One of the best, if not the best, plans to supplement Social Security and qualified benefit plans for retirement, is the Individual Retirement Account – IRA. This has been briefly discussed in Chapter Eight in discussions of EIAs. As of 1998, there are two types of IRAs – the “regular” IRA, which will be addressed first, and then the “new” form of IRA, named the Roth IRA (after the Senator who introduced the legislation).
Subject to certain restrictions, for many taxpayers, both married couples and single persons, who have earned income and have not reached age 70, the IRA gives them an opportunity to put aside the lesser of $3,000 per individual for 2002 and indexed thereafter (or 100% of earned income, whichever is lesser), or $6,000 per couple on a tax-deductible status. This means that the amount of the IRA is subtracted from the earned income on their federal income tax (and some state’s income tax).
If each spouse has earned income of more than $3,000 a year, each can make up to $3,000 contributions to the IRA. Even if one of the spouses’ has no earned income, there can still be up to $3,000 contributed to their IRA for the total of $6,000 (for exact limits, see below). If there are investment earning in the IRA, it will remain there on a tax-deferred status until withdrawn from the IRA. The funds must be “earned” (as opposed to investment earnings, including dividends and interest) and the individual must not have reached age 70 ½.
When the owner of the IRA reaches age 59 ½, they may withdraw funds from the IRA and such funds will be subject to taxation as regular income at that point. (This is one of the main differences between a “regular” IRA and the Roth IRA).
Contributing to an IRA is rather simple and can be set up by banks, savings and loan institutions, insurance companies (through annuities – life insurance is not permitted), mutual funds or brokerage houses. Investments must be made in cash or other legal tender; i.e. works of art, jewelry, or other valuable assets do not qualify.
There is considerable leeway to changing IRA’s, but the rollover of an IRA may occur only once a year if the owner takes control of any of the assets. If it is a tax-free rollover, such as between trustees of IRA accounts, there is no once-a-year limitation.
Since 1986, only those persons who do not participate in a company retirement plan or whose adjusted gross income fall below certain limits can deduct their contribution. If neither spouse participates in a company retirement plan, they can make a contribution to an IRA regardless of how much money they make.
More Rollover Options: Eligible rollover distributions from qualified plans, § 403(b) annuities, and governmental §457(b) plans can be rolled over to any of such plans as well as to an IRA. IRA distributions can be rolled over into a qualified plan, § 403(b) annuity, governmental § 457(b) plan, or another IRA. A distribution to an individual from a qualified plan will not be eligible for capital gain or averaging treatment, however, if the same individual previously made a rollover to the plan that would not have been permitted under prior law. Employers must revise the rollover notice to reflect the new rules. Effective for distributions after December 31, 2001.
Rollover of After-Tax Contributions: Employee after-tax contributions may be rolled over into another qualified plan or a traditional IRA. Effective for distributions after December 31, 2001.
Waiver of 60-Day Rollover Rule: The Treasury may waive the 60-day rollover period if the failure to waive the 60-day period would be against equity or good conscience. Effective for distributions after December 31, 2001.
IRA Contribution Limits: The IRA contribution limits are increased gradually, to $3,000 for 2002-2004, $4,000 for 2005-2007, and $5,000 for 2008 and later years, subject to future indexing in $500 increments. Catch-up IRA contributions are permitted for individuals age 50 or older in annual amounts starting at $500 in 2002-2005 and increasing to $1,000 in 2006 and thereafter.
Employers may permit employees to make voluntary contributions to deemed traditional IRA accounts and deemed Roth IRA accounts under qualified plans. Effective in years beginning after December 31, 2002.
If IRA funds are withdrawn before the owner reaches age 59 ½, they are designated as “premature” by the IRA, and are subject to a 10% tax penalty on any of the taxable part of the withdrawal. The “taxable” part is the part of the withdrawal that represented deductible contributions or earnings. This is in addition to the regular income taxes that will be paid on the withdrawal; therefore it is a true “penalty.” However, there are some exceptions where the penalty tax will not have to be paid:
An individual may not borrow against an IRA or pledge it as collateral for a loan. This is specifically prohibited and could result in the IRA losing its entire tax-deferred status. To further strengthen this prohibition, not only will the income tax on the full value of any previously untaxed amounts of the IRA become payable, but there will be a 10% excise tax imposed.
CONSUMER APPLICATION
Rhonda and Renee are twins and usually agree on things of common interest. However, when they both reached age 35, Rhonda’s husband insisted that she starts an IRA and contribute $2,000 each year towards it.
Renee and her husband decided that they needed a new van more than they need to worry about retirement. After 10 years, on Rhonda & Renee’s 45th birthday, Rhonda finally convinced her sister that she should start an IRA with $2,000 paid in each year.
If both women earned 8% on their IRA’s, at age 65:
Renee’s IRA would be valued at $98,846.
Rhonda’s IRA would be valued at $244,692.
A Parent can make a non-deductible contribution of $500 per year per child into an educational IRA until the time that the child reaches age 18. The deduction amount, $500, is reduced for those single parents with incomes between $95,000 and $110,000 couples with joint incomes between $150,000 and $160,000. There can be more than one educational IRA as long as the total does not exceed $500. Some states offer tuition plans and in those states, a child who is enrolled in one of the state qualified tuition plans would not be eligible for the education IRA.
The money that is in the education IRA can be withdrawn tax-free for the purposes of tuition, fees, books, supplies and equipment. If a student is enrolled on more than half time, then board and room can also be withdrawn tax-free. All money must be withdrawn by the time the student is age 30, or they will be assessed a 10% penalty tax. If there are funds remaining and there is another family member (of the same generation), the remaining funds can be used for their education.
As of January 1998, as a result of the Taxpayer Relief Act of 1997, an individual may establish the Roth IRA, regardless of age, which have earned income below $95,000 for single, $150,000 for joint filing. The contribution of $2,000 will be reduced for amounts above $96,000 and will not be allowed if single income is over $110,000. For couples filing jointly the amount is between $150,000 and $160,000.
Roth IRA accumulates income tax-free instead of tax-deferred, but there is no annual deduction for Roth IRA contributions.
A Roth IRA can be established by individuals who participate in various company, agency, or not-for-profit plans, such as SEP IRA’s, SIMPLE IRA’s, 401(k), 403(b) and 457 plans. The maximum contributed would be $2,000, but the earned income must at least equal the amount contributed.
Dividends, interest and capital gain growth within a Roth IRA is not taxable, and money that is eventually removed is tax free, if the account is owned at least 5 years and the owner is over 59 ½.
There are no minimum distributions or withdrawal requirements after age 70 ½. At any age after the Roth IRA has been created and in operation for at least 5 years and the owner is over age 59 ½, any withdrawals are tax-free. In addition, at any age after the account has been opened for at least 5 years, the owner can withdraw a lifetime maximum of $10,000 in contributions and earnings, without taxes or penalties, for a first time home purchase.
There is a wide variety of investment vehicles available for this plan. Many planners suggest Variable Annuities or mutual funds.
As of January 1998, many traditional IRA investors have the option to convert their regular IRAs to a Roth IRA. A regular IRA offers tax deferred growth on all earnings, and the earnings will be taxed upon withdrawal. However under a Roth IRA while the deductions are not deductible, the growth of the Roth IRA is tax deferred, and is tax free when the distributions are taken from the Roth IRA under certain guidelines:
While the conversion of a regular IRA to a Roth IRA sounds good to a great many holders of IRA accounts, they must be aware that the entire amount that is converted to a Roth IRA is subject to income taxes. Therefore, this amount is added to any earned income for that year and taxes are due on the total gross income at the appropriate rate for that particular filing. And as stated above, the taxes that are due cannot be taken from the IRA. (See discussion example below).
Many regular IRA holders will want to know the advantage of converting to a Roth IRA. The philosophy of always deferring taxes as long as possible especially since the money that they would pay in taxes would continue to grow on a tax deferred basis inside of the regular IRA is not necessarily true in the case of a Roth IRA. Actually, the money in a Roth IRA compounds tax free as opposed to compounding at a tax-deferred basis.
Simply put, a Roth IRA conversion will give the account holder more, net after taxes, than if they continued with the regular IRA. The reason is that within any retirement plan, the largest component of the plan is the growth, not the amount of contributions. The tax-deductible plans’ compounded growth is eventually taxable (pay now or pay later), whereas the Roth plan compounded growth is tax-free. It has been stated by Wall Street On-line that it is “sort of like compounding out 8.0% Net After Tax versus 10% Tax Free.”
According to “Roth to Riches,” written by John Bledsoe, CLU, CFP, to first determine if consideration should be given to converting an IRA to a Roth IRA, 2 questions must be asked: (1) Are you over age 59 ½? and (2) Do you have funds outside the IRA with which to pay the income tax, if you were to convert to a Roth IRA? If either answer is “Yes,” then they should convert to a Roth IRA, according to this author.
As an example, Assume the client had $300,000 in a traditional IRA and $99,000 in (let’s say) a money market account outside of the IRA. For simplicity, assume further that everything grows by 10% per year, and taxes are at the 33% rate. Therefore, from the IRA, annual income would be $30,000 with tax of $10,000 if the client took the money that year – leaving a net of $20,000 to the client.
The client receives $9,900 from the other funds, after tax the fund would be $6,600. So total (spendable) income is $26,000.
For the “Roth” version:
For the client to pay the entire tax on the $300,000 IRA and make it a tax-free Roth, she would have to pay the tax on the IRA today. Therefore, the $99,000 in the other fund is used to pay the taxes. (Can you imagine how it would feel to give Uncle Sam $99,000 in one fell swoop?) Now the client still has the income from the IRA of $30,000. And guess what? A Roth IRA is tax free, so she is better off by $4,000 of spendable income.
If the client does not spend the income or even part of it, each year, the advantage of the Roth IRA becomes even bigger!
For Roth conversions, the client must not exceed $100,000 “modified” gross income the year that the IRA is converted. The Modified Gross income is similar to Adjusted Gross Income, but does not include the Roth conversion.
Usually, couples may not filed as “married filing separately” for the year that they want to convert an IRA to a Roth IRA.
Income tax must be paid on the entire IRA balance the year that it is converted.
A Salary Continuation plan arrangement, which is often funded by life insurance, continues an employee’s salary in the form of payments to a beneficiary for a certain period after the employee’s death. The employer may be the beneficiary, collect the death benefit and then make payments to the employee’s beneficiary.
A Deferred Compensation plan is a means of supplementing an executive’s retirement benefits by deferring a portion of his or her current earnings. To qualify for a tax advantage, the IRS requires a written agreement between an executive and the employer stating the specified period of deferral of income. An election by an executive to defer income must be irrevocable and must be made prior to performing the service for which income deferral is sought.
In a salary continuation plan in its generic form, the employee prior to retirement, does not lose any compensation or pay into the plan as the employer pays all benefits. The nonqualified deferred compensation plan provides basically the same benefits after retirement, but the funds either comes from a reduction of salary of the employee, or any salary increases will be used for the funding.
Either arrangement is primarily used with key employees as a method to entice them to remain with the firm and is frequently combined with a “non-compete” arrangement. These plans are supplemental to IRA’s, Social Security, and qualified pension plans, and are taxed at time that the employee receives them. Ironically, the only way to make certain that the maximum tax benefit can be obtained with either plan, is to make them unsecured and unfunded. This is the only way to show that there has been no ‘constructive” receipt of an immediate and therefore, taxable, benefit by the employee.
Qualified Pension plans are retirement programs designed to provide employees and frequently, their spouses, with a monthly income payment for the rest of their lives. To qualify, an employee must have met minimum age and service requirements. Benefit formulas can be either the Defined Contribution Pension” (Money Purchase Plan) or the “Defined Benefit Plan.” See earlier discussion.
NOTE: The term “Instrument” in describing methods of providing funds for a pension plan, is used in the legal sense, which is defined as a formal legal document, as a contract, deed, etc. An insurance policy/plan is considered as an “instrument.” An established method of funding for a qualified plan may be also considered as an “instrument.”
The Employee Retirement Income Security Act of 1974 (ERISA) requires a pension plan to provide an income for the rest of a retired employee’s life, and at least 50% of that amount to the surviving spouse of a retired employee for the rest of her life, unless the spouse waives this right in writing. Death and disability benefits are also provided by most pension plans. The Tax Reform Act of 1986 changed the vesting requirements, as did the Economic Growth and Tax Relief Reconciliation Act of 2001 (discussed earlier). Funds for these plans can be generated under numerous Pension Plan Funding Instruments as described below.
Under the Defined Benefit Plan, the retirement plan is fixed (defined) in advance by an approved formula. The contributions of the employer to the plan may vary (and are not “defined” as defined below). The defined benefit plan can either be a Fixed Dollar plan, or a “Level Percentage of Compensation” approach, as follows:
The Fixed Dollar plan can use the “Unit Benefit” approach, the “Level Percentage of Compensation,” or the Flat Amount approach.
(a) Unit Benefit approach is where a unit of benefit (that is not discriminatory and is approved by the commissioner of the Internal Revenue Service) is credited to the employee for each year of service recognized by the plan as determined by the employer. The “Unit” may either be a flat dollar amount or usually, a percentage of the employee’s compensation ‑ usually 1% - 2% - and the total years of service is multiplied by this percentage.
CONSUMER APPLICATION
Sam has worked for BH Plumbing for 30 years. The percentage of his income that is credited to him for each year is 1 ½%, therefore 45% (1.5 times 30) would be applied to either (1) his career average earnings or (2) his highest income for 3 out of his highest 5 years of earnings.
Sam’s five consecutive years of earnings were $120,000, $100,000, $80,000, $75,000 $60,000, therefore the average Sam has made would be $100,000 as the average of 3 out of the 5 consecutive years of earnings. His retirement benefit would be $45,000.
(b) Level Percentage of Compensation approach is where, after an employee has served for a minimum number of years (usually 20) and has reached a minimum age (usually 5O), then all employees will receive the same percentage of earnings as a retirement benefit, regardless of how much money they make, how long they have been with the organization, and regardless of position.
CONSUMER APPLICATION
Earnest turns age 50 in July. At that time he will have worked for the Southeastern Shipping Co. for 20 years. He is making $80,000 a year salary, and does not expect an increase before he retires. At his retirement, under his company’s “level percentage of compensation” approach to the retirement plan, he would receive 20% of $80,000, or $16,000 per year.
(c) The Flat Amount approach states that after an employee has been with the organization a minimum period of time (such as 20 years), and has reached a specified age (usually 50), then all employees meeting this criteria will receive the exact same dollar amount of retirement benefit (again, regardless of income, position in the company, or years of service). For example, the plan could state that each employee who is at least 50 years of age; with at least 20 years of service would receive $80,000 a year in retirement benefits.
(a) Cost‑of‑Living Plan is quite popular during inflationary times as it is tied to changes in a designated price index, usually the Consumer Price Index (CPI). Simply put, if the CPI would increase by 3%, then benefits would increase by 3%.
(b) Equity Annuity Plan pays premiums into a Variable Annuity plan, which is used to purchase “Accumulation Units.” At retirement, the Accumulation Units are converted to retirement units whose values fluctuate according to the common stock portfolio in which the premiums were invested.
Defined Benefit plans can be integrated with Social Security in either of two ways: (1) the Excess method, or (2) the Offset method.
It is a rule of the IRS, (“engraved in stone”) that any qualified pension plan must be non-discriminatory. However, there is an inconsistency when integrating Social Security whereby the more highly compensated employees may be allowed to receive higher benefits. This is because Social Security has a maximum benefit so that they do not replace the same percentage of income for those with higher incomes, than those of lower incomes. Therefore, the laws allow Social Security benefits to be considered so as to increase disproportionately either the plan contributions or the plan benefits of those with higher incomes.
The “Excess” is a plan that provides an additional amount to supplement the employee’s Social Security Benefits. These plans provide benefits based on an employee’s “annual average compensation.”
The “Offset” plans are based upon a predetermined percentage of salary, which is then “offset” by the portion of the employee’s Social Security benefits that was provided by the employer. The number of years that the employee has been employed by the organization may also be taken into consideration in determining the employee’s retirement benefits.
If a participant or beneficiary makes a voluntary election to transfer an account from one defined contribution plan to another, and if certain other requirements are satisfied, the receiving plan is no longer required to provide all of the forms of distribution previously available under the transferor plan. In addition, an employer may amend a defined contribution plan to eliminate a form of distribution, provided that (1) a single sum distribution is available at the same time or times as the eliminated form of distribution, and (2) the single sum distribution applies to a portion of the participant's account at least as great as the portion that was eligible for the eliminated form of distribution. (The new rules permitting the elimination of distribution options are less restrictive in certain respects than similar rules recently included in Treasury regulations.) Effective for years beginning after December 31, 2001.
Under the 2001 Act, the Treasury is directed to issue regulations providing that the prohibitions against eliminating or reducing an early retirement benefit, a retirement-type subsidy, or an optional form of benefit do not apply to amendments that eliminate benefits, subsidies, or optional forms that create significant burdens and complexities for the plan and its participants, but only if the amendment does not adversely affect the rights of any participant in more than a de minimis manner. (An example in the Joint Explanatory Statement indicates that this rule could be used to eliminate one of two similar benefits after a plan merger.) The Treasury is directed to issue final regulations by December 31, 2003.
The Defined Contribution Pension Plan is also known as the Money Purchase Plan. Under this plan, contributions are fixed in advance by formula, and benefits vary. (As opposed to the Defined Benefit plan, where the benefits are fixed but contributions may vary). These plans are used by those organizations that must know what their pension plan will cost in the future. A good example of this are nonprofit organizations who must project their pension expenses that are set at a predetermined limit, thereby enabling the organization to be able to present an accurate a budget each year as possible for the benefit of its contributors, members, stockholders, etc. Obviously, it is needed so that they can solicit funds during the year.
The most common types of Qualified Defined Contribution pension plans are:
With all of the rules and regulations of creating a Tax Qualified retirement, the inducements to the employer must be significant. Basically, the employer is allowed to take a business income tax deduction for the amounts that it contributes to the plan. As one would expect, the amount that can be deducted for tax purposes, and the maximum amount that can be contributed, is tightly regulated. The IRS considers the amount of new money that is contributed each year, as an “annual addition,” which must include the sum of employer contributions, any allocated “forfeitures” and all employee contributions.
A “forfeiture” is the amount of an employee’s plan that remains when a plan participant leaves a plan and is not fully vested. Generally, if the employee leaves the plan (usually terminates employment) for a specified period of time – such as 5 years – then the amount remaining in his “account” becomes the property of the plan itself. The administrator can then either use them to offset future employee contributions or to increase benefits of the remaining participants.
The reason that the law specifies “annual additions” is so that they can be limited. In The Tax Reform Act of 1986, employer contributions may be deducted to the extent that they do not exceed the lesser of: 25% of the annual compensation of a plan participant, or $30,000 (indexed). This provision of the law limits both contributions and deductions.
Additionally, a restriction on profit-sharing plans such as the 401(k) allows the employer to deduct an amount equal to 15% of the total annual compensation of the employees in the plan. Therefore, an employer may contribute more to a money purchase plan than to a profit sharing plan.
A Money Purchase Plan specifies contributions to a pension plan on a fixed basis according to a formula, but with variable benefits. Contributions can be made under an “allocated funding instrument” (paid to an insurance company that purchase an individual annuity or a group deferred annuity –see below), or under an “unallocated funding instrument.” Benefits due to an individual would be determined by the person’s age, sex, normal retirement age and rate (premium) schedules in effect at the time the insurance company receives the contributions. The Money Purchase Plan is attractive particularly to an organization or business that must know in advance, the amount of funding &/or premium it must provide in future years.
During the discussion of the various methods of funding tax-qualified pensions pension trust funding must be mentioned. Trust funds are the oldest, and still the most common, method of funding pensions. All contributions made by the employer and employees are deposited into a trust fund, with a trustee responsible for investing the money, administering the plan, and paying benefits.
Full Funding Limit: The current-liability full funding limit is increased to 165% of current liability for plan years beginning in 2002 and to 170% of current liability for plan years beginning in 2003, and then is repealed for plan years beginning on or after January 1, 2004.
If a plan terminates, the employer may deduct a contribution equal to the plan's unfunded termination liability. Effective for plan years beginning after December 31, 2001.
Excise Tax on Nondeductible Contributions: For purposes of the 10% excise tax on nondeductible contributions, an employer may elect to take into account only contributions exceeding the accrued-liability full funding limit.
If an employer makes this election, it loses the benefit of certain exceptions that are available under current law.
Effective for years beginning after December 31, 2001.
Timing of Plan Valuations: The Act codifies the proposed regulation generally requiring plan valuations to be made as of a date within the applicable plan year or within the immediately preceding month. The Act also includes an exception that permits the valuation date to be any date within the preceding plan year if, as of that date, the value of the plan's assets is not less than 100% of the plan's current liability. Effective for plan years beginning after December 31, 2001.
The Group Deposit Administration is a pension plan-funding instrument in which contributions paid by an employer are deposited to accumulate at interest. (These plans are usually noncontributory.) Upon retirement, an immediate annuity is purchased for the employee. The benefit is determined by a formula, and the investment earnings on funds that are left to accumulate at interest. This is a flexible plan because the annuity is purchased at the time of retirement, so the deposit administration plan can be used with any benefit formula.
The IPG is a modification of the group deposit administration annuity under which an employer participates in the investment (which entails some risk to the employer, and perhaps to the employee, as participation in an investment may prove to be adverse as well as favorable), mortality, and expense experience of the plan on an immediate basis. Under the IPG, contributions are paid into a fund to which interest is credited. At retirement, an immediate annuity is purchased for the employee. The size of the benefit will depend on the benefit formula used and the investment, mortality, and expense experience of the plan.
Another method of funding a pension plan involves using a Group Permanent Contract, which is an insurance policy under which the value equals the benefits to be paid to the plan participants (employees) at normal retirement age, assuming that (1) their rate of earnings remains the same until normal retirement age, and (2) the contributions to the plan are sufficient to meet funding requirements for benefits under the plan. Normal retirement age is the earliest age at which an employee can retire without a penalty reduction in pension benefits after having reached a specified minimum age and served a minimum number of years with an employer. In the past this has usually been age 65, however many employers have changed this to a lower age. Age 65, of course, is when full Social Security retirement benefits are payable. Adjustments to contributions are made as employee earnings increase. Retirement benefits depend on the benefit formula used, and the investment, mortality, and expense experience of the plan.
As the wording would indicate, an individual contract pension plan is a retirement plan for an individual based on a single contract with a benefit based on current earnings, as if they will remain static until normal retirement age. As the earnings of the plan participant increase, additional contracts are purchased (with an increase in the contributions to the plan). The amount of retirement benefits depends on the benefit formula used and the investment experience of the company underwriting the plan.
Many, if not most, pension plans are integrated with Social Security benefits which offset or subtract the Social Security benefits from earned benefits in a qualified pension plan and which has the effect of reducing the pension benefit. Many business firms offset their pension payments by the amount of a retiree's Social Security benefit.
CONSUMER APPLICATION
Bob Freeman has earned a monthly pension benefit of $1,000. His monthly Social Security payment is $766. If his employer applies 100% integration, his pension is reduced by the entire Social Security benefit; he will receive $1,000 minus $766, or $234 monthly. More commonly, integration is based on a percentage of Social Security. With 50% integration, 50% of the Social Security benefit ($383) would be subtracted from the $1,000 pension for a monthly benefit of $617. Offsets were limited by the Tax Reform Act of 1986.
Prior to 1988, there was a right to withdraw retirement assets before age 59 1/2 without having to pay a 10% penalty under the following circumstances:
1. medical expenses are incurred or
2. the plan participant becomes disabled.
With the passage of the Technical And Miscellaneous Revenue Act Of 1988 (TAMRA), Employee Benefits, a third option is available to the plan participant:
(3.) …” distribution must be a part of a scheduled series of substantially equal periodic payments.” This means that any distributions from the pension plan must be made so that they will continue for the lifetime of the plan participant, or for the participant and his/her beneficiary.
There are certain rights of employees who leave an employer with a qualified plan to withdraw their accumulated benefits. With a Contributory plan, employees have immediate rights to their own contributions, plus earnings. If they leave the employer, the accumulated money belongs to them. However, they are not entitled to the employer contributions, unless the plan is vested (See VESTING below). Vesting depends on the terms of the plan, but law sets maximum time limits. A vested employee who withdraws accumulated benefits.
There is insurance coverage available that is provided by the Pension Benefit Guaranty Corporation (PBGC) that guarantees plan participants a certain level of pension benefits even if the plan terminates without assets. The PBGC was authorized under ERISA. The insurance, paid for by employers, protects vested interest only.
“Vesting” refers to the benefit entitlement of a participant in an employee benefit insurance plan to receive benefits regardless of his or her employment status.
The term “vesting” refers to the entitlement of a pension plan participant (employee) to receive full benefits at normal retirement age, or a reduced benefit upon early retirement, whether or not the participant still works for the same employer. ERISA had previously (1974) established vesting provisions under (1) 45-year rule, (2) 5 to 15 year rule, or (3) 10-year rule.
On January 1, 1989, (under the Tax Reform Act Of 1986), these vesting requirements were replaced with the following:
1. Full vesting (100%) after a participant completes five years of service with an employer; or
2. Vesting of 20% after completion of three years of service with an employer, increasing by 20% for each year of service thereafter, until 100% vesting is achieved at the end of seven years of service.
There are three types of Vesting:
Faster Vesting of Matching Contributions: Employer matching contributions must vest at least as fast as under one of two schedules: (1) 100% vesting after 3 years of service, or (2) 20% after 2 years of service and an additional 20% per year thereafter, with 100% vesting after 6 years of service. Effective for contributions for plan years beginning after December 31, 2001, with a delayed effective date for collectively bargained plans.
This very important retirement vehicle has been discussed earlier, but it should also be discussed in this particular section with other tax-related and tax-qualified retirement plans.
A 401(l) plan is named for the section of the IRA code that permits employees to invest pre-tax dollars into the plan and the employer usually matches the funds provided by the employee in some proportion. The Tax Reform Act of 1986 limited their use as a short-term savings plan by imposing a 10% penalty on any and all money withdrawn before the employee’s retirement. The maximum contribution (annual) had been $30,000 and it was lowered to $7,000 (adjusted annually for inflation). Employees may still borrow against there 401(k) and pay themselves interest.
§401(k) Dollar Limit: The limit on § 401(k) contributions is increased from $10,500 to $11,000 in 2002. Beginning in 2003, the limit is increased in $1,000 annual increments until the limit reaches $15,000 in 2006, with future indexing in $500 increments. Similar changes are made to the limits on contributions to § 403(b) annuities, § 457(b) plans, and other elective plans.
Catch-Up Contributions to Qualified Plans: An additional increase in the dollar limit on §401(k) contributions and other pre-tax elective contributions allows individuals age 50 or older to make catch-up contributions. For §401(k) plans, the increase in the dollar limit starts at $1,000 in 2002 and increases by $1,000 for each subsequent year until it reaches $5,000 for 2006, with future indexing in $500 increments. Catch-up contributions are not subject to any other contribution limits and are not subject to nondiscrimination testing. However, the plan must allow all eligible participants to make the same catch-up contribution election; all plans of related employers are treated as a single plan for this purpose.
Individual Tax Credit: The Act provides a temporary nonrefundable tax credit for contributions to a qualified plan made by certain lower-income taxpayers, including contributions to § 401(k) plans. The maximum annual contribution eligible for the credit is $2,000. The credit rate depends on the taxpayer's adjusted gross income ("AGI"). Only joint returns with AGI of $50,000 or less, and single returns with AGI of $25,000 or less are eligible for the credit. Effective in taxable years beginning after December 31, 2001, and before January 1, 2007.
Deduction Limits: The annual deduction limit for profit sharing and stock bonus plans is increased from 15% to 25% of compensation, and a money purchase pension plan is treated like a profit sharing or stock bonus plan for deduction purposes. Under the Act, § 401(k) contributions are not subject to the qualified plan deduction limits, and do not count against the limits in determining whether other contributions are deductible. In addition, the participant compensation used to calculate the deduction limits includes salary reduction contributions that are treated as compensation for § 415 purposes. Effective in years beginning after December 31, 2001.
Age 70 1/2 Minimum Distribution Rules: The Treasury is directed to revise the life expectancy tables used to calculate required minimum distributions to reflect current life expectancy, effective on date of enactment.
Plan Loans: The Act eliminates the special restrictions for plan loans to owner-employees, and makes such loans subject to the general statutory exemption for plan loans. Effective in years beginning after December 31, 2001.
• Top-Heavy Rules: The Act makes a number of changes in the top-heavy rules, such as amending the definition of "key employee," establishing an exemption for plans meeting the nondiscrimination safe harbors for 401(k), after-tax, and matching contributions, and allowing matching contributions to count toward the minimum top-heavy contribution requirement. Changes in the key employee definition will also affect funding limits for port-retirement life and medical benefits and other provisions that incorporate the definition by reference.
The 401(k) plan may be a “salary reduction plan,” a “cash or deferred plan,” or a “salary deferral plan.”
There are two traditional ways for an employee to defer income into a 401(k) plan.
1. The employee is given a cash bonus and most or some of it will be deferred into the plan on a before-tax basis.
2. The employee may defer part of his compensation under a “salary reduction” agreement, such funds to go directly into the 401(k) on a tax-advantaged basis.
When the 401(k) was first under discussion prior to 1974, it was expected that it would be a way for an employer to reward certain select key employees. However, the law states that the amount deferred (or percentages of salary) or the most highly compensated employees, are limited by the elective deferrals of the other employees. The IRS is very cognizant of anti-discrimination and will not allow any discrimination of any sort in a qualified plan.
Subject to certain rules that apply to some collectively bargained plans, there is a maximum dollar amount that an individual can elect to defer into any Cash or Deferred Arrangement (CODA) plan in which the employee participates. This would not only apply to 401(k) plans, but to a 403(b) plan (described below) also. Contributions to a 403(b) plan will reduce on the same basis, the amount that can be contributed to a 401(k) plan.
Option to Treat Pre-Tax Contributions as After-Tax Contributions: A §401(k) plan (or a § 403(b) annuity plan) is allowed to include a "qualified Roth contributions program" that permits a participant to have all or part of his future elective contributions treated as after-tax Roth contributions. A qualified distribution of contributions and related investment earnings from a Roth contribution account is not included in gross income. Effective for taxable years beginning after December 31, 2005.
Repeal of the "Same Desk" Rule: The Act repeals the "same desk" rule, which generally prohibited a § 401(k) plan from distributing an employee's account when the employee continued in the same job for a successor employer after a business sale. (The Act uses the term "severance from employment" to describe changes in employment status that may trigger distributions under the new rule.) The repeal is effective for distributions after December 31, 2001, even if the severance from employment occurred many years earlier. A plan may provide, however, that specified types of severance from employment are not distributable events. If a portion of the employee's benefit is transferred (other than by rollover or elective transfer) to a plan sponsored by the employee's new employer, the employee is not deemed to have severed from employment.
The term “simplified” certainly pertains to the SEP pension plan. It is a defined-contribution plan, wherein, according to a written (and non-discriminatory) plan, the employee opens an IRA. The employer makes tax-deductible contributions on behalf of the employee. The SEP has the same tax treatment as a 401(k) or profit-sharing plan, but the administrative rules are also simple.
The eligibility requirements are rather severe, particular in comparison to other qualified plans.
(a) is at least 21 years old
(b) has been paid over $400 (1996 figure, adjusted for inflation) during the year.
(c) has worked for the employer who is contributing to the SEP, during the year of contribution and any part of 3 of the immediately preceding 5 calendar years, and
(d) qualified during the year, whether still employed or not at the end of the year.
An SEP may be used as a retirement plan for an employer with less than 25 employees. In that case the maximum contribution is limited to $7,000.
A major difference between an SEP and other pension plans is that the employee is immediately vested, and the employee has total control over the investments.
Federal income taxes, FICA and FUTA withholding taxes are not necessary on SEP contributions.
SEPs (like IRAs) are not allowed to use contributions to purchase incidental life insurance.
Whether an individual is completely self employed, or is just bringing in self-employed income from part time work or consultations, they should seriously consider setting up an SEP. If the individual is self-employed, there are special rules that apply when calculating the maximum deduction for those contributions. In determining the percentage limit (15%) on contributions, compensation is considered as net earnings from self-employment, taking into consideration the contributions to the SEP.
The “Simple” Retirement Plan, (Savings Incentive Match Plan for Employees) pertains only to employers with no more than 100 persons who earned more than $5,000 the preceding year. The business must not have any other qualified plan, and can either be an employer-established IRA or 401(k) plan.
Employees can contribute a percentage of their compensation, not to excess $6,000 a year adjusted for inflation, and these contributions are not included in the employee’s taxable income (but they are subject to employment tax). Employers may contribute to the plan by matching the employee’s contribution up to 3% of the employee’s income, or they may contribute 2% of the compensation to every employee who has earned at least $5,000 that year. If the employer elects to set up an IRA type of account, they can reduce the employer’s contribution to 1% but may not reduce the participation to less than 3% for more than 2 years in any 5-year period. This does not apply if they use the 401(k) format.
Employees are immediately vested for 100%, and distributions from the plan are taxed as if they were regular IRA distributions. A 10% penalty is imposed for early withdrawals, but there is a 25% penalty if withdrawals are made during the first 2 years.
The employer may exclude contributions from the employer’s income and are excluded from the employee’s income. They are not subject to employment tax.
Small Employer Tax Credit: The Act provides a nonrefundable tax credit for a small business that adopts a new qualified defined benefit plan or defined contribution plan, SIMPLE plan, or simplified employee pension. The credit applies to 50% of the first $1,000 in administrative and retirement-education expenses for the plan for each of the plan's first 3 years. Effective for costs paid or incurred in taxable years beginning after December 31, 2001, with respect to plans established after that date.
For years, life insurance products have been frequently used to fund employee benefits, including non-qualified plans such as executive bonus plans and non-qualified deferred compensation. When the base life insurance policy is combined with the investment features of the Variable Life, it is relatively easy to meet the benefits needs of employees.
As a background, the Executive Bonus Plan (EBP) the employer gives a tax-deductible bonus to a key employee or executive who then must pay taxes on the bonus, but uses the money to purchase a life insurance policy. The employee is the owner of the policy and as such, appoints the beneficiaries and has availability to the cash values. Being life insurance, it provides a death benefits, either during retirement or prior to retirement. The cash value may be used to supplement retirement if needed.
The EBP is the least restrictive of any of the benefit plans. Occasionally, the employer wants to have more control of the policy, so an agreement between the employer and employee is used, whereby the employee agrees not to access the policy’s cash values until specified requirements (usually regarding length of service, etc.) are met. The employer agrees to continue the funding as long as the employee is with the firm, These arrangements are known as Restrictive Endorsement Bonus Arrangement, or a REBA.
The employer and the employee share (split) the ownership of the premiums, death benefits and cash values, thereby allowing the employer more control than with and EBP bonus plan. When the employee retires, the employer is reimbursed for the contributions it has made to the policy, and the employee then has full ownership of the policy. The employee then can use the policy for future death benefits and/or supplemental retirement income.
Under this arrangement, the employee agrees to defer a certain specified portion of their income and employer credits this money, with interest, such funds to be paid to the employee at time of retirement.
The interest rate can be determined by basing it on the performance of the company, a stock market index, an interest index, or on blended results of certain accounts, or by some other method agreeable to both parties. Under ERISA rules, the investment vehicle remains as part of the company’s general assets.
Some companies prefer to fund their NQDC plans with mutual fund, stock, or even self-funding, but life insurance can offer benefits not available in other funding methods, particularly since life insurance cash values grow at a tax-deferred rate and loans/withdrawals can be taken from the policy tax-free. Of course, the death benefit is income-tax free to the company in most cases (they could have alternative minimum tax problems). Further, the policy can provide the most unique of benefits used for funding, the recovery of the cost. Since the company is the owner and beneficiary of the life policy, this plan provides maximum control while at the same time, helping employee retention.
Under IRS Section 401(a)(17), companies can supplement the retirement income provided to executives, as the amount of income that can be considered for the purpose of qualified pension plans, is limited to $200,000 in 2002 (indexed in later years). This limits the amount of money that highly compensated personnel can receive in retirement income.
Many companies offer their highly-compensated employees a Supplemental Executive Retirement Plan (SERP) wherein the employer provides an additional bonus to be paid at time of retirement. This amount is “unfunded” for ERISA purposes, so the funding vehicle remains as part of the company’s assets. Therefore, the tax-deferred cash value, tax-free loans and withdrawals, plus the income tax-free death benefit of the life insurance policy, makes life insurance one of the best (if not the best) funding vehicles available.
CONSUMER APPLICATION
William is a Vice President of Ajax Corp. and has an annual income of $250,000. Ajax pays its retirees 50% of their pay at retirement. William would receive $125,000. However, according to the IRS regulations, in 2002, 40% is available, William would receive $100,000.
William feels that he will have a difficult time maintaining his standard of living with such a dramatic reduction in pay. Ajax agrees to provide a supplemental plan (SERP) which would alleviate this situation, and the company would still control the policy and its benefits in case William is tempted to join another company with perhaps a little higher salary.
Variable Life can prove to be a most unique vehicle for the funding of these non-qualified programs. The tax-deferral growth, loans and withdrawals and the tax-free death benefit have been discussed. The tax-free death benefits are particularly important in executive’s benefits.
If the employee dies prior to retirement, the death benefit can be used to automatically complete the plan, or provide additional funds to the employee'’ beneficiaries, and the company can use the proceeds to recover the costs of the plan to the corporation since inception. And of course, as discussed earlier in this text, the death benefits can be used as key employee coverage to help the company fund a search for a replacement. Again, no other funding vehicles can offer these advantages.
These advantages are available with any permanent life insurance product. However, with Variable Life , there are so many options and the plan is so flexible, there are unique advantages to both the employer and the employee.
To the employee, a Variable Life plan offers as many different investment options as a 401(k) plan – if not more. The wide choice of sub-accounts (some insurers offer 60 or more) is quite attractive to an employee. When the Variable Life is used in an EBA, REBA or split-dollar plan, the employee has direct control of the underlying investment choices that will have the most impact on the cash values of the policy. If the employer agrees, the employee can have some choices in the underlying investment options of a NQDC plan.
Since the employer is both the policy owner and beneficiary, the employee cannot make the actual fund choices or the employee would be in the position of having “incidents of ownership” in the policy, and therefore, all the deferrals would become immediately taxed. But, the employer can give the employee the option to allocate the deferral amount different investment styles – such as between equity index, growth and income, balanced, etc. The employer then allocates the employee’s deferral to the funds offered by the insurer that matches the generic type of investment vehicle chosen.
The advantages of flexibility, choice and control to the employer are important, but there is one more significant advantage. With a NQDC plan funded by life insurance or Universal Life insurance, the employer would have to choose a rate to credit the deferrals of the employees. If the chosen fund did not keep up with the chosen interest rate, the employer would have to put in sufficient funds to make up the difference.
However, with Variable Life insurance, the employee’s deferral account would be based on the performance of the policy’s sub-accounts, and this would be chosen by the employer. The employee gains flexibility and choice and at the same time, the employer does not have to worry about having to fund the plan in order to meet the specific interest-crediting rate.
One of the leading authorities on business and estate planning, James G. Blase, CPA, JD, LLM, writing in industry publications, recently raised the subject of proposed new tax “regimes” for employee-owner and company-owned split dollar plans.
In Notice 2002-8, the IRS has taken two approaches to the taxation of split-dollar plans. These proposed regulations, which appear to have no opponents, will not be effective until 2003 at the earliest, but they may be used today. These two approaches (called “regimes” by Mr. Blase) are based upon how the arrangements are structured.
Previously, the IRS maintained there was no difference for tax purposes between the collateral assignment split-dollar plans where the employee is the policy’s legal owner and assigns the policy to the company with the promise to repay the company for the portion of the premiums that the company paid – and the tax rules which apply to the endorsement split-dollar where the company is the policy’s legal owner but endorses certain interests in the policy to the employee, such as naming beneficiaries of the employee’s portion of the benefit. The IRS proposes to tax these two plans under mutually exclusive set of rules.
Rather than entering a discussion at this point as to the new proposed tax rules, briefly summarized, the proposed rules in respect to a company-owned plan, current life insurance protection would be treated as being provided by the company and taxed on this basis. If the employee is the owner of the policy, the company-paid premiums will be treated as a series of loans by the company to the employee (if the employee is obligated to repay the company) and taxed accordingly.
The current life insurance will be valued according to proposed (and detailed) rules. The IRS does propose that for existing split-dollar arrangements, entered into prior to Jan. 28, 2002, the parties can terminate the arrangement without tax consequences if terminated prior to Jan 1, 2004.
What will this mean? Experts maintain (correctly) that sound income tax planning requires that whenever possible, any arrangement should never be structured to generate an item of taxable income without an offsetting income tax deduction.
Notice 2002-8, when combined with the 2001 Tax Act, lowers individual income tax rates relative to corporate income tax rates, over the next four years and will necessitate re-thinking of tax strategies regarding life insurance in an employee’s benefit package. By 2006, the maximum federal individual marginal income tax rate will fall to 35% applicable to taxable income in excess of $75,000. Corporate income tax of 35% applies to taxable income in excess of $10 million, with an effective 38 - 39% tax rate because of phase-out of lower income tax rates.
Under the proposed tax law, the marginal corporate income tax rate will exceed the employee’s marginal tax rate. However, bonuses paid to C and S Corporations would be income tax neutral.
Experts in taxation, as a general rule, believe that the existing pronouncements of the IRS on split-dollar plans, including Notice 2002-8, means not only that the company cannot deduct premium payments on split-dollar plans, but also the company cannot deduct the value of the current life insurance protection taxable to the employee. Therefore, any split-dollar arrangement generating taxable income to an employee for the value of current life insurance protection, is not an income tax neutral plan. Where split-dollar plans are treated as loans from the company will cause the person to be deemed to make annual nondeductible interest payments to the company.
When a pure bonus approach is used to pay premiums on policies owned by the employee, this is usually income tax neutral, and therefore should be used for S corporations, in particular, and C corporations with taxable income in excess of $75,000.
CONSUMER APPLICATION
Ajax Corp. is in the 34% marginal federal corporate income tax bracket. Vice President Sam is in the 30% marginal federal individual income tax bracket. Ajax has a split-dollar arrangement, funded by life insurance, with Sam with annual premium of $10,000. The company pays Sam a bonus annually of $15,000 for premium payment purposes.
Ajax takes a tax deduction for the bonus, thereby costing Ajax $10,000. Sam will pay income taxes of approximately $5,000 on the bonus before netting the $10,000 needed for the premium.
This arrangement is income tax-neutral as there is no net amount paid to the IRS after factoring in the $5,000 income tax savings for the company.
If the company wanted to be later reimbursed for after-tax cost of its premium and bonus payments, the company could purchase a key-man life insurance policy on the life of the employee for this purpose. Since this policy would not be part of the arrangement with the employee, it is doubtful that it would be treated as a loan from the company to the employee.
Also, the pure bonus approach means that since bonuses or premiums never need to be repaid to the company, the employee would not have to later use the cash value of the policy to repay the company.
This pure bonus arrangement would also work where the employee is not intended to get the equity in the policy. Under the Notice 2002-8, those non-equity split-dollar arrangements would be treated as either as taxable current life insurance protection to the employee; or an interest-free loan arrangement where interest payments are considered as paid to the employee which are not deductible by the employee, but taxable to the company.
This would seem to indicate that consideration should be given terminating existing split-dollar plans under existing rules before Jan. 1, 2004, and the pure bonus approach be used. However, C Corporations with less than $75,000 in taxable income, because the employee would incur higher income taxes that the company is receiving a benefit because of its income tax deduction. If the company wants to provide the employee with the policy’s equity above the total of the premiums paid, then the two-“regime” method may be preferred.
At the start, the employee would be taxed on the value of the current life insurance protection. Then when the policy’s cash surrender value is equal to the total of the premiums paid, the parties involved should then be able to switch regimes and tax the ongoing arrangement as an interest-free loan from the company to the employee. According to the Notice 2002-8, and as contrasted with previous such Notices, it does not appear to require the arrangement to be treated as a loan from the beginning of the plan in order to achieve loan treatment prospectively.
Sometimes, it may be wise to convert the arrangement to the loan “regime” before the break-even point (when the annual nondeductible deemed interest payment is less than the value of the current life protection and the amount or this interest payment is not expected to rise significantly higher than that level in the future – such as if significant future premiums are not expected and the applicable federal interest rate is not expected to rise significantly in the future and especially if the full FICA taxes would be payable on the value of the current life insurance protection.
This Notice 2002-8, if enacted (which it is almost certain to be) eliminates an agent from using split-dollar plans to eliminate income tax on the equity build-up on behalf of the employee as part of an equity split-dollar arrangement without adverse income tax ramifications. However, thanks to the new tax law that lowers the individual income tax rates in relationship to corporate income taxes, usually funding life insurance benefit plans under the pure bonus approach will provide an income tax neutral approach as premiums are being paid on the policy. This will allow the employee income tax-free access to the full cash value of the policy during the employee’s lifetime, plus income tax-free protection of the death benefits.
The income tax leverage resulting from the inclusion of life insurance as part of the employee’s benefit package, will remain after Notice 2002-8 is enacted, provided the arrangement is property structured.
NOTE: “Employee” as referred to above in this discussion, includes a shareholder that enters into the arrangement.
It is important that those who use split-dollar plans in planning with their client, obtain a copy of IRS Notice 2002-8 and fully understand it in setting up such employee benefit arrangements. If a tax accountant is to be used during the planning process, either by the client or by the agent, it would be wise to make sure that the accountant is knowledgeable about this Notice.
The Keogh ace was first passed in 1962. It permits the self-employed person to establish his/her own retirement plan. The self-employed can make nondeductible voluntary contributions and tax deductible contributions, subject to a maximum limit of 25% of earned income, up to a maximum of $30,000 for a defined contribution to the Keogh Plan. This is an equivalent rate of 20% of earned income prior to the contribution of the Keogh Plan
There are 4 types of Keogh plans:
The Tax Deferred Annuity is generally referred to as the “TSA,” but it also includes 403(b) and 501(c)(3) plans. These are all plans that are offered only to employees of certain specific nonprofit, tax-exempt organizations and public schools as outlined in the Internal Revenue Code, Sections 501(c)(3), 414(e) and 170(b)(1).
Under these sections, “annuities” refer to the fact that the distributions are made in a series of installments. The IRS Code Section 403(b) is the section that gives the tax-favored status to these plans. Basically, TSA contributions are made on a before-tax basis (federal income tax), and accumulate tax-free (federal income tax) until distributed. Some states also defer taxing of TSA’s, but not all states do this.
Under the Federal Rules, TSA contributions can come from employees by voluntary salary-reductions. They will receive favorable income tax treatment if they are properly funded by any combination of fixed or Variable Annuity contracts, or the shares of open-ended or closed-ended investment companies. In some states, life insurance can be used as an incidental TSA benefit.
The plans must be non-discriminatory if mutual funds are to be used as an investment option or if the employer is making matching or discretionary contributions to the TSA (in addition to the salary deferrals by employees). The amount of each participant's annual contribution that will be allowed to escape current taxation is determined by a formula, called the “Exclusion Ratio.”
The Exclusion Ratio is:
. Amount Invested in the Annuity
Expected Return under Annuity.
(where the expected return under the annuity equals the life expectancy of the annuitant – times – the annual income payment)
CONSUMER APPLICATION
Rush had invested $40,000 into an annuity. At age 60, he has life expectancy of 14 years. He receives an annual income of $5,000. Therefore, 57.14% of each income payment would not be subject to taxation.
Amount Invested in the Annuity: $40,000
Expected Return under Annuity: 14 years – times - $5,000 = $70,000
$40,000 divided by $70,000 equals .5714 (57.14%)
The “Amount Invested in the Annuity” is defined as the “cost basis” of the amount the individual has personally paid into the annuity and upon which income taxes have already been paid. An individual may fund the cost basis by life insurance, whereby the pure Term Insurance cost is taxed to the individual in the year in which each premium payment is made.
The “cost basis,” i.e. the “Amount Invested in the Annuity” can be continued after the individual ceases to be an employee for 501(C)(3) or 403(b) purposes, continue to make payments after the employer ceases to be a 403(b) plan sponsor. Also, if money has been borrowed from the TSA plan, if the amount is repaid the cost basis will continue. If an individual had owned the annuity and had made contributions (nondeductible) to it before it became part of a TSA plan, they can obtain a cost basis.
When distributions are made, the benefits will be taxed as ordinary income, except that a portion of the proceeds may be excluded from federal income tax as “cost basis”
Qualified participants are usually only employees of 501(c)(3) organizations and public school systems. Care must always be taken that an employee is in fact an employee and not an “independent contractor.” Many persons who perform services for educational institutions, or doctors, who use hospital facilities, are contractors under the law, and not “employees.”
NOTE: If an individual with an IRA, Keogh plan, or other type of tax-advantaged plan, uses municipal bonds as an investment for the retirement plan, there are some situations that must be taken into consideration. If the municipal bonds are issued by the state or municipality of residence of the individual, there are no taxes paid on the bonds. However, if the bonds are put into a tax-deferred retirement account, the income that is earned becomes taxable when the individual receives the money from the plan. Therefore, the individual has converted a tax-free investment into a low-earning taxable investment!
Similarly, it is also recommended that the individual remember that Series EE U.S. Savings Bonds are taxed at the federal level, but at time of redemption. Also, there is no state income tax. Therefore there is no real reason to include them in a tax-advantaged retirement plan. If they are put into the retirement plan, they are subject to tax at the time of disbursement from the fund.
As indicated in the previous sections, the government continues to pile one retirement program on top of another with the resulting plethora of acronyms – 401(k), 403(b), 457, traditional IRA, Roth IRA, SIMPLE, SEP, etc. This has resulted in some interesting statistics from those who are working, regarding what they are doing for retirement and how they plan on saving for their “golden years.”
The vast majority of working Americans, ages 22 to 52, say they are confused about how to save and invest for retirement. And about a third of Americans, who haven’t even started saving for retirement, cite confusion as a major reason. As a matter of fact, about a third of those eligible for a Roth IRA say they haven’t opened one because they are too confused about the rules.
86% of all workers eligible to contribute to a company-sponsored 401(k) plan, do so, which is approximately 30 million Americans, and they contribute about $1.4 Trillion! However, statistics also indicate that only 55% of Baby Boomers (those who are ages 34 to 52) contribute to a 401(k). There are a wide variety of reasons as to why they do not contribute but not surprising, 57% of Baby Boomers are concerned that they will not have enough to retire on. Baby Boomers actually got a late start in saving and investing for retirement, as most of them had considered that the “government” or their employers would take care of them in retirement without any effort on their part. Even today, the typical Baby Boomer contributes $284 a month to a 401(k) plan, while the “Generation X” individual contributes $224. This is probably why that after the long bull market in the 1990’s but before the recent market slide, the average Boomer has only about $50,000 – and probably some less now, in view of the market volatility - saved in their 401(k) account.
CONSUMER APPLICATION
Pamela is a medical technician in her mid 30’s who has worked at various jobs throughout her state for more than 10 years.
Her first job was at a public hospital where she worked long enough to qualify for a traditional pension plan (although quite small). She also contributed to a tax-deferred 457 retirement plan (a 401(k) type of plan used for those working for public institutions or entities)
She then went to work for a doctor’s office in her hometown, but it did not offer a pension plan but did offer a 401(k). She contributed 15% of her salary to the plan.
The doctor was bought out, so she went to another public hospital and back to a 457 plan.
About a year later, she was offered a good position with a nonprofit hospital, where she was able to contribute to a 403(b) (similar to a 401(k) but with different investment options and different rules).
During this period of time, she opened a traditional IRA, and then later converted it into a Roth IRA with a Mutual Fund. She also opened another Roth IRA with another mutual fund group. In addition, she acquired other mutual funds that are not in retirement accounts.
At this point in time, unless there is portability legislation enacted, she will find herself writing to all of the companies trying to determine how much she has in each account, how much she can withdraw, and when she can withdraw it.
CHAPTER 9 – STUDY QUESTIONS
1. An individual who has contributed to an IRA can begin to receive payments when they reach age
A. 71.
B. 59 ½ .
C. 55.
2. The major difference between a regular IRA and a Roth IRA is
A. how and when the accumulated funds are taxed.
B. different financial investments available.
C. in a Roth IRA the owner must start taking the funds at age 65 and in a regular IRA the funds must start before age 70 ½.
3. With an IRA
A. the owner may borrow against it.
B. married couples who have earned income can contribute to an IRA.
C. contributions must be to a bank.
4. A life insurance plan that keeps on paying the compensation of an employee after they have died is called a
A. buy-sell agreement.
B. salary continuation plan.
C. 401(k) plan.
5. In order to receive the maximum tax benefit from a deferred compensation plan, the funding must be
A. in Treasury bills.
B. annuities.
C. cash value life insurance.
6. Under the defined benefit retirement plan, the fixed dollar approach can be distributed in the following manner
A. cost of living plan.
B. equity annuity plan.
C. flat amount plan.
7. In order for an employee to receive benefits from a retirement plan, they must be “vested” in the plan. This means
A. the employee has contributed as much as the employer prior to retirement.
B. the employee has worked a sufficient length of time to own either a part of or all of the employer contributed funds.
C. the employee has contributed enough to get back all of the contributions in the event of death.
8. If an employer has 20 employees, how much can the employer contribute per employee, to a Simplified Employee Pension Plan?
A. 15% of gross wages or $24,000 whichever is less.
B. 30% of gross wages or $160,000 whichever is less.
C. 15% of gross wages or $7,000 whichever is less.
9. The “Split-dollar” plan was developed so that
A. an employee could get more life insurance and the employer would pay a portion of the cost (usually one half).
B. the client could pay equal amounts into a life insurance policy and an annuity.
C. the client would make one payment, each month, to an insurance company and the insurer would split the benefits between life insurance and health insurance.
10. Why is it not a good idea to use Municipal Bonds to fund a retirement plan.
A. The interest is so low that it would be better to pay taxes on a higher yielding in-vestment.
B. The interest earned, although tax free when paid, if allowed to accumulate will be taxable at time of receipt of the retirement money.
C. Municipal Bonds are not allowed to be used in a retirement plan.
ANSWERS TO CHAPTER NINE REVIEW QUESTIONS
1B 2A 3B 4B 5C 6C 7B 8C 9A 10B