Making Sense of Retirement Planning
Our clients often ask us—“What’s the best way for me to save for retirement?” and, “How can I ever afford to retire?” With careful planning and a financial commitment, you really can build enough wealth for your retirement years.
We understand that choosing the right retirement plan(s) can be daunting—whether you’re employed by a company, self-employed, or you’re an employer providing benefits for your staff. Each plan has its advantages and disadvantages. We offer this article as a starting point for clarifying the retirement planning options available today.
This plan allows qualified employees to contribute to a retirement fund through tax-free salary deferral. Up to $15,000 can be deferred with a $5,000 “catch up” if you’re over 50. Employers then offer a contribution “match” up to a certain percent. For example, X Company offers a 100% match for every dollar contributed by an employee, up to 6% of their salary. (The employee can contribute more than 6%, but the employer match limit is 6%.)
Advantages: If you work for a company that offers a 401(k) matching contribution, make the most of it by deferring at least the amount that will get you the most matching funds.
You reduce your gross income and defer tax on this amount until the cash is distributed to you.
- You can earn a guaranteed 25%, 50% or even 100% return on your investment through the employer’s match…plus the return you earn on the fund(s) itself.
- Loans are permitted with this plan.
- New employees usually need to wait a few months before they can participate.
- Some plans have "vesting," which requires employees to be with the company for a certain time before they’re entitled to some of the employer contributions.
SIMPLE 401(k) Plan
SIMPLE, which stands for Savings Incentive Match Plan for Employees, allows small businesses with 100 or fewer employees to offer 401(k) matching contributions (up to 3%) based on contributions elected by participating employees. Or instead, a small business may elect to offer a 2% contribution to non-elective employee accounts through this plan. The primary difference between this plan and the regular 401K is that the deferral limit is $10,500 with a catch up of $2,500 if you’re over 50.
Advantages: See the 401(k) description above. Again…take full advantage of this free money!
Disadvantages: See the 401(k) description above.
Small business owners with no employees (mainly sole proprietors) can establish a 401(k) plan with low paperwork and easy management. Contributions are based on revenue generated by the business.
Advantages: It may offer higher contribution limits than other retirement plans available for small businesses, and it offers loans, which many other small business plans do not.
Disadvantages: If you anticipate hiring staff for your business someday, you will be required to offer the same plan to all employees. So, you’ll probably need to change the plan.
403(b) Tax-Sheltered Annuity Plan
This plan works like a traditional 401(k), but it’s for employees of certain public schools, colleges, universities, churches, public hospitals, and other tax-exempt charitable organizations.
Advantages and Disadvantages: This plan is run very similarly to a 401(k) plan. Please review those advantages at the top of this article. It’s a winner!
Simplified Employee Pension (SEP)
With this plan, employers can make contributions directly to an individual account (IRA) or an individual retirement annuity established for each eligible employee. Employers make contributions to their own IRAs and the IRAs of their employees, subject to certain percentages of pay and dollar limits. These plans have special rules and aren't tied to normal IRA contribution limits.
Advantages: This plan can be used for one-person operations or for businesses with multiple employees, to provide regular payments to a retirement fund. SEPs can be set up at just
about any financial institution that offers an IRA. Plus, SEPs can be set up by the company’s tax filing date, not year-end (in case you want to set one up for 2006).
Disadvantages: Contributions are immediately 100% vested, which is great for the employee but not so great for the employer when compared to vesting. That’s because an employee may withdraw the amount immediately after it’s deposited into the SEP IRA. In addition, SEP plans do not offer loans.
SIMPLE IRA Plan
Small businesses and self-employed individuals may choose to set up and contribute to a tax-deferral SIMPLE IRA (individual retirement account). This is different from a SEP because the individuals make the contributions, not the employer. Any employee making at least $5,000 per year must be allowed to enter a “qualified salary reduction arrangement” and can elect to have a percentage of salary set aside in an IRA, instead of receiving it in cash.
Advantages: For the employer, contributions are a tax-deductible business expense, the plan is easy and inexpensive to administer, and no government reporting is required. For employees, contributions are immediately 100% vested and are tax-deferred, and 100% of earned income can be contributed (up to the allowable limit).
Disadvantages: Loans can’t be taken against it.
Payroll Deduction IRA
If a small business cannot or chooses not to offer a retirement plan with employer contributions, it can allow its employees to make IRA contributions through payroll deduction, helping eligible employees save systematically.
Advantages: It’s a simple way for employees to set up an IRA and save for retirement. By making regular contributions through their payroll, they can contribute smaller amounts each pay period to their IRAs, rather than having to come up with a larger amount all at once.
Disadvantages: This plan has no additional benefits for the employee (match, loans, etc.).
This plan allows an employer to make discretionary contributions to employees based on the company’s performance.
Advantages: For employers, contributions don’t have to be made if profits were low in a given year, and they can establish a vesting schedule. Employees can earn tax-deferred income until withdrawn, and in many cases, take a loan against the account.
Disadvantages: Withdrawals may be restricted for the employee, and investment decisions are controlled by the employer.
Individual Retirement Accounts (IRAs)
Traditional IRAs can be set up at most banks or investment firms, and can be funded with deductible and nondeductible contributions.
You can make an annual deductible contribution if:
- you (and your spouse) are not enrolled in an employer-sponsored retirement plan, or
- you (or your spouse) are enrolled in an employer plan, and your modified adjusted gross income (AGI) doesn't exceed certain levels that vary from year-to-year by filing status.
These accounts are not taxed until you withdraw them. Please see “Withdrawal Limits” in the glossary on page 2.
You can make an annual nondeductible IRA contribution no matter what your employer offers or what you earn. Nondeductible contributions aren't taxed when they are withdrawn.
If you don’t qualify for a deductible IRA, you might contribute (if eligible) to a Roth IRA instead of making a nondeductible IRA contribution. You can also roll over your traditional IRA into a Roth IRA if you qualify. Why would you choose to do this? The Roth IRA can offer a better tax benefits. Here are some of the reasons why.
- Even thought Roth contributions aren’t tax-deductible, you can withdraw the money tax- and penalty-free at age 59½ if you had the account for at least five years. (With a traditional IRA, any pre-tax money you put in will be taxed as income when you withdraw it.)
- You may be able to make Roth IRA contributions even after age 70-1/2
- You don’t have to take minimum distributions from a Roth IRA after age 70-1/2
Two Important Notes
For most retirement plans, if you take withdrawals before you reach age 59-1/2, the amount will be fully taxed as income AND you’ll pay an additional 10% penalty unless the money is used for qualified exceptions such as a home down-payment or college expenses. Please consult your accountant before you consider an “early withdrawal” from your retirement plan!
Lower-income workers might qualify for a tax credit for a percentage of their contributions. Please call us to discuss requirements for this credit.
IMPORTANT! New IRS “Age-Weighted” Provisions Help Those Nearing Retirement
New IRS rules make it possible for an employer to set up a qualified profit-sharing plan that favors older employees. An age-weighted profit-sharing plan allows employers to make flexible contributions each year, and there is no requirement that any contribution be made in a given year. This means an employer can choose to set aside more money for older employees nearing retirement age while remaining in compliance with nondiscrimination rules. This type of plan can be helpful for businesses that want to reward older employees and for partnerships with older and younger partners. This provision can also apply to other plans that have an elective deferral component. Please call us if you’d like to learn more about this.
Each of these retirement plans is different and can be complicated to set up and administer, so be sure to talk with your accountant for assistance.
Our financial articles are presented by Honeck O’Toole, Maine-based certified public accountants. If you ever have questions about your finances, please email us or call 207-774-0882.