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Retirement Planning

Retirement plans play a crucial role in providing a source of income in our later years. We've all seen or heard about "the three-legged stool" that shows Social Security, our personal lifetime savings, and company retirement plans as the triad from which we will draw the funds to pay for our expenses after we retire.

These plans serve many purposes for employers and employees alike, and they come in many varieties. Yet few of us really understand the plans we have, despite the critical function they fulfill in our lives. To help increase that understanding, we are providing this overview of those retirement plans that are most common. It also provides a few definitions along the way, too, to help clarify some of the terminology used in discussing these plans.

Qualified Retirement Plan. A qualified retirement plan is one that meets the numerous requirements of the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA). Plans meeting these requirements qualify for four important tax benefits.

First, employers may deduct allowable contributions in the year they were made on behalf of plan participants. Second, plan participants may exclude contributions and all earnings thereon from their taxable income until the year they are withdrawn. Third, earnings on the funds held by the plan's trust are not taxed to that trust. And fourth, many times participants and/or beneficiaries may further delay taxation on a plan's benefits by transferring those amounts into another tax-deferred vehicle such as an Individual Retirement Arrangement (IRA).

A qualified retirement plan falls into one of three general categories: A defined benefit plan, a defined contribution plan, or a hybrid plan. A hybrid plan is one that combines various attributes of the first two categories, which are discussed below.

Nonqualified Retirement Plan. A nonqualified retirement plan is one that does not meet the requirements of the IRC or ERISA. These plans may be discriminatory in their application and are typically used to provide deferred compensation to key personnel. Because these plans allow a broader flexibility to the employer, they do not receive the same favorable tax treatment as that permitted qualified plans. Employers receive no tax deduction until the employee receives proceeds from the plan. On receipt, the proceeds are taxed to the employees and are ineligible for transfer to an IRA. In some situations the employee may face immediate taxation on the benefit even when the funds will not be received until much later in the future.

Defined Benefit Plan. A defined benefit plan is the traditional company pension plan. It is so called because the ultimate retirement benefit is definite and determinable as a dollar amount or as a percentage of wages. To determine these amounts, defined benefit plans usually base the benefit calculation on a combination of years of employment, wages, and/or age. These plans are funded entirely by the employer, and the responsibility for the payment of the benefit and all risk on monies invested to fund that benefit rests with the employer.

Benefits typically are not payable until normal retirement age and usually are paid in the form of a lifetime annuity. Nevertheless, a large minority of plans permits lump sum payments at retirement. Monies received as a lifetime annuity will be taxed at ordinary income tax rates and are ineligible for rollover to an IRA. Lump sum payments may be transferred to an IRA to defer immediate taxation. On transfer to an IRA, the proceeds are subject to IRA rules and regulations.

Five-year forward income averaging for lump sum payments was eliminated as of as of January 1, 2000; however, persons born December 31, 1936 or earlier retain the option to use 10-year forward averaging based on 1986 tax rates and to use the 20% long-term capital gains rate on benefits attributable to service prior to 1974.

Persons younger than 55 who receive retirement benefits as income in a form other than a lifetime annuity are subject to an excise tax based on a premature distribution from a qualified retirement plan. The excise tax will continue until the retiree reaches age 59 1/2. These unfortunates will be taxed on that benefit at ordinary rates and assessed an additional 10% early distribution penalty as well. Care to rethink that plan about retiring at age 50?

Defined Contribution Plan. A defined contribution plan is a qualified retirement plan in which the contribution is defined, but the ultimate benefit to be paid is not. In such plans, each participant has an individual account. The benefit at retirement depends on the amounts contributed and on the investment performance of that account through the years. In such plans, the investment risk may rest solely with the employee because of the opportunity to choose from a number of investment options. These plans take many forms and are known by various names such as money purchase, profit sharing, 401(k), or 403(b) plans.

Annual contributions by the employee and/or employer are limited to a maximum of $30,000 or 25% of compensation. At retirement, benefits are typically paid in installments or as a lump sum; however, they may also be paid as an annuity. Income tax ramifications and rollover options are the same as those described above for defined benefit plans. Installment payments for a period of less than 10 years are eligible for transfer to an IRA, while those lasting for a period of 10 years or more are not.

Individual Retirement Arrangement (IRA). An IRA, or Individual Retirement Arrangement, is a personal retirement savings plan available to all persons under age 70 1/2 who receive taxable compensation during the year. Compensation includes wages, salaries, fees, tips, bonuses, commissions, taxable alimony, and separate maintenance payments. Husbands and wives may each have an IRA even if one person in that marriage is not working. Except as noted below, annual individual contributions are limited to the lesser of total taxable compensation or $2,000.

There is no minimum or required IRA contribution, and all earnings on the amounts in an IRA are untaxed until withdrawn. Contributions may or may not be deductible in the tax year made depending on the owner's income tax filing status, Adjusted Gross Income (AGI), and eligibility to participate in a tax qualified retirement plan through employment.

If the IRA owner participates in an employer's qualified retirement plan on any day in the tax year, the deductibility of contributions declines to zero between certain AGI ranges. In 2000, the AGI range is $32K to $42K for a single filer and $52K to $62K for joint filers. These AGI ranges will increase gradually through 2007, at which time they will be $50K to $60K for single filers and $80K to $100K for joint filers. As of January 1, 1998, a working spouse not covered by a retirement plan through employment may make a tax-deductible contribution of up to $2,000 annually to an IRA despite the other spouse's coverage under an employer-provided retirement plan. When the couple's AGI reaches $150K, deductibility for such contributions begins to decline, and it reaches zero at a joint AGI of $160K.

Money may be withdrawn from an IRA at any time, but on withdrawal it will be taxed at ordinary income tax rates. Except as noted below, withdrawals from an IRA other than a Roth or Education IRA prior to age 59 1/2 will result in a 10% excise tax in addition to ordinary income tax. Non-deductible contributions, if any, will be excluded from taxation as a portion of a withdrawal based on the percentage those contributions represent when divided by the sum of that withdrawal plus the total IRA balance as of December 31 of the year of withdrawal. Mandatory distributions must begin no later than April 1 of the year following the year the IRA owner reaches age 70 1/2. Failure to take required minimum distributions at that age results in a 50% excise tax on the amounts not distributed.

There are seven exceptions to the 10% penalty for withdrawals prior to age 59 1/2. The penalty does not apply to early distributions that:

1. Occur because of the IRA owner's disability.
2. Occur because of the IRA owner's death.
3. Are a series of "substantially equal periodic payments" made over the life expectancy of the IRA owner.
4. Are used to pay for unreimbursed medical expenses that exceed 7 1/2% of AGI.
5. Are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for more than 12 weeks.
6. Are used to pay the costs of a first-time home purchase (subject to a lifetime limit of $10,000).
7. Are used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members.

Except as noted in the discussion for Roth and Education IRAs, ordinary income taxes still must be paid on withdrawals for these purposes.

There are ten types of IRAs:

a. An Individual Retirement Account is an IRA set up with a financial institution like a bank, broker, or mutual fund in which contributions may be invested in many types of securities such as stocks, bonds, money market, CDs, etc.

b. An Individual Retirement Annuity is an IRA set up with a life insurance company through the purchase of a special annuity contract.

c. An Employer and Employee Association Trust Account, or Group IRA, is an IRA set up by employers, unions, and other employee associations for employees or members.

d. A Simplified Employee Pension (SEP-IRA) is an IRA set up by an employer for a firm's employees. An employer may contribute up to $30,000 or 15% of an employee's compensation annually to each employee's IRA. (See SEP).

e. A Savings Incentive Match Plan for Employees IRA (SIMPLE-IRA) is an IRA set up by a small employer for a firm's employees. Employees may contribute up to $6,000 per year to these IRAs and will receive some level of a matching percentage of pay from their employer. Between the employer and the employee, up to $12,000 may be contributed annually to the participant's account. (See SIMPLE).

f. A Spousal IRA is an IRA funded by a married taxpayer in the name of his or her spouse who has less than $2,000 in annual compensation. The couple must file a joint tax return for the year of contribution. The working spouse may contribute up to $2,000 per year to the Spousal IRA and up to $2,000 per year to his or her own IRA. A couple, then, may contribute up to $4,000 per year provided neither IRA receives more than $2,000.

g. A Rollover (Conduit) IRA is an IRA set up by an individual to receive a distribution from a qualified retirement plan. Distributions transferred to a rollover IRA are not subject to any contribution limits. Additionally, the distribution may be eligible for subsequent transfer into a qualified retirement plan available through a new employer. To retain this eligibility, the IRA must be composed solely of the original distribution and earnings (i.e., no other contributions or rollovers may be added to or mingled with the IRA), and the new employer's plan must permit the acceptance of rollover contributions.

h. An Inherited IRA is an IRA acquired by the non-spousal beneficiary of a deceased IRA owner. Special rules apply to an inherited IRA. A tax deduction is not allowed for contributions to this IRA, a rollover to or from another IRA is not permitted, and the proceeds must be distributed and taxed within a specific period as established by the Internal Revenue Code. If the owner died before beginning required minimum distributions, then the beneficiary must receive distribution of the inherited IRA by December 31 of the fifth year following the owner's death. Alternatively, the IRA may be paid as an annuity or in installments payable over a period not extending beyond the beneficiary's life expectancy. If the owner had begun to receive required minimum distributions while living, then the beneficiary must receive the remainder of the IRA at least as quickly as the owner would have under the schedule of distribution selected by that owner prior to death.

i. An Education IRA (EIRA) is an IRA established on or after Jan. 1, 1998, to provide funds that will allow a beneficiary to attend a program of higher education. There is no tax deduction allowed for the contribution, but all deposits and earnings may be withdrawn free of tax and penalties if used to pay for the costs of higher education. Contributions are limited to a maximum of $500 per year, but that's in addition to the $2K limit on any other IRA. They may be made regardless of the beneficiary's income, but cannot be made on or after the beneficiary's age 18. If distributions exceed the education expenses, the earnings must be included ratably in gross income and are subject to the 10% excise tax to the extent of the excess. Contributions begin to phase out at $150K for joint filers and $95K for single filers. The EIRA, if unused on or before age 30, may be transferred to another qualifying family member as the new beneficiary for educational use. Such transfers must occur before the benficiary reaches age 30.

j. A Roth IRA is an IRA authorized on or after January 1, 1998, in which:

1. Contributions to the account are not deductible.
2. "Qualified" distributions (i.e., withdrawals) from the account are not taxable; and
3. Earnings on the account are taxable only when a withdrawal is not a "qualified" distribution.

A "qualified" distribution from a Roth IRA is a withdrawal that meets one or more of the following:

1. Made after the taxpayer attains age 59 1/2.
2. Made to a beneficiary after the taxpayer's death.
3. Made because the taxpayer is disabled.
4. Made by a first-time homebuyer to acquire a principal residence.

No withdrawal except those attributable to previously taxed contributions will be a qualified distribution unless it is made after the five-taxable-year period beginning with the taxable year in which the taxpayer first contributed to a Roth IRA.

Annual contributions to a Roth IRA are limited to $2,000 minus the taxpayer's deductible IRA contributions. Contributions to a Roth IRA may be made even after the owner reaches age 70 1/2. The $2,000 limit is phased out as AGI increases from $150,000 to $160,000 (married filing jointly) or $95,000 to $110,000 (single filer).

Amounts in deductible IRAs may be transferred to Roth IRAs provided the taxpayer's AGI (married or single) for the transfer year is $100,000 or less. Transferred amounts must be included in that year's income, but the money transferred will be exempt from the 10% excise tax for a withdrawal prior to age 59 1/2. If the transfer occurs in 1998, income from the transfer may be spread and taxes due may be paid over four years (i.e., one-fourth of the transferred amount is included as taxable income in 1998, 1999, 2000 and 2001). No withdrawal allocable to earnings on the transferred amounts can be a qualified distribution unless made more than five years after the transfer.

Further details on IRA provisions may be found in IRS Publication 590, Individual Retirement Arrangements. This publication may be obtained at no cost by calling 1-800-TAX-FORM, or it may be downloaded online.

Profit-Sharing Plan. The most popular type of a qualified defined contribution plan, a profit-sharing plan permits employers to make a discretionary annual contribution of up to a maximum of 15% of pay or $30,000 to each employee's account. Originally designed to encourage productivity and to reward employees with part of a firm's annual profits, today employers may make contributions even when the business earns no profits in the year; however, no contribution by the employer is required during a profitable year. These plans are often coupled with a 401(k) arrangement to allow voluntary pre-tax contributions by employees from their wages. Contributions and earnings accumulate tax free until withdrawn by the participant.

Money Purchase Plan. Also a qualified defined contribution plan, a money purchase plan is one in which the employer is required to make an annual contribution to each employee's account regardless of the firm's profitability for the year. Contributions are usually specified as a percentage of annual compensation and are capped at the lesser of $30,000 or 25% of an individual's annual salary. Contributions and earnings accumulate tax free until withdrawn by the participant.

Target Benefit Plan. While technically a defined contribution plan, a target benefit plan is actually a hybrid plan. In such plans, the employer sets a target benefit for employees. Each year contributions are made to the employee's account based on actuarial assumptions that project the annual funding needed to reach that benefit. In that sense, the target benefit plan mimics a defined benefit plan. However, the actual earnings on the individual accounts may differ from the estimated earnings used in the assumptions. Thus, because the benefit actually received cannot be determined in advance, the target benefit plan is like a defined contribution plan. Regardless, contributions and earnings accumulate tax free until withdrawn by the participant.

Employee Stock Ownership Plan (ESOP). An ESOP is a qualified defined contribution plan in which the assets are invested mostly in qualifying employer stock. Usually, purchases of this stock are funded by employer contributions made to the plan based on total employee compensation. The plan may permit purchase of stock by employees as a plan option. When combined with a 401(k) plan, an ESOP is sometimes called a KSOP. On leaving the firm through separation or retirement, the participant will receive all vested interests in the form of the actual shares in the account. Alternatively, he or she may demand a cash distribution in lieu of the shares.

401(k) Plan. Also known as a cash or deferred arrangement (CODA) plan, a 401(k) is a qualified defined contribution plan that takes its name from the section of the Internal Revenue Code that prescribes the rules under which it operates. It is a retirement plan in which an employer permits an employee to defer receipt of part of his or her compensation by contributing that part to his or her account in the 401(k) plan. Deferred contributions are made on a pre-tax basis, and those contributions and all earnings remain untaxed until withdrawn from the plan. The 401(k) may permit voluntary, after-tax contributions by employees. Earnings on after-tax contributions accumulate tax free until withdrawn.

Many 401(k) plans include a matching contribution from the employer according to a set formula (e.g., 50% of the employee's contribution up to a maximum of 6% of compensation). Employers may also make contributions to an employee's account independent of the employee's contribution, and these contributions may be tied to a firm's profits as part of a profit sharing plan. Participant's pre-tax contributions are limited to the lesser of a maximum percentage of pay or $10,500 (as adjusted periodically for inflation) per year. The percentage limitation varies from employer to employer depending on a number of factors, but generally ranges from 12% to 20% of annual compensation.

A 401(k) plan generally offers participants an opportunity to direct their account contributions to a broad range of investment options from conservative risk to aggressive risk. These options may include institutional or mutual funds investing in the money market, bond market, or stock market; annuities; guaranteed investment contracts (GICs); company stock; and self-directed brokerage accounts. A typical plan will offer a selection of a money market fund, a bond fund, and a stock fund.

In general, a 401(k) plan limits withdrawals of assets to five occasions: Termination from employment, disability, reaching the age of 59 1/2, retirement, and death. Additionally, the plan may optionally include provisions for loans and/or hardship withdrawals.

State and local governments are prohibited from offering 401(k) plans to their employees. This was once true of private, tax-exempt employers as well; however, as of January 1, 1997, the latter may now establish a 401(k) plan for their qualified employees.

403(b) Plan. A 403(b) plan is a defined contribution plan that takes its name from the section of the Internal Revenue Code that establishes the rules under which it operates. It is also known as and sometimes called a tax-sheltered or a tax-deferred annuity program. This plan is for educational, religious, and charitable (i.e. 501(c)(3)) organization employees. It operates under similar maximum contribution rules and withdrawal privileges as a 401(k) plan. Like the 401(k), pre-tax contributions and all earnings remain tax free until withdrawn.

There are two principal differences between a 401(k) and 403(b) plan. First, unlike the 401(k) plan, investment options in the 403(b) plan are limited to annuities and mutual funds only. Second, the 403(b) plan permits additional contributions under certain conditions that would otherwise exceed the normal annual limit of $10,500, as indexed. These additional contributions are to allow participants to "catch up" contributions for years in which they didn't participate, a feature not found in a 401(k) plan.

457 Plan. A 457 plan is a nonqualified retirement plan established for the benefit of state and local government employees or the employees of tax-exempt organizations. Participants may defer up to $8,000 in wages per year in a 457 plan. Until withdrawn, these contributions and all earnings remain untaxed. The 457 plan assets of tax-exempt employers are subject to the claims of the employer's creditors, but those of plans sponsored by governmental entities are not. Plan distributions may occur at retirement; on separation from employment; as the result of an unforeseeable emergency; and at death. Distributions may be taken as a lump sum, in annual installments, or as an annuity. Regardless of how the money is distributed, on withdrawal it is subject to immediate taxation at ordinary income tax rates. Plan proceeds are ineligible for transfer to an IRA.

Keogh (HR-10) Plan. A Keogh plan is a qualified retirement plan established in law by the Self Employed Individuals Tax Retirement Act of 1962, otherwise known as the Keogh Act, or HR-10. Keogh plans may be set up by self-employed persons, partnerships, and owners of unincorporated businesses as either a defined benefit or defined contribution plan. As defined contribution plans, they may be structured as a profit sharing, a money purchase, or a combined profit sharing/money purchase plan. Contributions are limited to the smaller of $30,000 or 25% of taxable compensation per year for employees, and to the smaller of $30,000 or 20% of taxable compensation for owner-employees.

Keogh plans may not authorize loans. Contributions and all earnings accumulate free of tax until withdrawn, generally at retirement. In general, withdrawals prior to age 59 1/2 are subject to a 10% premature distribution penalty in addition to ordinary income tax; however, distributions are eligible for transfer to an IRA.

Simplified Employee Pension (SEP). A SEP is a retirement plan designed for self-employed persons, partnerships, sole proprietors, independent contractors, and owner-employees of an unincorporated trade or business; however, it may be set up by any type of business. A SEP is an easy method for a small employer to establish a retirement plan for employees without the complex administration and expense found in qualified retirement plans. In fact, an employer may establish a SEP only if that employer has no qualified retirement plan in effect.

Under a SEP, the employer may make a contribution of up to the lesser of 15% or $30,000 of compensation to IRAs established in each employee's name. Hence, such an arrangement is known as a SEP-IRA. When made, these contributions are owned in their entirety by the employee, and they may be withdrawn and/or transferred by the employee at any time. Contributions to a SEP by the employer are discretionary, but must be deposited into each eligible employee's IRA when made. Because these accounts are IRAs, the amounts therein are subject to all IRA rules regarding transfer, withdrawal and taxation.

Prior to January 1, 1997, a SEP-IRA could have included a salary reduction arrangement in which an employee may elect to defer taxation on part of his or her compensation by contributing that amount to the SEP. This type of salary reduction plan is known as a SARSEP, and could have been established by an employer who had fewer than 25 employees provided at least 50% of all employees agreed to participate in the arrangement. Like a 401(k) plan, the employee's contribution to the SARSEP is limited to $10,000 per year. Effective January 1, 1997, no new SARSEP may be established; however, those in existence as of December 31, 1996, may continue to operate. The SARSEP has been replaced by the new SIMPLE arrangement discussed below.

Savings Incentive Match Plan for Employees (SIMPLE). Established by the Small Business Protection Act of 1996, a SIMPLE may be set up by employers who have no other retirement plan and who have 100 or fewer employees with at least $5,000 in compensation for the previous year. SIMPLE plans are the replacement for the SARSEP plans discussed above. They may be structured as an IRA or as a 401(k) plan. Employees may defer any percentage of compensation up to $6,000 per year to the SIMPLE, and the employer is required to make a matching contribution of up to 3% of the employee's pay based on that election. The employer may reduce the maximum matching percentage in any two years out of five. Alternatively, the employer may establish a uniform 2% of salary contribution per year for all eligible employees regardless of whether they contribute to the SIMPLE or not. Together, the employee and the employer may contribute a maximum of $12,000 annually to the SIMPLE.

Contributions are immediately vested with the employee, and deposits and earnings in the account will accumulate tax free until withdrawn. In general, distributions from a SIMPLE are taxed like those from an IRA. Withdrawals prior to age 59 1/2 are subject to the 10% early withdrawal excise tax in addition to ordinary income tax. Unlike an IRA or SEP, however, employees who withdraw money from a SIMPLE IRA within two years of their first participation in the plan will be assessed a 25% penalty tax on such withdrawals instead of 10%. This extra penalty does not apply to early withdrawals from a SIMPLE 401(k). Distributions from both types of SIMPLE may be transferred to another SIMPLE or to an IRA, but they are ineligible for transfer to a qualified retirement plan.