Retirement plan basics

Retirement plan basics

Qualified retirement plans

By now I hope you have a good understanding of the power of compounding. Starting early and attaining even modest increases in your return can lead to a much larger nest egg down the road.

But now let's look at the best way to actually build that nest egg. By far the best way to save and invest your retirement money is through a tax-sheltered retirement account.

One of the first things to understand about all employment-related retirement plans is the difference between so called qualified and non-qualified plans.

There are plenty of different qualified plans but they all meet IRS standards. Qualified plans provide the best deal for both employers and employees.

How qualified plans work

Under a qualified plan, any contributions that the company makes are immediately deductible as wages by the company. This increases their expenses and thus lowers their taxable profit.

Under a 401(k) arrangement, you as the employee, divert part of your salary to a tax-deferred account. The employer may also match a portion of your diverted wages.

In this case, the employer gets to deduct immediately your diverted wages and the employer's match. You, on the other hand, won't pay income taxes on your savings or the employer's match. This is a win-win scenario for the company and it's workers, and a lose-lose scenario for the US Treasury.

Qualified plans, however, come with strings attached. To get immediate deductibility, employers must meet non-discriminatory requirements. These are meant to ensure that the employer doesn't slant the plan to favor executives or owners.

The employee also faces restrictions. Most plans limit access to funds until age 59.5, and place tax penalties on those who withdraw funds early, although there are exceptions.

Non-qualified plans

There are also non-qualified plans. These include special plans set up for executives or pension plans set up between large companies and large unions.

These plans are too complex to discuss here, and they have even more strings that limit their attractiveness. So almost all of the plans that you'll participate in, such as the 401(k) plan, will be qualified plans.

Graduated and cliff vesting

To become a qualified plan, a plan must offer a fairly lenient vesting schedule. Once you're vested in a plan, you're entitled to benefits. Back in the bad old days, you often had to work for a company for 10 or even 20 years before becoming vested in the program.

However after the Tax Reform Act of 1986, almost all people must become vested in a plan after seven or fewer years of employment. A company can offer so-called "cliff vesting" or "graduated vesting".

With cliff vesting, an employee becomes eligible to get 100 percent of the company's contribution after five years of employment.

Under graduated vesting, the employee gradually stakes a claim to the company's contribution over years three to seven of employment. After the third year, you claim 20 percent of what the company had already contributed in your name. After the fourth year, you claim 40 percent and so on up to 100 percent after year seven.

These five and seven year schedules are the worst-case allowed for qualified plans. However, companies often offer better deals, such as 100 percent graduated vesting over five, not seven, years.

Forfeited money due to lack of vesting

So what happens if you you're in a plan that offers five year cliff vesting and you leave after year three? What happens to the money that the company chipped in your name?

The answer depends on the plan, but if you're in a big company's plan your money usually is split up between the remaining employees. You lose, and remaining employees win. But if you're in a small company's plan, you may be able to keep the employer's matching contribution.

Still, remember one thing. The money that you personally save in the plan is always 100 percent yours. Assume that you have a 401(k) plan and you divert $2,000 of your salary into it. The company offers a 50 percent match and thus adds $1,000 to your account.

The $2,000 you saved is always your money, but the $1,000 contribution by the company is subject to the plan's vesting rules. If you leave early, you may lose some or all of the $1,000 match.