Private retirement plans can be separated into two categories. 401(k) plans are known as defined contribution plans. A 401(k) is funded by employee contributions which can be matched by employers. This type of plan accounts for 93 percent of private plans and “by almost any measure, have taken on a primary role in how workers save for retirement,” said a GAO report delivered to the House Ways and Means Committee in March.
A second type of private retirement plan is a pension plan known as a defined benefit plan. These are attractive to those who own their own businesses because IRS rules allow larger contributions to these plans than they do to 401(k) plans. Certain owner-manager businesses such as doctors, dentists, lawyers and other small business professionals have taken advantage of these plans enabling them to put as much tax-deferred income aside for retirement as possible.
Defined benefit plans allow the principal owners of a small firm to contribute relatively high amounts to the plan in lieu of a salary increase, the GAO commented. “The tax advantages for contributions to a tax-qualified plan compared to taxable compensation can be large because contributions and investment growth are tax-deferred, and hence the earnings compound tax-free, although benefits paid in retirement are taxed.”
The IRS limits contributions to 401(k)s to $16,500 per employee in 2011. Workers aged 50 and older can make an additional $5,000 catch-up contribution. The combined employer and employee contribution is capped at $49,000.
Contributions for defined benefit plans cannot exceed the lesser of $195,000 or 100 percent of the participant’s average compensation for his or her highest three consecutive years. Employees may be allowed to make additional non-deductible contributions, which can grow tax free.