Understanding the Tax Treatment of Retirement Plans

Over the past 50 years, there has been a dramatic shift in funding retirement for the average American. Most people rely on savings and few have pensions available to them. One of the most common ways to save is through a retirement savings plan offered by your employer; the most common being the 401(k) plan. These plans are designed to incent you to save every year, often with contributions from your employer, with the goal of maintaining a comfortable lifestyle in retirement.

Understanding defined contribution plans
A 401(k) plan is one kind of defined contribution plan. In a defined contribution plan, the employer, employee, or both make regular contributions to the plan. The money is invested and taxes are deferred until withdrawal. The retirement benefit is the balance in the account. Other types of defined contribution plans include 403(b) plans, SEPs, and SIMPLE plans. In general, both employers and employees can contribute to these plans to a maximum of $69,000 in 2024 (in addition to a “catch-up” contribution, if eligible). Certain plan designs, such as including a profit sharing feature, can help self-employed and small business owners build up their own retirement nest egg and provide options for the deferral of taxable income, as well as enhanced employee benefit packages.

“Defining” defined benefit plans

A defined benefit plan, as the name suggests, is designed to fund a certain level of retirement income at a future date. It is funded by annual contributions based on the individual’s age, income, length of time until retirement, and rate of return on the fund’s investments. The contribution amount is determined each year by actuarial calculations. For 2024, the funded benefit payable at retirement can be as much as $275,000, based on up to $345,000 of annual compensation. The plan is funded entirely by employer contributions, which are generally 100% tax deductible. For a business owner close to retirement age, the required contribution can be considerable, along with the tax deduction. Annual contributions are mandatory, and if the business has other employees, contributions have to be made for them, too. However, plans can be set up with eligibility requirements to exclude, for example, employees who work fewer than 1,000 hours in a year. A defined benefit plan is more costly than many retirement plans, but allows for greater contributions than most other plans.

Data source: Home | Internal Revenue Service .

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any business/estate planning or investment strategy is suitable for a specific business or investor. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.

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