Thread by @fin_empowerment

RETIREMENT PLANS 101 🏝️

Part 7 of a series reviewing insights from CFP® professional education.

Retirement plans offer big tax savings for employers and a tax-efficient way for employees to save for future financial security.

In fact retirement plans are some of the largest tax breaks in the US tax code today. 💰

Are you taking advantage?

Let's help you prepare for life after work.

👇🧵

This post outlines the main types of retirement plans and how they work.

- requirements for plan sponsors (employers)
- how much you can contribute
- how to access the funds
- who can participate

... and more, so you can make the most of your retirement savings. 💪💵

Whether you're an employee looking to save for retirement or a business owner looking to fund a plan I've got tons of useful info for you. Bookmark this one 🔖

WHAT ARE QUALIFIED RETIREMENT PLANS?
Qualified retirement plans adhere to certain rules put forth by the IRS and Department of Labor (ERISA).

Defined benefit pension plans and section 401(k) plans are examples of qualified plans.

People with no retirement savings are likely to draw on government programs as they age. Qualified retirement plans encourage the private sector to help ease this burden.

TYPES
There are four main types of retirement plans

- Defined Benefit (DB) plans pay a specified retirement benefit
- Defined Contribution (DC) plans permit a specified amount of pre-tax contributions into the plan
- Pension plans must be funded every year by the employer
- Profit Sharing plans allow more flexibility in funding

This chart shows the different types of plans we'll cover in this post.

BENEFITS
In return for complying with government rules, qualified plans offer benefits to workers and companies who sponsor them.

- Tax-deductible contributions for employers (contributions also avoid payroll taxes).
- Tax-deferred growth of earnings within the plan until distribution at retirement.
- Under ERISA, qualified retirement plans are fully protected (up to any $ amount) from employer and employee creditors, including bankruptcy proceedings.
- Creditor protection has also been extended to SIMPLE, 403B, 457, and rollover IRAs.
- Some plans allow in-service withdrawals while the employee is still working. Lots of rules around this including being over 59.5 years old, or facing financial hardship

REQUIREMENTS
In return for the benefits retirement plans offer, there are many requirements that must be met. The IRS reviews and provides a determination letter signifying approval if the plan meets the standards.

- Qualified plans must be established in writing by plan documents. Your human resources department should have these on file - read them to understand how your plan works.
- There must be permanent intent (not just created as a temporary tax shelter).
- Pension plans must be funded every year by the employer to retain their tax-qualified status.
- Profit sharing plans must be funded on a substantial and recurring basis (not specifically defined). Contributions in 3 of every 5 years is generally thought to be sufficient.
- The plan must be a separate legal entity. Contributed funds are held in trust, and cannot be accessed by the employer.
- Plans cannot overwhelmingly benefit higher paid workers, and must prove specific levels of employee coverage and participation.

HIGHLY COMPENSATED EMPLOYEE (HCE)
To remain tax qualified, plans must identify highly paid employees and measure the amount of plan benefits they receive relative to other workers. An HCE is defined as one of the following:

- 5% (or more) owner in the company this year or last
- more than $160,000 annual compensation in 2025 (the number adjusts each year)
- top 20% of employees ranked by compensation

COVERAGE TESTS
Qualified plans must prove they adequately cover their workforce by meeting one of the following tests each year:

- Percentage Test: # of covered non-HCEs / # of eligible non-HCEs (based on age + years of service) >= 70%
- Ratio Test: % non-HCEs covered / % HCE covered >= 70%
- Avg. Benefits: Avg. benefits % non-HCEs / Avg. benefits % HCE >= 70%
- 50/40 test (DB plans only): Plan must benefit lesser of 50 employees OR 40% of eligible employees

QUALIFIED PLAN ELIGIBILITY
Defines which employees can participate in the plan.

- Standard: 21 years old and at least 1 year or 1,000 hours service (21 + 1)
- Some plans can require 2 years of service but must offer immediate vesting (vesting refers to the moment when the employee fully owns the funds)

NON-QUALIFIED PLANS
Do not comply with DOL and IRS regulations, and thus do not offer all benefits of qualified plans, including:
- no creditor protection (assets may be seized)
- no immediate employer tax deduction (employer can deduct when employee withdraws funds).

BENEFITS
Non-qualified plans can discriminate in favor of higher paid employees. This allows higher paid workers, or those who max out their contributions to qualified plans, to continue to accumulate retirement funds.

Section 457 plans are an example of a non-qualified retirement plan.

This chart illustrates other qualified plan classifications you should know. 🤓

FREE GIFT 🎁
Are you a business owner looking to take advantage of tax breaks?

I have a simple chart that outlines the key rules for the most used small business retirement plans.

Comment on this post and I'll send it to you for free (must be following).

Moving on 👇

DEFINED BENEFIT VS. DEFINED CONTRIBUTION
There are two major categories of qualified plans.

Defined Benefit (DB) plans pay a specified benefit amount at retirement. The plan makes a promise to the employee to pay the specified benefit, and bears the investment risk associated with earning enough to pay the stated benefit amount.

Defined Contribution (DC) plans specify the amount the employee and employer may contribute into the plan in a given period. They do not guarantee a specific amount at retirement, instead the employee manages their funds and selects investments to pursue their retirement goals. The employee bears the investment risk.

VESTING
Vesting details when an employee owns their contributions or plan balance.

DB plans must use 5-year cliff or 3-7 year graded vesting (or something at least as generous)

DC plans (or DB plans considered "top heavy") must use 3-year cliff or 2-6 year graded.

The picture illustrates the different vesting schedules.

Let's talk about common DB and DC plans you may comes across.

DEFINED BENEFIT PENSION PLAN
Upon reaching retirement age, these plans pay a set monthly pension for the life of the employee. For married employees, their surviving spouse continues to receives benefits for their lifetime.

Funds for all employees are pooled together and managed by the employer. Employer chooses investments and is responsible to deliver the promised benefit.

CONTRIBUTIONS
- Employer contributes on employee's behalf. Does not accept employee contributions.
- Actuarial services are required to calculate the required employer contribution needed to fund the promised benefits. Calculations are based on employee ages, salary, investment strategy assumed returns and other factors. This makes DB pension plans expensive and complex for employers to offer.
- As a pension plan, annual employer contributions are MANDATORY. For this reasons these plans are best for companies with a history of stable profits.

QUALIFIED PLAN DISTRIBUTIONS
The IRS wants people to use retirement funds for retirement, so there are many rules around how and when money can be taken out of qualified plans. Here are some highlights, and look for a future thread on this ....

Three main types of distribution options for qualified plans:

- Lump sum (may be eligible for special tax treatment)
- Annuity (common for DB plans)
- Rollover

DB PENSION DISTRIBUTIONS
- Lifetime annuity
- Available at retirement age (65), may be available for early retirement at 62 (check plan docs).
- Early retirees may see benefits reduced by 10% for every year under 10 years of service. For example, an early retiree with 8 years of service could see a 20% benefit reduction.
- Paid to eligible retired employees regardless their age when they entered the plan.
- Guaranteed by the Pension Benefit Guarantee Corporation, part of the US government.
- Benefit amount based on a formula. Typically either a % of final compensation, or a unit benefit where the worker earns a set % for each year of service.

EXAMPLE: 2% per year benefit means a worker retiring after 25 years of service would receive 50% of their final compensation as a pension (25 years x 2%).

2025 DB PLAN LIMITS (adjusted annually by the IRS to reflect cost of living changes).
Max benefit = $280,000 --OR-- 100% of employee's average compensation over the 3 consecutive highest paid years (whichever is less)

NOTE: limits for PBGC benefits is lower (just over $89,000 in 2025), so higher paid retirees in underfunded plans may see their benefit levels reduced.

ADVANTAGES of DB PENSIONS
- maximizes tax-deferred retirement savings. There is no $ contribution limit unlike DC plans, enabling employers to maximize tax deductible plan contributions.
- actuary determines contribution level necessary to pay stated benefits, and this amount is used to determine the tax deductible amount of contributions.
- favors older and higher paid employees.
- may encourage early retirement which can improve morale. Eligible workers don't need to remain employed just for a paycheck.
- guaranteed benefits may be attractive for people uncomfortable with investment risk

DRAWBACKS
- complex and expensive to manage (actuary services, additional testing required)
- employees who leave early don't benefit
- mandatory funding may not work for businesses with volatile profits
- employer assumes investment risk

PROFIT SHARING PLANS
- no annual funding requirement
- good for companies with variable profits, whose ability to contribute varies
- benefits younger employees who have longer time for tax deferred growth of contributions
- employer contributions are tax deductible up to a max. of 25% of the aggregate value of all employee compensation (max. $350,000 compensation per employee is considered in calculating the deduction).

DISCRIMINATION TESTS (DC PLANS)
The government wants to be sure plans don't discriminate in favor of higher paid workers. Annual deferral and contribution percentages for HCEs cannot exceed that of non-HCEs by more than specified amounts. There are some complicated rules and tests around this which I'll save for another thread.

If a company fails the tests, they must remedy by either HCEs taking a corrective distribution -- and getting slapped with a tax bill -- or the employer contributing more to non-HCE accounts within the plan to balance things out.

Complying with these tests is expensive and complicated. There are some things companies can do to streamline compliance.

AUTOMATIC ENROLLMENT
DC plans can avoid nondiscrimination testing by auto-enrolling eligible employees.

- must auto-defer 3% - 15% of employee's annual compensation
- if deferring less than 6%, must auto-increase by 1% per year until reaching 6%
- employer must match 100% of 1% and 50% of next 5%, OR flat 3% profit share
- employer contributions must fully vest after 2 years of service
- must notify employees 30 days prior to enrollment and annually thereafter giving opportunity to NOT participate (negative consent), and advise of the default investment option

If your employer's plan has auto-enrollment, this is a GOOD THING. They are looking out for your financial future!

401(K) PLANS
A popular form of defined contribution profit sharing plan where both employer and employee contribute. Annual employer funding not mandatory, and there is no promised benefit amount. Eligible employees may enter the plan within 6 months of eligibility (21 + 1) being met. 2 entry dates per year typically January and July.

Employees choose how much they contribute (up to specified IRS limits), and how their retirement funds are invested.

Funds accumulate in an account which the employee owns, and are portable from one employer to another.

CONTRIBUTIONS
- Employee defers income pre-tax and employer matches the deferral up to a % specified in the plan documents.
- After tax contributions permitted if plan offers a Roth option
- Employee deferrals are 100% vested immediately; employer matches vest on either a 3-7 year cliff or 2-6 year graded schedule (see vesting picture above).

SAFE HARBOR RULES
Allows 401k plans to avoid discrimination testing by adoption a uniform set of rules. Many plans use safe harbor rules to streamline administration and setup costs.

- Provide written notice to participants of their rights within the plan, including automatic enrollment, the default investment option, and the option not to contribute. Notice must be provided 30 days prior to enrollment, and on an annual basis afterward
- Employer contribution must fully vest immediately using 1 of the following methods (or something at least as generous):
--- BASIC MATCHING FORMULA (MOST COMMON): employer matches 100% of first 3% deferred by employee & 50% of next 2% (4% total match). HCE matching rate cannot exceed that of non-HCEs.
--- 3% minimum nonelective contribution for ALL eligible employees (whether participating in plan or not)

2025 ANNUAL DEFERRAL LIMITS FOR DC PLANS
- TOTAL annual contributions (employer + employee portion) limited to 100% of a given worker's compensation -- OR -- $70,000, whichever is less (rollovers and 50+ catch-up contributions are excluded from this amount).
- EMPLOYEE contributions are limited to $23,500 per taxpayer in 2025, across all DC plans in which they participate. This includes 403b and 457 plans as well. (SIMPLE plans have different limits).

This chart shows the 2025 deferral limits for various DC plans.

🚨 REMEMBER TO CHOOSE YOUR INVESTMENTS!
Some people think they're done once they choose the amount of salary they contribute to their 401k, but that's only the first step. Your 401k will not grow if they aren't invested properly.

Each plan has a list of available investments. These typically include stock and bond mutual funds, as well as a "stable value" option, which is a money market or cash equivalent.

Some plans offer target retirement date funds that shift from higher risk growth assets to a lower risk posture as you approach retirement.

Be sure to review the available investments carefully. Talk to human resources or an advisor if you don't understand them.

Some plans have auto-enrollment and default investments to make this easier, but you need to read the documents for your plan to be sure.

Don't leave your retirement to chance!

401K DISTRIBUTIONS
Because DC plan contributions were made pre-tax (except Roth contributions), those distributions will be subject to income tax.

Distributions that occur for reasons other than these will be subject to a 10% early withdrawal penalty in addition to income taxes (these apply to most DC plans as well as 403b plans).

STILL WITH COMPANY (in-service withdrawals)
- Distributions permitted after age 59.5
- If the person becomes disabled or passes away
- Cases of financial hardship. Lots of rules around what qualifies and even if allowed, they will be subject to a 10% early withdrawal penalty and taxes (exception: unreimbursed medical expenses over 7.5% of AGI not subject to the 10% penalty).

NO LONGER WITH COMPANY (retired / separated from service)
- Distributions permitted beginning the year they turn 55

LOANS (if permitted in plan documents - check to verify) depending on vested plan balance.
- $0-$10k balance --> can borrow entire balance
- $10-$20k balance --> can borrow up to $10k
- $20-$100k balance --> can borrow 50% of balance up to $50k max
- Available loan amount is reduced by highest loan balance in the last 12 months.
- Must be repaid within 5 years (longer if used to purchase a primary residence).
- If employee leaves the company, the loan balance becomes immediately due, and failure to repay causes it to be deemed an early distribution, and subject to taxes and 10% early withdrawal penalty.

DIVORCE OR SEPARATION
- Qualified plan transfers related to Qualified Domestic Relations Orders (QDROs) avoid the 10% early withdrawal penalty

ROLLOVER
401k funds can be rolled into another qualified plan or IRA. Must be done carefully to avoid tax consequences -- worthy of a separate thread.

401K PLAN ADVANTAGES
- No need for an actuary
- Can be funded exclusively by employee contributions
- Favors younger workers with time for retirement savings to grow
- Portable if you switch employers
- In-service withdrawals and loans (if allowed by plan docs)

DISADVANTAGES
- Retirement benefit not guaranteed.
- Investments must be properly managed by employee (do-it-yourself)
- Contribution limits mean less tax deductions for employers vs. DB pension
- Testing requirements can be costly if Safe Harbor options not used.

ROTH 401(K)
- after-tax elective deferrals, no income tax deduction.
- tax-free qualified distributions after 5 years AND age 59.5, death, or disability.

🚨 DIFFERENCES B/W ROTH IRA
- no phaseout on contributions based on income. This makes Roth 401k a very attractive retirement savings vehicle for high income workers.
- no first time home purchase exception for Roth 401k (Roth IRA only)

DC plan employee deferral limits apply to both Roth and traditional 401k contributions ($23,500 in aggregate across both types in 2025).

IN-PLAN ROTH CONVERSIONS
- not subject to early withdrawal penalties.
- must pay taxes from other funds
- no 20% tax withholding

STOCK BONUS PLAN
Profit sharing DC plan where employer contributes company stock rather than cash. Employee Stock Ownership Plan (ESOP) is a common example.

The key advantage of these plans is the ability to elect Net Unrealized Appreciation (NUA) treatment on lump sum distributions.

NUA
- Refers to the unrealized appreciation while stock inside the plan
- After separation from service, employee must select lump sum distribution of SHARES of employer stock, not cash (in-kind distribution), and make NUA election on their tax return.
- Basis (value of stock when originally received) subject to ordinary income tax upon distribution
- NUA amount not taxed at distribution. Instead is taxed when stock sold, at long-term (lower) capital gain rates
- Appreciation above NUA may be short- or long-term depending on hold period after distributed (> 1 year = long term gain).

Here's a picture to illustrate.

STOCK BONUS PLAN DISADVANTAGES
- non-diversified
- appraisal costs for non-public companies
- potentially dilutive to existing stockholders

403B PLANS
- Available only for non-profit 501c3 organizations (religious, charitable, schools, etc).
- Not a qualified plan, but works similar to 401k and other profit sharing plans
- special 15-year catch-up for eligible institutions.

IRAs
I'll do a separate post on these. They have their own set of rules and this is getting long.

Let's close by talking about small business plans.

SIMPLE 401k
Cheap and easy to administer. Great for small businesses.
- qualified plan under ERISA (SIMPLE IRA is not)
- avoids ADP/ACP & top-heavy rules
- employees who earned $5,000 in 2 preceding yrs & expect to earn $5k this year are eligible

REQUIREMENTS
- 100 or fewer employees, earning $5,000 or more
- cannot have another retirement plan (unless it's a 457)
- different deferral limits than traditional 401k
- ER matches 3% comp or 2% nonelective for all eligible → 100% immediate vesting

SIMPLIFIED EMPLOYEE PENSION (SEP)
- Tax-advantaged plan (not qualified)
- All employees > 21 years old, worked 3/5 prior years, and who made ≥ $750 comp. this year must be covered.
- Employer makes discretionary contributions. Employees cannot contribute.
- Everyone gets the same contribution % (this is how it avoids discrimination testing).
- Whatever employer decides to contribute on worker's behalf, they get the same percentage for example.
- tax deductible lesser of 25% of employee comp or $70,000 (2025)
- immediate 100% vest

SOLO 401K
- Covers business owner (and spouse if applicable).
- Owner can contribute on employer and employee side, enabling a larger contribution amount vs. SEP.

That's a wrap! Hopefully you have enough information to start using, or improve your use of, workplace retirement plans.

YOUR ACTION STEPS ⚡
- Get information on your company's retirement plans from human resources dept.
- Read it and determine what type of plans you have access to
- Determine how much you are allowed to contribute (if any) by reviewing this thread
- Review your budget to see how much you can AFFORD to contribute
- Send me a message here or email [e-mail] if you have questions

Thanks for reading! Please share if you found value and follow me for more on personal finance and investing.

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- Matt
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