U.S. Retirement Plans and Taxation

Abstract

Generally speaking, in the United States, there are two categories of work-related retirement plans. One type is the tax qualified retirement plan (including some variations discussed below), and the other type is commonly referred to as the nonqualified retirement plan. For today’s Americans, the most common sources of retirement funds are derived from (i) work related retirement plans, (ii) personal savings and investment, and (iii) Social Security benefits. This article focuses on the mechanics of the first source . work related retirement plans, which is discussed in the Section II of this article. Section II contains three subsections. Subsection A covers two types of popular work-related retirement plans . defined contribution plans and defined benefit plans, and their tax consequences. Subsection B discusses certain individual retirement accounts and simplified retirement plans for small employers. Subsection C describes nonqualified retirement arrangements, which are more commonly used by employers to fund retirement for highly compensated employees. Qualified retirement plans have two general categories: defined contribution plans and defined benefit plans. By definition, a defined contribution plan means contributions to the plan are fixed. A defined benefit plan means the benefits (i.e., distributions) received by the plan participants are fixed. The latter was more popular in the past. Nowadays, a vast majority of qualified plans in the United States are of the defined contribution plan type. A nonqualified deferred compensation plan, thus, provides a lot more flexibility in terms of plan provisions and operation. For instance, it may be offered only to highly compensated employees and executives (as opposed to all eligible rank and file employees as required for a 401(k) plan). The United States has implemented many tax breaks to encourage employers to sponsor qualified retirement plans for their employees. It also has similar tax advantages for individuals to encourage them to save for retirement. Participating in a retirement plan is just one component of retirement planning. Retirement planning should take a variety of forms, and start early.