k, 403b, most 457 plans, and the federal government’s Thrift Savings Plan is increased from $19,000 to $19,500.
The catch-up contribution limit for employees aged 50 and over who participate in these plans is increased from $6,000 to $6,500.
The limitation regarding SIMPLE retirement accounts for 2020 is increased to $13,500, up from $13,000 for 2019.
The income ranges for determining eligibility to make deductible contributions to traditional Individual Retirement Arrangements (IRAs), to contribute to Roth IRAs and to claim the Saver’s Credit all increased for 2020.
Taxpayers can deduct contributions to a traditional IRA if they meet certain conditions. If during the year either the taxpayer or his or her spouse was covered by a retirement plan at work, the deduction may be reduced, or phased out, until it is eliminated, depending on filing status and income. (If neither the taxpayer nor his or her spouse is covered by a retirement plan at work, the phase-outs of the deduction do not apply.) Here are the phase-out ranges for 2020:
For single taxpayers covered by a workplace retirement plan, the phase-out range is $65,000 to $75,000, up from $64,000 to $74,000.
For married couples filing jointly, where the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range is $104,000 to $124,000, up from $103,000 to $123,000.
For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple’s income is between $196,000 and $206,000, up from $193,000 and $203,000.
For a married individual filing a separate return who is covered by a workplace retirement plan, the phase-out range is not subject to an annual cost-of-living adjustment and remains $0 to $10,000.
The income phase-out range for taxpayers making contributions to a Roth IRA is $124,000 to $139,000 for singles and heads of household, up from $122,000 to $137,000. For married couples filing jointly, the income phase-out range is $196,000 to $206,000, up from $193,000 to $203,000. The phase-out range for a married individual filing a separate return who makes contributions to a Roth IRA is not subject to an annual cost-of-living adjustment and remains $0 to $10,000.
The income limit for the Saver’s Credit (also known as the Retirement Savings Contributions Credit) for low- and moderate-income workers is $65,000 for married couples filing jointly, up from $64,000; $48,750 for heads of household, up from $48,000; and $32,500 for singles and married individuals filing separately, up from $32,000.
Key Limit Remains Unchanged
The limit on annual contributions to an IRA remains unchanged at $6,000. The additional catch-up contribution limit for individuals aged 50 and over is not subject to an annual cost-of-living adjustment and remains $1,000.
Details on these and other retirement-related cost-of-living adjustments for 2020 are in Notice 2019-59, available by clicking here.
DEFINED BENEFIT PLANS
A defined benefit plan (“DB” plan) is a form of a qualified retirement plan under Section 401 of the Internal Revenue Code. The other type of Section 401 plan is a Defined Contribution Plan. With a DB Plan, the only contributions made are those by your employer. Whereas with a DC Plan, both employee and employer contributions can be accepted depending on the plan design (i.e.: a 401(k) plan). The amount received at retirement in a DB Plan is a guaranteed amount which is expressed as a monthly benefit. Hence the name “Defined Benefit.” The amount of the retirement benefit, or accrued benefit, is generally determined based on a combination of your average salary and years of service with your employer. Unlike a DC Plan, where the earnings will directly affect your retirement benefit (i.e., the participant bears the investment risk), the investment earnings on the contributions made by your employer to a DB Plan will not affect your final retirement benefit. In essence, the employer assumes the investment risk. As such, if the rate of return on the plan assets is less than the actuarial assumed rate, the employer’s contribution will increase. Alternatively, If the assets return greater that the assumed rate in the plan, the employer contribution will be reduced. The participant will receive the same benefit regardless of earnings. This differs from a DC plan in the sense that the benefit in a DC Plan is not guaranteed. Rather, in a DC Plan, your retirement benefit is expressed as your account balance at retirement age and is a function of both the cumulative contributions made to the plan by either you or your employer and the investment earnings/losses over said time period.
Your employer may apply a vesting schedule to your benefit. As such, should you leave your employer before completing the required service for 100% vesting, you may not be entitled to receive 100% of your accrued retirement benefit.
When you are a participant of a DB plan, your employer (or yourself if you’re self-employed) pays into a trust account titled in the name of the plan on your behalf. A Plan document is required which will outline, among other provisions, the normal retirement age, the plan formula which determines the benefit paid at the normal retirement age, the form of benefit (i.e.; various forms of annuities and in some cases lump sums), and how you will accrue (earn) that benefit from your date of participation to normal retirement age. In order to gain the full retirement benefit, employees must continue working until their Normal Retirement Age (NRA) in order to accrue/earn their full retirement benefit. If the plan allows for lump sum distributions (theoretical DC account balance), once a participant reaches NRA, they may opt for a lump sum rather than an annuity and roll over the lump sum amount to an IRA and begin taking withdrawals as necessary.
You must begin taking required minimum distributions (RMDs) by April 1 of the year following the year you turn 72 or the year you retire, whichever is later. Age threshold prior to the passage of the SECURE Act was 70 ½. These distributions are calculated by an Actuary and are generally higher than that of an IRA or DC Plan,
Possible candidates for a DB plan: High income earners, self-employed individuals, sole owners, family owned business or small partnerships. Those whose owners age is greater than 35, and would like to contribute more than the maximum for a DC Plan ($57,000) for at least three years.
Contribution limit: Calculated based on the lump sum you will need at retirement to fund for the stated benefit. The greater your age, the higher the contributions as there are less years to accumulate the lump sum necessary to fund for the stated retirement benefit .
Tax advantage: Contributions are tax deductible, earnings on investments accumulate tax deferred. In return for the higher contributions, the administrative costs are slightly higher as an actuary must calculate and certify the contribution. Administrative fees are tax deductible.
Commitment/contribution for employees: If you have full time employees, you generally must make contributions on their behalf. A full time employee is one who works over 1,000 hours in a plan year.
CASH BALANCE PLANS
A Cash balance plan is a relatively new variety of a Defined Benefit. It is subject to the same reporting, documentation and Actuarial certification requirements of a defined benefit plan. The benefit, however, is expressed 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 rather than an annual benefit.
As with a DB Plan, your employer may apply a vesting schedule to your benefit. As such, should you leave your employer before completing the required service for 100% vesting, you may not be entitled to receive 100% of your accrued benefit.
In a typical cash balance plan, a participant’s account is credited each year with 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). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, similar to a DB Plan, the investment risks are borne solely by the employer.
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. For example, assume that a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to an annuity based on that account balance. Such an annuity might be approximately $8,500 per year for life. In many cash balance plans, however, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit equal to the $100,000 account balance.
If a participant receives a lump sum distribution, that distribution generally can be rolled over into an IRA or to another employer’s plan if that plan accepts rollovers.
If the plan covers non owner/common law employees, 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.
A defined benefit plan and a cash balance plan are very similar in most aspects. The largest difference is in the expression of the benefits earned. While both traditional defined benefit plans and cash balance plans are required to offer payment of an employee’s benefit in the form of a series of payments for life, traditional defined benefit plans, even if a lump sum payment option is available, expresses an employee’s benefit as a series of monthly payments for life to begin at retirement. Cash balance plans however define the benefit in terms of a stated account balance which are often referred to as “hypothetical accounts”. Each year, assuming a participant has met the requirements for receiving an additional benefit, his/her account will be credited with a “contribution” as well as an interest credit at the interest rate stated in the plan document (normally around 5%). If a participant has not earned/accrued an addition benefit in any given year, the “hypothetical account” will still be credited with the earnings rate stated in the plan. The account is credited with this rate of return regardless of the actual investment performance of the plan assets (i.e.; the employer bears the investment risk)
DEFINED CONTRIBUTION PLANS
A defined contribution plan (“DC” plan) is the other form of a qualified retirement plan under Section 401 of the Internal Revenue Code. Whereas with a DB Plan, the only contributions that made are those by your employer a DC Plan, accepts both employee and employer contributions depending on the plan design. The most common form of Defined Contribution Plan is a Profit-Sharing Plan. Some older, not widely used types of DC plans are money purchase plans and Target Benefit Plans.
A Defined Contribution Plan (DC Plan) is sometime referred to an “individual account plan.” Whereby each participant has their own individual account. Each year, if contributions are made, the account would be credited with contributions for eligible employees (employee and/or employer) as well as with the actual investment experience (gains and/or losses) for the year. The employee, rather than the employer bears the investment risk. The retirement benefit is the amount income your account balance (lump sum) would allow for at retirement. At that time, should you prefer an annuity, all, or portion of your account balance maybe used to purchase an annuity. If you do not purchase an annuity, you would withdraw an amount each year based on your needs. With the latter option, careful planning with a Financial Advisor is recommend.
With a Profit Sharing Plan a variety of contribution options are available which an employer can select from. They are sometimes referred to as “buckets” employer contributions are normally expressed as a percentage of salary/compensation. Possible “buckets” are broken down in to two main categories, employee and employer. Employee contributions would be 401(k) deferrals (ROTH and Traditional) and after tax contributions. Employer contributions may be stated or discretionary and may consist of all or a portion of the following; employer matching (assumes the plan has a 401(k) feature) and employer non elective (discretionary). The method of the allocation of the employer contributions is defined in the plan document.
You are always 100% vested in your salary deferrals. As such, should you leave your employer, you will be entitled to 100% of your employee 401(k) deferrals. However, as with a Defined Benefit and cash balance plan, your employer may apply a vesting schedule to employer contributions. As such, should you leave your employer before completing the required service for 100% vesting, you may not be entitled to receive all of the funds in your employer contribution account (match and discretionary).
Defined Contribution Plans, may also allows for participant loans. Participant loans are limited to the lesser of $50,000 or ½ of your vested account balance. Repayments must be made in level instalments and cannot exceed 5 years. In most cases, repayments are made via post tax salary reductions. Should you leave your employer, loans maybe rolled over to a successor employers plan (if the plan allows) and repayment may continue. Loans may not however, be rolled over to an IRA. As such the loan would be subject to income tax, and a 10% penalty tax if you are under age 59 ½ if not repaid to the plan or contribution to the IRA within the grace period.
There are four major differences between DB and DC Plans typical cash balance plans and 401(k) plans:
Employee Contributions – Contributions to defined benefit and cash balance plans are generally only made by the employer. Whereas defined contribution plans can contain provisions for employer contributions only (profit sharing), Employee Contributions (401(k)) and a combination of both; 401(k) with an employer match or 401(k) with an employer profit sharing component.
Investment Risks – The investments of DB plans are managed by the employer or an investment manager appointed by the employer. The employer bears the risks of the investments. Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. By contrast, the investments in a DC plan can either be managed by the employer/ investment advisor (pooled account) or may permit participants to direct their own investments within certain categories. 401(k) deferrals are often managed by the participants. Under either case, participants bear the risks and rewards of investment choices.
Life Annuities – Unlike Defined Contribution plans, Defined Benefit plans are required to offer employees the ability to receive their benefits in the form of lifetime annuities. Should a participant in a DC plan desire an annuity, they may purchase one with all/ a part of their account balance at or after retirement
Federal Guarantee – Benefits promised by DB plans are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and to begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.
PROFIT SHARING WITHOUT A 401(K) FEATURE
With this type of DC plan, contributions from the employer are discretionary. That means the company can decide from year to year how much to contribute—or whether to contribute at all—to an employee’s plan. If the company does not make a profit, it does not have to make contributions to the plan. (But a company does not need to be profitable to have a profit-sharing plan.)
This flexibility makes it a great retirement plan option for small businesses or businesses of any size. Plus, it aligns the financial well-being of employees to the company’s success.
Employees with profit sharing plans do not make their own contributions. However, the company include a 401(k) feature in a profit sharing plan, or offer an additional 401(k) Plan.
Employer contributions may be made in the form of cash (traditional) or company stock (ESOP or Stock Bonus Plan). Some plans offer a combination of deferred benefits and cash, with cash being distributed and taxed directly at ordinary income rates. Distributions, if the plan allows, after age 59 ½ will not be subject to a 10% IRS penalty.
If you leave the company, you can move your vested account balance from a profit-sharing plan into a Rollover IRA, but distributions taken before age 59 1/2 may be subject to a 10% penalty. While still employed, an employee may be able to take a loan from a profit-sharing plan.
While there is no set amount that must be contributed to a profit-sharing plan each year, there is a maximum contribution amount for each employee. The amount fluctuates over time with inflation. The maximum contribution amount for a profit-sharing plan is the lesser of 25% of compensation or $57,000 in 2020.
Additionally, the amount of your compensation that can be taken into consideration when determining employer and employee contributions is limited. The compensation limitation is $285,000 in 2020.
Employees really don’t have to do anything to benefit from this type of plan. Assuming you have met the eligibility requirements, all of contributions are made by the employer with no contribution requirement by the employee.
If the employer does decide to make a profit-sharing contribution in a given year, the company must follow a predetermined formula for deciding which employees get what and how much. An employee’s allocation is typically determined in as a percentage of pay and is outlined in the plan document.
Your employer may apply a vesting schedule to employer contributions. As such, should you leave your employer before completing the required service for 100% vesting, you may not be entitled to receive all of the funds in your employer contribution account.
The plan assets may be invested by the employer or investment advisor in pooled account. In a pooled account structure, everyone shares in the earnings. This is the most common structure. In However, in some cases, they may allow for participant directed accounts. This is similar to a plan that contains a 401(k) feature.
As with all qualified plan designs, the employer must also ensure that the plan complies with the Internal Revenue Service and Department of Labor regulations. They must prepare a plan document which outlines all of the plan features, set up a system that tracks contributions, investments, distributions, and more, and file an annual return with the government. These plans can require a good deal of administrative upkeep, but many plan administrators will do this work on the company’s behalf.
If you have a 401(k), you have to start taking required minimum distributions (RMDs) by April 1 of the year following the year you turn 72 or the year you retire, whichever is later. Age threshold prior to the passage of the SECURE Act was 70 ½ Here’s a quick look at the pros and cons of 401(k) plans.
401(K) TRADITIONAL AND ROTH
Named after section 401(k) of the Internal Revenue Code, a 401(k) is an employer-sponsored retirement plan. To contribute to a 401(k), you designate a portion of each pay check to divert into the plan.
With a traditional 401(k) salary deferrals, these contributions occur before income taxes are deducted from your pay check. While, ROTH 401(k) deferrals are deducted after income taxes are deducted from your pay check.
The investment options among different 401(k) plans can vary tremendously, depending on the plan provider. In most cases, the employer, with the guidance of an investment advisor, will select a menu of funds to choose from which comply with IRS and DOL standards. Nevertheless, no matter which fund (or funds) you choose, any investment gains realized within the plan are not taxed by the Internal Revenue Service (IRS) while still in the Plan.
Notably, 401(k)s have much higher contribution limits than IRAs. These limits are a per person limit not per employer and include ROTH and traditional 401(k) deferrals. As such, should you change employers during the year, your overall deferral may not exceed the applicable annual limit. For 2020, the 401(k) contribution limit is:
$19,500 if you’re under age 50
$26,000 if you’re age 50 or older.
Overall, 401(k) plans are most beneficial when your employer offers a match, contributing additional money to your 401(k) account. The match is usually a percentage of your contribution, up to a certain percentage of your salary.
For example, your employer may match 50% of your contributions, up to 6% of your salary. The employer match doesn’t count toward your contribution limit, but the IRS does cap the total amount that can go into your 401(k) each year (your contributions plus the match).
Your employer has the option of applying
If your employer so decides, they may make an additional discretionary contribution on behalf of eligible employees. This contribution is made to an eligible employee regardless of whether an employee makes a 401(k) deferral.
For 2020, the combined contribution limits for a 401(k) are as follows:
$57,000 if you’re under age 50
$63,500 if you’re age 50 or older and make a “catch-up” 401(k) deferral
100% of your salary (if it’s less than the dollar limits)
You get a tax break when you contribute to a 401(k). The tax break depends on whether you select traditional pre-tax deferrals or ROTH deferrals. With traditional pre-tax deferrals, the current contribution from your salary reduces your current income and results in current tax savings. Earnings will accumulate and compound tax deferred until retirement. When the funds (contributions and accumulated earnings) are withdrawn they will be taxed as ordinary income. With ROTH deferrals, your deferrals will be subject to current income tax, just as with traditional, your contributions and earnings will accumulate and compound tax deferred util retirement. When distributed, neither the contributions (which you have paid tax already on) nor the accumulated earnings will be subject to income tax.
With traditional 401(k) deferrals and employer contributions, you’ll pay taxes after you reach retirement age and begin to make withdrawals from the plan. These distributions, as they are known, are subject to income taxes at your then-current tax rate. Traditional 401(K) saves on current income taxation as well as helps your money grow and compound faster as the amount you would have paid in current income taxes to the IRS is working for you and compounding. Also, if you tax rate is lower at retirement than currently, you will also experience an overall tax savings.
With a ROTH deferrals, assuming you have met the eligibility requirements for withdrawal (made after age 59 ½, have accumulated for 5 years, etc..), earnings on the contributions will never be taxed. This is advantageous for younger individuals who have many more years for the earnings to compound on the contributions and for those who feel the tax rates will be higher later on. This type of deferral reduces your future taxable income, which saves you money.
If you have a 401(k), you have to start taking required minimum distributions (RMDs) by April 1 of the year following the year you turn 72 or the year you retire, whichever is later. Age threshold prior to the passage of the SECURE Act was 70 ½ Here’s a quick look at the pros and cons of 401(k) plans.
A variation of traditional individual retirement accounts (IRAs), a Roth IRA is set up directly between an individual and an investment firm. Your employer is not involved.
As you set up and control the account, your investment choices aren’t limited to what the plan provider offers. This gives IRA holders a greater degree of investment freedom than employees have with 401(k) plans, even though the fees charged by those providers are typically higher.
In contrast to the 401(k), after-tax money is used to fund a Roth IRA. As a result, no income taxes are levied on withdrawals during retirement. While in the account, any investment gains are untaxed.
Your ability to make contributions to a ROTH IRA may be limited by your income.
The contribution limits are much smaller with Roth IRA accounts. For 2020, the maximum annual contribution for a Roth IRA is:
$6,000 if you’re under age 50
$7,000 if you’re age 50 or older
Roth IRA Income Limits
For 2020, you can make a full contribution if your income is less than $124,000 for individuals and $196,000 if you’re married filing jointly. If your income is between $124,000 and $139,000 for individuals and $196,000 and $206,000 for those married filing jointly, you can make a reduced contribution. If you earn more than these IRS-imposed limits, you can’t contribute to a Roth IRA.
You can withdraw your Roth IRA contributions at any time or any age with no tax or penalty. Withdrawals on earnings, however, could be subject to income taxes and a 10% penalty, depending on your age and how long you’ve had the account.
In general, you can avoid taxes and the penalty if your account is at least five years old and the withdrawal is:
Made after you turn age 59½
Taken due to a permanent disability
Made by your beneficiary or estate after your death
Used to buy, build, or rebuild your first home (a $10,000 lifetime maximum applies)
If you don’t meet those guidelines, you may be able to avoid the penalty (but not the tax) if a qualified exception applies.
Unlike 401(k)s, Roth IRAs have no RMDs during your lifetime. If you don’t need the money in retirement, you can leave it in the account, where it can continue to grow tax-free for your beneficiaries.
Below is a rundown of the pros and cons of Roth IRAs
401(k)s vs. Roth IRAs
Feature 401(k)-traditional pre-tax Roth IRA
Current tax break Yes. Contributions are deductible. No
Withdrawals Taxed as ordinary income Tax-free
Contribution Limits $19,500, or $26,000 if you’re age 50 or over $6,000, or $7,000 if you’re age 50 or over
Income Limits No Yes. At higher incomes contributions are reduced or eliminated.
Employer Match Yes. There’s a $57,000 ($63,500 for age 50 or over) limit on combined employer/employee contributions. No
Automatic Payroll Deduction Yes No
Earliest age to withdraw funds without penalty 59½ Withdraw contributions at any time, earnings at 59½
RMDs Yes. RMDs must start by April 1 following the later of the year you reach age 72 or the year you retire. Not during the owner’s lifetime
Average Fees High Low
Investment choices multiple Many
Maintained By Employer Self
Withdrawals are tax-free in retirement
More investment choices
No RMDs during your lifetime
Lower contribution limits
Income limits can prevent you from contributing
No employer match
A 403(b) plan (written variously as a 403b or 403 b plan) is a retirement account for certain employees of public schools and tax-exempt organizations. Participants include teachers, school administrators, professors, government employees, nurses, doctors, and librarians.
The 403(b) plan is in many ways similar to its better-known cousin, the 401(k) plan. Each offer employees a tax-advantaged way to save for retirement, but investment choices are typically more limited in a 403(b) and 401(k)s serve private sector employees.
403(b)s resemble 401(k)s, but they serve employees of public schools and tax-exempt organizations rather than private sector workers.
The advantages of a 403(b) compared to a 401(k) can include faster vesting of your funds and the ability to make additional catch-up contributions.
Investment choices may be more limited with a 403(b), however, and some accounts offer less protection from creditors than 401(k)s.
The features and advantages of a 403(b) plan are largely similar to those found in a 401(k) plan. Both have the same basic contribution limits—$19,500 in 2020. The combination of employee and employer contributions are limited to the lesser of $57,000 in 2020 (up from $56,000 in 2019) or 100% of the employee’s most recent yearly salary.
Both also offer Roth options and require participants to reach age 59½ to withdraw funds without incurring an early withdrawal penalty. Like a 401(k), the 403(b) plan offers $6,500 catch-up contributions for those age 50 and older in 2020 (up from $6,000 in 2019). Unlike a 401(k), it also offers a special plan for those with 15 or more years of service with the same employer (see below).
Although it is not very common, your job situation could end up giving you access to both a 401(k) and a 403(b) plan.
If your employer offers a 403(b) and a 401(k) you can contribute to both, but your aggregate contribution cannot be more than the $19,500 ($19,000 in 2019) limit, not counting any catch-up contributions.
Earnings and returns on amounts in a regular 403(b) plan are tax-deferred until they are withdrawn. Earnings and returns on amounts in a Roth 403(b) are tax-deferred if the withdrawals are qualified distributions.
Employees with a 403(b) may also be eligible for matching contributions, the amount of which varies by employer.5 Plans that do not offer employer matches deprive employees of the essentially free money these provide, but they may lead to lower administrative costs. Those 403(b)s that lack matching contributions are not required to meet the onerous oversight rules of the Employee Retirement Income Security Act (ERISA), which means that their administrative fees may be lower than for 401(k)s or other retirement plans subject to greater oversight.
Many 403(b) plans vest funds over a shorter period than 401(k)s, and some even allow immediate vesting of funds, which 401(k)s rarely do. Also, if an employee has 15 or more years of service with certain non-profits or government agencies, they may be able to make additional catch-up contributions to a 403(b) plan that those who have a 401(k) plan can’t make.
Under this provision, you can contribute an additional $3,000 a year up to a lifetime limit of $15,000. And unlike the usual retirement plan catch-up provisions, you don’t have to be 50 or older to take advantage of this. But you do have to have worked for the same eligible employer for the whole 15 years.5
Clergy can also participate in a 403(b) but there’s a special plan type—a 403(b)(9)—that’s designed specifically for employees of religious institutions.
You must be a “qualified entity”
As with a 401(k), funds withdrawn from a 403(b) plan before age 59½ are subject to a 10% tax penalty, although you may avoid the penalty under certain circumstances, such as separating from an employer at age 55 or older, needing to pay a qualified medical expense, or becoming disabled.
A 403(b) may offer a narrower choice of more costly investments than the other types of retirement plans. The reason is that 401(k)s tend to be administered by mutual fund companies, which can offer a host of these diverse and versatile investment options. Most 403(b) plans now offer mutual fund choices as well, albeit inside a variable annuity contract in many cases. However, fixed and variable contracts and mutual funds are the only types of investments permitted inside these plans—other securities, such as stocks and real estate investment trusts (REITs), are prohibited.
The presence of an investment option that 403(b)s favor is, at best, a mixed blessing. When the 403(b) was invented in 1958, it was known as a tax-sheltered annuity. While times have changed, and 403(b) plans can now offer mutual funds, as noted, many still emphasize annuities. These investments have some advantages, but financial advisors often recommend against investing in annuities in a 403(b) and other tax-deferred investment plans for a variety of reasons.
For 403(b)s that don’t have ERISA protection, as is typically the case for those that lack employer matches, accounts may lack the same level of protection from creditors as plans that require ERISA compliance, including 401(k)s. If you are at risk of creditors pursuing you, speak to a local attorney who understands the nuances of your state. The laws can be complex.
A lack of ERISA protection means that the plan doesn’t have to follow ERISA standards to ensure plan safety.
Another disadvantage of non-ERISA 403(b)s include their exemption from non-discrimination testing. Done annually, this testing is designed to prevent management-level or highly compensated employees from receiving a disproportionate amount of benefits from a given plan.
457 plans are IRS-sanctioned, tax-advantaged employee retirement plans offered by state and local public employers and some non-profit employers. They are among the least common forms of defined-contribution retirement plans.
As defined-contribution plans, both 401(k) and 457 plans are funded when employees contribute through payroll deductions; participants of each plan set aside a percentage of their salary to put into their retirement account. These funds pass to the retirement account without being taxed, unless the participant opens a Roth account, and any subsequent growth in the accounts is not taxed.5
As of 2020 the annual maximum contribution limit for 457 plans is $19,500. For employees over the age of 50, both plans contain a catch-up provision that allows up to $6,500 in additional contributions. Contributions to each plan qualify the employee for a “saver’s tax credit.” It is possible to take loans from both 401(k) and 457 plans.
However, 457 plans are a type of tax-advantaged nonqualified retirement plan and are not governed by ERISA. As ERISA rules do not apply to 457 accounts, the IRS does not assess an early withdrawal penalty to 457 participants who take money out before age 59½, though the amount taken is still subject to normal income taxes.
Notably, 457 plans feature a double limit catch-up provision that 401(k) plans do not have. This provision is designed to allow participants who are nearing retirement to compensate for years in which they did not contribute to the plan but were eligible to do so. In 2020 this provision would allow an employee to contribute up to $39,000 to a plan.
Under the right conditions, a 457 plan participant may be able to contribute as much as $38,000 to his or her plan in one year in 2019—and $39,000 in 2020.
While both plans allow for early withdrawals, the qualifying circumstances for early withdrawal eligibility are different. With 457 accounts, hardship distributions are allowed after an “unforeseeable emergency,” which must be specifically laid out in the plan’s language.
Both public government 457 plans and non-profit 457 plans allow independent contractors to participate. Independent contractors are not eligible to participate in 401(k) plans, however.
NON-QUALIFIED DEFERRED COMPENSATION PLANS
A non-qualified deferred compensation (NQDC) plan allows a service provider (e.g., an employee) to earn wages, bonuses, or other compensation in one year but receive the earnings—and defer the income tax on them—in a later year. Doing this provides income in the future (often after they’ve left the workforce) and may reduce the tax payable on the income if the person is in a lower tax bracket when the deferred compensation is received.
Non-qualified deferred compensation (NQDC) is compensation that has been earned by an employee, but not yet received from their employer.
The tax law requires the plan to be in writing; the plan document(s) to specify the amount to be paid, the payment schedule, and the triggering event that will result in payment; and for the employee to make an irrevocable election to defer compensation before the year in which the compensation is earned.
The intended tax benefits of NQDC plans are realized only if the plan conforms to tax law requirements, and other restrictions can become onerous.
Deferred compensation plans can be qualifying or non-qualifying. The non-qualified type is created by an employer to enable employees to defer compensation that they have a legally binding right to receive. There are several varieties of NQDC plans (also called 409A plans after the section in the tax code governing them, introduced in 2004); the one discussed here is the basic unfunded plan for deferring part of annual compensation (the most common type).
The tax law requires the plan to meet all of the following conditions:
The plan is in writing.
The plan document(s) specifies, at the time an amount is deferred, the amount to be paid, the payment schedule, and the triggering event that will result in payment. There are six permissible triggering events: a fixed date, separation from service (e.g., retirement), a change in ownership or control of the company, disability, death, or an unforeseen emergency. Other events, such as the need to pay tuition for a child, a change in the financial condition of the company, or a heavy tax bill, are not permissible triggering events.
The employee makes an irrevocable election to defer compensation before the year in which the compensation is earned. However, a special deferral election rule applies to commission payments.
The NQDC plan can also impose conditions, such as refraining from competing with the company or providing advisory services after retirement.
The deferred amount earns a reasonable rate of return determined by the employer at the time that the deferral is made. This can be the rate of return on an actual asset or indicator—say, the return on the Standard & Poor’s 500 Index. Thus, when distributions are made, they include both the compensation and what amounts to earnings on that compensation (though there are no actual earnings; it’s merely a bookkeeping entry).
Violating the stringent conditions in the law triggers harsh results. All of the deferred compensation becomes immediately taxable. What’s more, there is a 20% penalty, plus interest, charged on this amount
NQDC plans refer to supplemental executive retirement plans (SERPs), voluntary deferral plans, wraparound 401(k) plans, excess benefit plans, and equity arrangements, bonus plans, and severance pay plans.1
Teachers’ salaries are non-qualified compensation plans that meet the requirements of IRC Section 409A. If a teacher earns $54,000 a year and works from Aug. 1, 2016, to May 31, 2017, she earns $5,400 a month. If the teacher is paid for only the months she worked, she is paid $5,400 a month for 10 months. If, however, she is paid over 12 months, she earns $4,500 a month.
In the example dates above, with a 10-month salary, the teacher earns $27,000 in 2016 and $27,000 in 2017. With a 12-month salary, she earns $22,500 in 2016 and $31,500 in 2017. Based on the hours worked, if she is paid a 12-month salary, $4,500 worth of work conducted in 2016 is paid out in 2016. Under IRC Section 409A, the $4,500 from 2016 is considered non-qualifying deferred compensation that meets the requirements of the code.
Because NQDC plans are not qualified, meaning they aren’t covered under the Employee Retirement Income Security Act (ERISA), they offer a greater amount of flexibility for employers and employees. Unlike ERISA plans, employers can elect to offer NQDC plans only to executives and key employees who are most likely to use and benefit from them. There are no non-discrimination rules, so deferral need not be offered to the rank-and-file. This gives the company considerable flexibility in tailoring its plan. The plans are also used as “golden handcuffs” to keep valued staff on board, as leaving the company before retirement can result in forfeiting deferred benefits.
An NQDC plan can be a boon to cash flow, since currently earned compensation is not payable until the future. However, the compensation is not tax-deductible for the company until it is actually paid.1
The costs of setting up and administering an NQDC plan are minimal. Once initial legal and accounting fees have been paid, there are no special annual costs, and there are no required filings with the Internal Revenue Service (IRS) or other government agencies.
Unlimited Savings and Tax Benefit
The IRS imposes strict limitations on the amount of money you contribute to a qualified retirement plan, like a 401(k). Deferred compensation plans have no such federally mandated limits, though employers may specify a contribution limit based on your compensation. If you are a highly compensated employee, you can maximize contributions to your 401(k) and then continue to build your retirement savings through an NQDC plan without restriction.
The ability to defer any amount of compensation also reduces your annual taxable income. This can, in turn, put you in a lower tax bracket, further decreasing your tax liability each year. However, deferred compensation is still subject to FICA and FUTA taxes in the year it is earned.
Many NQDC plans offer investment options similar to 401(k) plans, such as mutual funds and stock options. NQDC plans aren’t just fancy deposit accounts for high rollers. Instead, they allow you to grow your wealth over time. However, you can invest at a larger scale because your contributions are unlimited, increasing the potential for more significant gains.
Strict Distribution Schedule
Unlike a 401(k), you must schedule distributions from an NQDC plan in advance. Rather than being able to withdraw funds at will after retirement, you must choose a distribution date at some time in the future. You must take distributions on the designated date, regardless of whether you need the funds or how the market is doing. This means your taxable income for the year is increased, and the timing of the distribution may mean that the assets in your investment portfolio are liquidated at a loss.
The NQDC plan can allow for a subsequent deferral or a change in election (e.g., to receive deferred compensation at age 70 rather than at age 65) only under certain conditions. This requires that the subsequent election be made at least 12 months before the date that payment was originally scheduled to begin, that the subsequent election change delays the payment date for at least five years, and that the election is not effective until at least 12 months after it is made.
No Early Withdrawal Provision
Though it is discouraged, employees who contribute to 401(k)s or other qualified plans are legally allowed to withdraw funds at any time. While distributions taken before a certain age may incur tax penalties, nothing is preventing you from accessing funds in an emergency. In addition, most plans provide for several penalty-free early withdrawal if you can prove financial hardship.
NQDC plans, conversely, have no such provisions. You must withdraw funds according to the distributions schedule and no earlier. Funds contributed to an NQDC plan are not accessible before the designated distribution date, even if you have an emergency financial need that you cannot meet by other means.
No ERISA Protections
Because NQDC plans are not covered under ERISA, they are not afforded the same protections from creditors as other retirement plans. In fact, as a plan participant, you don’t own an account of any kind, because your employer reduces your compensation by the deferral amount rather than depositing funds into an account held with a financial institution. The amount of the employee deferral represents a liability on the employer’s balance sheet, essentially making the NQDC plan an unsecured loan between the lending employee and the borrowing employer.
If the plan is unfunded, you must rely on the employer’s promise to pay in the future according to the distribution schedule. If the employer falls on hard times and must pay off debts, the funds that might have been used to pay your employee distributions can be claimed by creditors. Funded NQDC plans offer more protection for employee contributions, but deferrals are generally taxable in the year they were earned, nullifying the tax benefit that unfunded plans provide.
There’s another financial risk: the rate of return paid on the deferred compensation. An employee may be able to earn a greater rate of return on the after-tax amount without deferral than what is paid under the deferred compensation plan.
An NQDC plan can supplement or supplant a qualified retirement plan to create retirement savings for an employee on a tax-advantaged basis. It can also be used for independent contractors, corporate directors, and other non-staffers. However, the intended tax benefits are realized only if the plan conforms to tax law requirements, and other restrictions can become onerous.
QUALIFIED DOMESTIC RELATIONS ORDER (QDRO) VALUATION
Qualified Retirement Plans are subject to “anti-alienation” provisions. That means that no one, except for the IRS can attach ownership to a participants account. If it so happens that a participant and their spouse divorce, and the retirement plan benefits are part of the settlement, technically the spouse of the participant cannot be assigned the right to or ownership of the participants account. A QDRO is a judicial order that recognizes the spousal ownership of a participants benefit.
QDROs must first be issued by a State-level domestic relations court and is then reviewed by the plan administrator to ensure compliance with regulations as well as the plan provisions. Once a valid QDRO is in place, the alternate payee (non participant former spouse) is now responsible for all taxes due on the distribution to him/her. They may defer taxation and have the option of rolling over the distribution to an IRA tax deferred. In absence of a valid QDRO the participant will be responsible for all taxes /penalties due on the distribution to the former non participant spouse.