How Employee Compensation Works

Retirement Plans

Your company's retirement (or pension) plan is not only good for your employees, but it's also one of the best tax shelters available -- both for your company and your employees. You can deduct contributions, and the contributions are tax deferred to the employee.

Pension plans fall into two categories: defined-contribution pension plans, and defined-benefit pension plans.

Defined-benefit pension plans are plans that have a set benefit, and contributions that a company makes to the plan are based on actuarial assumptions. Your employee will know what their retirement amount will be and can plan accordingly.

Defined-contribution pension plans base your employees' benefits on the amount of money contributed to the account. Some of the types of accounts that fall into this category include: profit-sharing pension plans, money-purchase pension plans, target-benefit pension plans, stock-bonus pension plans, ESOPs, Thrift savings pension plans, and 401(k) pension plans.

401(k) Plans

The most popular of the defined-contribution pension plans is the 401(k). It has been around since 1978, and allows employees to contribute up to $12,000 of pre-tax money ($12,000 as of 2003; this increases by $1,000 each year until it reaches $15,000 in 2006), which is the highest of any of the pension plans. The employee and employer combined cannot contribute over $40,000 annually (or an amount equal to the employee's salary, whichever is less) to the employee's account.

401(k) plans let your employees save for retirement easily and conveniently through pre-tax automatic payroll deductions. It's money they don't see, so they don't miss it. Implementing a 401(k) plan can improve employee morale and help in luring in new employees. The money your employees contribute, as well as your contributions and their account earnings, are all tax deferred until they actually withdraw the money when they retire. Employees have full control over their investments. Withdrawals are also permitted at termination of employment or during financial hardship, but a 10% penalty tax is charged if they are younger than 59 1/2 years old. Many companies allow terminated employees or employees who elect to leave the company the option to keep their 401(k) account, but they can no longer contribute to it.

As an employer, you are not required to match contributions or contribute at all to your company's 401(k) plan; however, to be competitive, most employers do. You do have the flexibility to alter your contributions year to year based on the profitability of your company. You even have the option of contributing on behalf of employees who aren't participating as long as they are eligible. Your contributions are tax deductible, like with the other plans. You can also set up a vesting schedule for the contributions you make to your employees' accounts. This is just another way to help motivate employees to stay with the company longer.

The down side of 401(k) plans is that they are usually expensive to administer.

In the next section, we'll learn about money purchase plans.