Some employee working for employers are been offered some type of pension plan. If a pension plan meets several federal government requirements, it can achieve “qualified” plan’s status. A qualified pension plan enables participating employees to save money for retirement and put it into a retirement account that is subject to the requirements of the regulatory. Money in this type of account earns tax-deferred interest, the advantages of such is you don’t have to pay income taxes on the earnings until you draw your money. On the other case, if you draw money from your retirement account before you retire (or before you reach age 59 1/2) your income tax should be paid on that investment, and additional penalties incurred.
There are several tax advantages if pension plans qualified into qualified plans. The great tax advantage is that with a qualified plan, income taxes can be deferred until you retired. To see precisely where the reward lies, consider a company that has had a good year. By the end of the year, it is considering paying an additional $100,000 to its employees. It is viewing either giving bonuses (taxable) or contributing the money to a qualified retirement plan.
With both option, the company has the privileged to take off $100,000 from its employee pension taxable income. If the company is in a 35% tax bracket, then by making the $100,000 payment, it will “save” $35,000 in income taxes. That is, the after- tax cost of the complementary payment will be $65,000: the $100,000 payment subtracted the $35,000 in tax savings.
If the payment is made as a bonus, then the income will be taxable to the employees. In the point view of Internal Revenue Service (IRS), the $100,000 is taken out of the company’s taxable income and put into the employee’s pension taxable income. If the employee is in 35% marginal tax rates or more, the IRS won’t get any income in the situation where the company pays that bonus of $100,000.
The situation is different, however, if the company gives the $100,000 to a qualified retirement plan. In this situation, the company is still able to take off the $100,000 from its taxable income. Nevertheless, in current financial year, $100,000 is not put into employee’s pension taxable income, and interest earned on the contribution will also be tax-free through the years. In fact, the employees will not pay tax until they receive distributions from the plan in retirement. It is in this sense that qualified retirement plans allow the deferral of pension taxable income.
Over time, Tax deferral total amount can be substantial. Consider a person whose employer routinely pay annual contributions to a qualified pension plan on the person’s behalf. Suppose the employer contributes $8,000 a year for thirty years, at which time the person retires. The plan earns 10% per year. As the plan is qualified, the person pays zero tax on either the annual interest or $8,000. At the end of 30 years, the fund has turned to $1,315,000. If the person withdraws pension plan money in one lump sum at retirement, the person pays taxes then. At a 30% tax rate, the individual receives $921,000 after taxes. In contrast, suppose the $8,000 were paid initially as taxable income to the employee. After tax, the amount of the contribution is only $5,600 per year. The person may place the money investment, but he or she will bear taxes for interest money earned. If the interest rate is 7% (after tax), the fund grows to only $528,980 after thirty years. Compare to qualified plan, it only 57% (after tax).
This tax deferral is the essential tax advantage obtainable to pension plans. A second tax advantage is that some individuals will face a lower marginal tax rate in retirement than while they were working. This gives two main advantages, not only are taxes postponed but the tax rate may be lower when the taxes are finally paid. Because taxes rules and law, employers can use pension plans to increment the after-tax compensation they pay their employees. This is an immediate justification for pension plans. On the other hand, it raises a deeper question of why the government encourages pension plans. One reason is that pension plans may shrink the political pressure on the government to provide all retirement income by expanding Social Security.
