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Pension System Design
The American state pension system (official name: OASDI – Old-Age, Survivors, and Disability Insurance program) operates on a pay-as-you-go basis and is financed through social security taxes paid by employers and employees (accounting for 84%), tax revenues paid by upper-income social security beneficiaries (2%) and interest earned on accumulated trust funds reserves (14%). The social security tax is shared equally between employer and employee. Contributions are tax-exempt, although the benefits are taxed if the total income in retirement exceeds a specified amount. The statutory retirement age depends on the retiree's year of birth and lies between 65 and 67.
In private industry 60% of the workforce has access to retirement plans. DC schemes dominate the occupational pension landscape and cover 43% of the workforce. By contrast, only 20% of the private sector workforce participates in a DB scheme. Altogether, 51% of the total workforce is integrated into any kind of pension plan; the entire sum is less than the individual items because some employees participate in both types of plans.
The most widespread type of DC plan is the 401(k) plan. 401(k) plans enable employees and employers to make tax-deferred contributions from their salaries to the plan. Most 401(k) plans provide retiring employees with multiple distribution options for receiving plan account balances. Lump-sum payments, instalment payments for a fixed number of months and annuities are available distribution methods. It is also possible to defer any payment until a certain age.
New regulations facilitate and encourage the automatic enrolment of employees into existing employer DC plans if the employees fails to make any decision. New regulations now define mechanisms that a Qualified Default Investment Alternative (QDIA) must apply. The products asset mix must take certain characteristics, such as age and retirement age of an individual or a group, into account. Life-cycle funds, balanced funds and professionally managed accounts are examples that match these requirements. Employees that do not make any investment decision are consequently enrolled into this default option.
In addition to the popular 401(k) plan, the following scheme types could be set up to provide occupational pension coverage:
- 403(b) plans: employer-sponsored retirement plans, which enable employees of Universities, public schools, and non-profit organisations to make tax-deferred contributions form their salaries to the plan.
- 457 plans: employer-sponsored retirement plans, which enable employees of State and local governments to make tax-deferred contributions form their salaries to the plan.
- Thrift Savings Plans: employer-sponsored retirement plans that enable employees of: The Federal Government to make tax-deferred contributions form their salaries to the plan.
- Employer-sponsored IRAs
- A SIMPLE IRA plan is an IRA-based plan that gives small employers (those with less than 100 employees) a simplified method to contribute toward their employees' pension.
- SEP IRAs: Simplified Employee Pension plans do not have the same start-up and operation costs as conventional work-based retirement plans and are designed mainly for small businesses as well. Trustees of SEP-IRAs are generally banks, insurance companies, mutual funds and other approved financial institutions.
Tax treatment of contributions and benefits
Contributions to qualified pension plans can be made on a pre-tax basis subject to certain limits. Dividends and capital gains remaining in the accounts accrue tax-deferred. Only when the money is withdrawn it is fully taxed as income.
Employees are allowed to transfer part or all of their contributions to a 401(k) plan as designated Roth contributions. The amount treated as Roth contributions is paid on an after-tax basis and, as a result, does not qualify for tax relief as the payments are included in gross income. Contrary to traditional 401(k) plans, investment returns and benefits remain tax-free. Another characteristic of traditional 401(k) plans that does not apply to Roth 401(k) plans is the forced withdrawal at a certain age. The retiree is completely free to choose the point of time when to withdraw the accumulated assets and particularly if, in fact, it will be withdrawn.
The Organisation for Economic Co-operation and Development (OECD) - http://www.oecd.org
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