How do tax-qualified retirement plans generate retirement income?

Tax-qualified retirement plans generate retirement income by taking advantage of a number of significant tax advantages for employees and employers. An employer that adopts a tax-qualified retirement plan is allowed a current deduction for its contributions to the plan. Plan participants pay no tax on the money contributed on their behalf until the plan makes a distribution to them. Moreover, earnings on plan assets accumulate tax free under the plan, and payments (e.g., distributions) from the plan may get favorable income tax treatment. The assets in tax-qualified retirement plans are generally protected from creditors.

Example 17-1: A physician, age 30, adopts a profit sharing plan for his professional corporation. He is the only employee and throughout his career occupies the 36 percent tax bracket. Each year, the physician contributes $30,000 to his profit sharing plan and then retires at age 65. Throughout this period the physician earns 10 percent on plan assets. At retirement, the physician has $8,130,871 in the plan. If he withdraws all the funds in the plan at retirement and is taxed at 36 percent, the physician still has $5,366,282. Had he allocated those amounts of money outside the tax-qualified plan for investments, the physician would have had $2,433,419 because taxes would have been assessed immediately, leaving less money to invest and grow. This dramatic difference occurs because, by using a tax-qualified plan, the physician avoids the 36 percent tax that would have been levied each year on the $30,000 available for investment (the tax would have reduced the amount available for investment to $19,200). Furthermore, when the 36 percent tax rate that is imposed on earnings outside the plan is applied to the earnings on those amounts, it reduces the rate at which earnings compound to 6.4 percent as compared with a rate of 10 percent for earnings on assets in the plan. Tax-qualified retirement plans are particularly attractive to working owners of closely held corporations and to self-employed individuals who typically have the longest periods of service with their companies and receive the highest salaries. Accordingly, they receive the most generous benefits, although benefits must be provided for other employees as well. Tax-qualified retirement plans also may help businesses attract and retain desirable employees.