Faced with a plethora of choices for retirement savings options, taxpayers need guidance. Whether from an employer sponsored account or retirement plans for employees and the self-employed, there are many options.
The following are popular options for employees and the self-employed (followed by employer-sponsored plans).
Employees and self-employed individuals who aren't active participants in an employer-maintained retirement plan can set aside and deduct up to $5,000 for 2010 and 2011, for contributions to an individual retirement account, or for the purchase of individual retirement annuities or endowment contracts. This limit is reduced by contributions made to all IRAs during the tax year. For individuals over 50, a catch-up contribution is available (if eligible) of an additional $1000 for a total maximum of $6,000 in 2010 and 2011.
An active participant in an employer plan (or whose spouse is) can't make deductible IRA contributions unless his/her adjusted gross income is below specified levels, as shown on the Individual Tax Tables.
Upon reaching 70-1/2, the taxpayer must start taking distributions as per distribution rules (see Individual Tax Tables.
Traditional IRAs can be rolled over penalty-free (but not tax-free) into Roth IRAs.
A taxpayer can make nondeductible contributions to Roth IRAs. Qualified distributions from Roth IRAs are tax-free and penalty-free. Roth IRAs are not subject to the post-age 70-1/2 required distribution rules
An individual can make annual nondeductible contributions to a Roth IRA in amounts up to $5,000 for 2010 and 2011 ($1,000 catch-up for 50 and older), or 100% of compensation, if less, reduced by contributions for the tax year made to all other IRAs (other than to a SEP or SIMPLE plan).
The allowable contribution phases out ratably (in $10 increments) over specific levels of modified adjusted gross income. See tax tables for individuals for the specific income ranges.
Taxpayers, including those filing married filing separately, may convert amounts in a traditional IRA to amounts in a Roth IRA without regard to their modified adjusted gross income or filing status. The conversion may be done one of three ways.
(1) Rollover to a Roth IRA of a distribution from a traditional RIA within 60 days of the distributions, (2) Trustee--to-trustee transfer from the trustee of the traditional IRA to the trustee of the Roth IRA or (3) Transfer of an amount in a traditional IRA to a Roth IRA maintained by the same trustee.
Qualified distributions from a Roth IRA are not included in income. These are distributions made after the five-year period beginning with the first tax year for which the taxpayer or the taxpayer's spouse made a contribution to a Roth IRA established by the taxpayer, including qualified rollover contribution from another IRA other than a Roth IRA, and are made: (1) on or after age 59 1/2, (2) at or after death (to a beneficiary or estate), (3) on account of disability, or (4) for a first-time home purchase expense.
A SIMPLE IRA is pretty simple (compared to other retirement arrangements). An employer with 100 or fewer employees that doesn't have a qualified retirement plan can establish a "SIMPLE" (savings incentive match plan for employees) retirement plan, without having to meet most requirements for qualified plans.
Employees designate contributions to be made to a SIMPLE plan under a "qualified salary reduction arrangement". This is a written arrangement under which an employee may elect to have the employer make elective employer contributions to a SIMPLE retirement account on behalf of the employee, or directly to the employee in cash.
The amount that an employee may elect for any year cannot exceed $11,500 for 2010 and 2011 (or 100% of net earnings if less), as indexed by inflation. Employees who are age 50 or higher may make an additional catch-up contribution of $2,500 for a total of $14,000.
Employer contributions are deductible in the employer's tax year with which the calendar year for which the contributions were made ends.
A SEP IRA sounds confusing too. It isn't based on Philadelphia's train system. Instead a Simplified Employee Pension is an individual retirement account or individual retirement annuity.
Maximum contributions are greater than a SIMPLE IRA or other individual retirement accounts, as indicated.
For 2010 and 2011, if you have a SEP, you are allowed to contribute the lesser of:
- 25% of your net earnings from self-employment
- $49,000
Once the money is in the plan, you can invest it in all of the same things you would be allowed to invest in with a regular IRA (stocks, bonds, mutual funds, CDs, etc). Also, the same withdrawal rules apply. With a few exceptions, you cannot make withdrawals from the plan prior to age 59.5 without being penalized.
One important thing to know is that, for purposes of calculating your maximum contribution, “net earnings from self-employment” is perhaps not quite what you’d expect. Basically, it’s all your revenues, minus your expenses (makes sense so far), minus two other items:
- The deduction for one-half of your self-employment tax.
- The deductions for contributions to your SEP IRA.
Qualified pension, profit sharing and elective deferral (401(k)) plans offer substantial tax benefits to sponsor-employers and their employees.
The principal advantages include:
Employer gets an immediate deduction for contributions under the plan
the employee isn't taxed on his/her share of the fund until distribution
the tax is deferred on qualifying distributions of appreciated employer stock until the stock is sold
A qualified pension plan (otherwise known as a defined benefit plan) provides systematically for the payment of definitely determinable benefits to employees (and their beneficiaries) after retirement over a period of years, usually for life.
Retirement benefits are generally measured by such factors as years of the employee's service and compensation received. Benefits under a defined benefit plan are 'definitely determinable' if they a re determined actuarially, on the basis that precludes employer discretion.
The employer must contribute to the plan on a regular basis so sufficient funds are available to pay required benefits to all retired employees as they come due. The employer bears the risk of having enough funds for pension payments.
A qualified profit sharing plan must have a definite, predetermined formula for allocating contributions made under the plan among the participants, and for distributing the funds accumulated under the plan only after a fixed number of years, the attainment of a stated age or upon the occurrence of some event (disability, death, ...).
Contributions can be made to a qualified profit-sharing plan whether or not the employer has current or accumulated profits. Contributions must be made on a non-discriminatory basis.
Cash or deferred arrangements (CODAs), popularly known as "401(k)" plans allow an employee to choose whether the employer should pay a certain amount directly to the employee in cash, or should instead pay that amount on the employee's behalf to a qualified trust under a profit-sharing plan, a stock bonus plan, a pre-ERISA money purchase plan or a rural cooperative defined contribution pension plan.
For 2010 and 2011, an employee may elect to defer a maximum of $16,500 on a pre-tax basis under a 401(k) plan, SEP, or Code Sec. 403(b) tax-sheltered plan. A 403(b) plan is offered by public schools and certain 501(c)(3) tax-exempt organizations. An individual may only obtain a 403(b) annuity under an employer’s TSA plan. Individuals that attain age 50 by the end of the plan year may make additional pre-tax "catch-up" contributions of up to $5,500 for 2010 and 2011, adjusted for inflation.
Distributions are taxed as ordinary income, unless distributed to the employee in a corrective (nontaxable) distribution during the tax year of by the April 15th (18th in tax year 2010) following the close of the employee's tax year.
a 401(k) plan must meet all the normal tax qualification rules, including the nondiscrimination rules, and, in addition, the following rules.
amounts must not be distributed except for reasons of (a) retirement, death, disability or other separation from employment;
employer contributions made under the employee's election must be nonforfeitable at all times;
a covered employee must be able to elect to have the employer make plan contributions on the employee's behalf or make the payment directly to the employee in cash;
elective deferrals under the plan must be prohibited from exceeding the above indexed dollar limits;
and, special nondiscrimination rules apply
An ESOP is a qualified defined contribution plan that is either a stock bonus plan, or a combination stock bonus plan and money purchase plan, that invests primarily in employer securities, and is formally designated as an ESOP.
For S Corporations, to ensure that ESOPs benefit a broad range of an employees, restrictions apply that generally prohibit the accrual or allocation of S corporation stock to certain disqualified persons in an ESOP where 10% owners hold 50% or more of the interests in the S corporation.
Dividends on employer securities that are distributed from an ESOP must be reported on a Form 1099-R that does not report any other distributions rather than on Form 1099-Div
Plans must provide that a participant right to his accrued benefit vests at certain rates during the years of his/her employment. Benefits from employee contributions must be 100% vested at all times. Benefits derived from employer contributions must become nonforfeitable when the employee reaches normal retirement age.
A qualified plan other than a government plan must meet special tests designated to ensure adequate coverage of rank and file employees and avoid discrimination.
The plan, on at least one day in each quarter, either (1) benefit 70% of the employees who aren't "highly compensated" or (2) benefit a percentage of nonhighly compensated employees that is at least 70% of the highly compensated benefiting, or (3) meet a test under which the average benefit for the nonhighly compensated.
The definition of "highly compensated" is an employee who (1) was a 5% owner at any time during the determination year or the preceding year, or (2) for the preceding year, received more than $110,000 for 2010 and 2011 in compensation from the employer, and, if the employer elects, also was in the "top-paid group" (top 20%) of employees for that year.
Sound confusing? For further information including other plan options and to speak with a retirement planner, contact us.
