From 401(k) to SIMPLE

This article describes the following types of defined contribution (DC) plans: 401(k), 401(a), 403(b), 457, KEOGH, Simplified Employee Pension (SEP), Individual Retirement Account (IRA) and SIMPLE Plan.

This is the most commonly known type of defined contribution plan. Created primarily for private corporations, the 401(k) allows both the employee and employer to contribute money for retirement on a pretax basis. Some employer-sponsored 401(k) plans permit "matching" employer pretax contributions, as well as employee after-tax contributions.

All contributions made to a 401(k) plan, as well as any earnings generated by the plan, grow tax-deferred. Pretax contributions and earnings aren't subject to state or federal taxation until the money is withdrawn from a participant's account, usually after the participant has retired. Withdrawals made before age 59-1/2 may be subject to Internal Revenue Service (IRS) penalties.

This plan gives the employer sponsoring the plan authority over the plan's features and administration. For example, it is the employer who defines the amount of money the company may contribute to an employee's account each year, the requirements the employee must meet to receive these contributions, and under what circumstances this money may be made available to the employee. Some 401(a) plans allow employees to make after-tax contributions. Examples of 401(a) plans include profit sharing, pension, and money purchase plans.

Created for 501(c)(3) nonprofit institutions (such as churches, hospitals, and colleges and universities) and public schools, the employer-sponsored 403(b) allows employees to contribute and invest money for retirement on a pretax basis. Similar in construction to the 401(k) plan, the 403(b) permits employers to make "matching" pretax contributions, and in some instances allows employees to make after-tax contributions.

All contributions made to a 403(b) plan, as well as any earnings generated by the plan, grow tax-deferred. Pretax contributions and earnings aren't subject to state or federal taxation until the money is withdrawn from a participant's account, usually after the participant has retired. Withdrawals made before age 59-1/2 may be subject to IRS penalties.

This plan allows tax-exempt employers and employees of state or local governments and their agencies to set aside money for retirement on a pretax basis through a plan sponsored by the employer. The primary differences between a 457 and a 401(k) or other type of qualified retirement plan is that 457 plan assets are owned solely by the employer and are subject to claims from the employer's creditors. Additionally, 457 plans determine whether it is the employee or the employer who directs where employee contributions are invested.

The plan was, however, modified by the Small Business Job Protection Act of 1996 which mandates that state and local governments that maintain non-qualified deferred compensation plans under Internal Revenue Code 457 must hold all plan assets and income in trust for the exclusive benefit of participants and their beneficiaries. This requirement was to have been satisfied by Jan. 1, 1999 for any plan established before Aug. 20, 1996. For plans founded on or after Aug. 20, 1996, the trust requirement must be met at the establishment of the plan. This change has no bearing on 457 plans of tax-exempt organizations.

KEOGH plans are tax-deferred retirement accounts for people who are self-employed (full- or part-time) or for employees of unincorporated businesses. Participants can contribute as much as 25% of their income to their account, or up to $42,000. These contributions are made pretax. The contributions can be invested as the participant chooses. Taxes are due only when funds are withdrawn from the KEOGH account. Funds can be withdrawn when you reach age 59-1/2 (although you may be subject to IRS penalties), but they must begin to be withdrawn the year following the year you turn 70-1/2.

A Simplified Employee Pension (SEP) is designed to appeal to small companies, though it can be adopted by companies of any size. They can be established by corporations, unincorporated partnerships and businesses, and by people who are self-employed. SEPs are also known as SEP-IRAs. Under a SEP, the employer sets up an IRA account for each employee eligible to participate. The account can be funded by the employer or by the employee through deferred compensation contributions. Employees are only taxed when they withdraw money from their account.

An Individual Retirement Account (IRA) allows individuals to save for retirement by letting those who qualify invest a certain amount each year on a tax-deferred basis. An IRA is different from an individual bank savings account in several important ways. Money that goes into an IRA can be invested. Any investments placed in an IRA grow tax-deferred until withdrawn. Individuals can put up to $4,000 a year in an IRA. Married couples can put $4,000 each in an IRA, for a total of $8,000 a year.

If you or your spouse participates in another qualified retirement plan, such as a 401(k) plan, your IRA contribution may not be deductible. If you're single and make less than $50,000 a year, your IRA contribution is deductible from your gross income. If you make between $50,000 and $60,000, part of your contribution is deductible. If you're married, it's deductible if you earn less than $70,000 jointly, and is partially deductible if you make between $70,000 and $80,000 together.

You only have to pay taxes on your IRA contributions or earnings from the investment of those funds when you withdraw the money from the account. You can begin taking money out of your IRA at age 59-1/2, but you must begin withdrawing funds the year following the year you turn 70-1/2.

The Savings Incentive Match Plan for Employees (SIMPLE) is a retirement plan created in 1996 for businesses with 100 employees or less. Self-employed workers also may participate.

Employers must match employee contributions following one of two methods:

• They can match employee contributions dollar-for-dollar, up to 3% of the employee's total compensation.

• Or they can contribute 2% of each employee's compensation to the plan, whether the employee contributes or not.

Employees can contribute up to $10,000 a year to the plan, their contributions are tax deductible, and the money isn't taxed until it's withdrawn.

Employers can set up a SIMPLE plan if the preceding year they paid an employee at least $5,000. They can't have any other employer-sponsored retirement plan. Employees who have earned at least $5,000 in two different years with the company, and are expected to make at least that in the current year, must be given the opportunity to participate.

The plan can be set up as an Individual Retirement Account (IRA) for each employee, or the employer can choose to set it up as a 401(k) plan. If it is set up as a 401(k) plan, it is subject to many of the same distribution limitations, reporting and disclosure requirements, and rules regarding fiduciary responsibilities that apply to other 401(k) plans. If set up as an IRA, the SIMPLE plan is considered a participant-directed retirement plan.