Tax rules on retirement plans are complicated. This helps explain why only a third of small businesses have retirement plans, compared to five-sixths of major companies that make the process simple for their employees. At a minimum, you should have an IRA which can be set up online in about five minutes. Download and mail the forms to a financial institution and you have a retirement plan. As the says; this post outlines retirement plan options as a general overview and then focused to the Individual Retirement Account [IRA]. Sure, I would discuss other retirement plans next time.
Many financial institutions and professionals are available to help you implement these options. Stock brokerages, banks, and insurance companies offer retirement plan advice, mostly to sell their investment products. Also, independent pension consultants, CPA s, and financial planners can help with the more complicated plans.
Advantages of Retirement Plans
Retirement plans share these tax attributes:
- Your contributions as an owner or employee are tax deductible from your current income, thus reducing your present income taxes. A contribution to a tax-advantaged retirement plan must come from earned income, meaning compensation for active work (not investing or inheritance) or net income after expenses. An investor in a business who isn’t active in it can’t deduct contributions to its retirement plan. Neither can a landlord contribute to a plan based on his rental income.
- Income generated by investments in your retirement plan accumulates tax-free until it is withdrawn, usually after you retire.
- There are penalties for taking money out of a plan before age 591?2, but some early withdrawals are allowed.
- When you retire, withdrawals from your plan are usually taxed at a lower rate than when you were working, as your overall income will probably be diminished.
Clearly, retirement plans are a deal that is hard to refuse. Not only can you put aside money before it’s taxed, but as long as you keep your hands off it, it will grow tax-free if invested wisely.
FYI: New tax credit for some retirement contributions.
There’s a tax credit of up to $1,000 for contributions to some types of plans such as IRAs and 401(k)s. The catch: Your adjusted gross income must be $50,000 or less. Plan participants contributing $5,000 to $8,000 a year can build up $150,000 to $400,000 over a ten- to 20-year period, depending on how plan investments perform. If you contribute for 20 or more years and make maximum contributions, you might easily accumulate several million dollars. The keys to retirement plan success are to start early, make the largest contributions you can, and take full advantage of all that the law allows.
What If You Don’t Have The Funds To Make A Contribution?
Many folks find themselves without the bucks to put aside for annual retirement contributions, and lose the opportunity once the year passes. If it comes time to make your annual contribution to a retirement plan, and you come up short, get creative. Borrow money from wherever you can, because the long-term tax savings will outweigh your borrowing costs. Or liquidate any nonretirement investments and use the funds for the plan contribution. Again, even if there is tax from selling an investment, the retirement plan benefits will likely outweigh it.
A retirement plan contribution is the only way I know to do any tax reduction planning after the year has passed. [You can make contributions between January 1 and April 15 of the next year or up to October 15 if you are granted an extension to file by the IRS].
Overview of Retirement Plan Types
Rules and more rules govern who can get into which retirement plans and how much money can be contributed each year. This can get confusing fast. When you’re finished reading this post, if you want more punishment, see IRS Publication 560, Retirement Plans for the Self-Employed.
Here are the different types of retirement plans—starting with the simplest. The differences between plans are largely a matter of the limits on the annual contributions and who can participate:
- Individual Retirement Accounts [IRA]. Set up by individuals, not by the business itself. Annual contribution limit of $4,000 [in 2007]. The law allows an additional $1,000 for individuals who are age 50 or older. There are two kinds of IRAs—the traditional IRA and the Roth IRA.
- Simplified Employee Pension Plans [SEPs]. Annual contribution limit of the smaller of 25% of compensation [or net business income] or $45,000 [in 2007].
- “SIMPLE” IRAs. Annual contribution limit of $10,500 (in 2007), plus an extra $2,500 for individuals who are age 50 or older. Plus, the business can match a worker’s contribution up to 3% of the employee’s compensation [or net business income] or, if employee’s contributions are not matched, can make a flat contribution to the plan of up to 2% of the employee’s compensation.
- Profit Sharing Plans [PSPs]. Same annual contribution limits as SEPs (see above), except the 25% limit is applied differently. Also, PSPs have differing rules on eligibility and the rate of contribution between employees and business owners.
- 401(k) and Roth 401(k) Plans. Annual contribution limits of $15,500 per owner or
employee, plus another $5,000 for individuals who are age 50 or older (in 2007). Participants can elect each year to contribute to the company’s 401(k) plan. Employer may (but isn’t required to) match a portion of the amount contributed by the employee.
- Money Purchase Plans [MPPs]. Same annual contribution limits as PSPs (see above). Recent changes in the law have rendered MPs obsolete.
- Defined Benefit Plans [DBPs]. The annual contribution limit is based on complex actuarial formulas, allowing up to $180,000 for individuals aged 52 or older.
- “SIMPLE” 401(k)s. These plans are so overly complicated that they are rarely ever used. They require a pooled trust and time-consuming paperwork. We don’t recommend them, and they won’t be discussed further.
You may the retirement plan that best serves your needs at the time. This usually means the one that allows you to make as large a contribution as you can afford. Then, as your business matures and you advance toward retirement, annually review your plan. Chances are your needs will change, and Congress will have altered the rules. You may want to add plans so you can make larger tax deductible contributions each year
Individual Retirement Accounts (IRA): Traditional and Roth IRA Plans
Anyone with earned income can contribute to an individual retirement account, called an IRA. Earned income simply means money from work, as opposed to collecting dividends or interest. Investments in IRAs compound tax-deferred until withdrawn. IRAs can be invested in a number of things—typically, stocks, bonds, and mutual funds. This post provides general overview of IRA rules.
It’s okay to have an IRA even with other retirement plans in place. And, a business owner can have an IRA without contributing to any employee’s retirement plans. An IRA is a fine starter plan, but may not be enough when your golden years arrive. The annual contribution limits are too small to provide for most folks’ needs.
FYI: Take Advantage of The Multiple Uses of IRAs
IRAs aren’t just for retirement; they can also be used for savings accounts to fund your children’s education, medical expenses, and first-time home ownership. (See below for details).
First we’ll discuss the rules for traditional IRAs, and then we’ll look at the Roth IRA. In both IRAs, the investment accounts build up tax-deferred until withdrawn. Contribution limits. The IRA contribution limit is $4,000 per year (in 2007), plus another $1,000 per year for individuals age 50 and older. You can contribute less to an IRA; this is just the maximum you can put in.
There’s an added break for married couples. Stay-at-home husbands or wives can contribute and deduct up to $4,000 per year to a spousal IRA, plus an additional $1,000 for those who are age 50 or older. The working spouse must earn at least as much as the IRA contribution made for the non-employed spouse. Spouses can’t share the same account—each must have a separate IRA. This could shave off as much as $1,750 in federal taxes on a joint tax return.
Relationship to other retirement plans you have. If you participate in a qualified retirement plan, you can still have an IRA. However, your IRA tax deduction is reduced once you earn more than $52,000 (single) or $83,000 (married). The deduction is phased out entirely once you earn more than $62,000 (single) or $103,000 (married). (These phase-out limits are for 2007. The dollar amounts are scheduled to increase in future years.)
Note: These phase-outs apply only to taxpayers covered by a retirement plan at work.
FYI: You Can Contribute Even if You’re Over The Income Limit
While you don’t get an IRA tax deduction if your income is above these limits, you can still contribute to an IRA. This is to take advantage of the IRA’s long-term tax-deferred earning benefit.
Other tax rules. You can make contributions to an IRA only if you have earnings from work. This eliminates folks who live on unearned income like interest, dividends, or income from rental property.
Deadlines. You have until April 15 to establish and contribute to an IRA for the preceding year (or if you file an extension Form 4868, until October
Withdrawal rules. There is an early withdrawal penalty of 10% if you make an IRA withdrawal before age 591?2—with two big exceptions:
- First-time home buyers or their close family members may withdraw up to $10,000 within four months of the purchase of the home.
- Higher education expenses of an IRA account owner or her immediate family may be withdrawn.
Note: Traditional IRA withdrawals are taxed in the year they are taken, along with all the rest of your income at your tax rate. IRA contribution limits are slated to increase in 2008 to $50,000, with an over-50 age bonus of $1,000.
The Roth IRA is an alternative to a traditional IRA. The most important difference between the two IRA plans is that Roth IRA contributions are never tax deductible. The reason you might choose a Roth IRA over a traditional IRA is that withdrawals from Roth IRAs are not taxed—as long as you don’t withdraw Roth earnings before age 591/2.
Contribution limits. Roth contribution limits are the same as with a traditional IRA (see above).
You can have both types of IRAs, but the overall contribution limit applies. No double dipping. Relationships to other retirement plans you have. You can make Roth IRA contributions even if you have other qualified retirement plans. However, your overall adjusted gross income must be less than $95,000 (single) or $150,000 (married). The Roth IRA offers much higher earnings limits than with traditional IRA contributions (see above).
No age limit on contributions. Unlike a traditional IRA, a Roth IRA can be established after you turn 701/2 years old.
Withdrawals. You may take out contributions, but not your earnings, from your Roth account at any time without penalty. With other retirement plans, you usually can’t make any withdrawals before 591/2 years old without penalty
Traditional IRA or Roth IRA?
“Should I take a tax break now with the traditional IRA or later with a Roth IRA?” For most low- to middle-earners under age 40, the long term benefits of tax-free compounding likely will outweigh the loss of the immediate tax deduction—so younger folks may want to go for the Roth. But, for individuals closer to retirement age, and in higher income tax brackets, the immediate deduction of the traditional IRA makes more tax sense. Ask a tax pro to run the numbers both ways, plugging in your age and tax bracket, to see how the two might compare over the long run.
Coverdell Education Savings Accounts (ESAs)
Similar to a Roth IRA is the Coverdell education savings account (ESA), formerly called the Education IRA. Contributions to an ESA may be made by anyone who earns at least $2,000. The contribution can be up to $2,000 to be used for educational expenses of named qualified family beneficiaries. Withdrawals from an ESA are tax-free, including any increases in value on investments in the ESA. There is no limit to the number of Coverdell ESAs that can be established for a beneficiary over a number of years.
Coverage. A qualified beneficiary must be under age 18, or older if he or she has special needs (physical or mental disabilities). If funds in an ESA aren’t used for the designated beneficiary, the account may be rolled over to another qualified person in the same family.
Withdrawals. Withdrawals from an ESA must be used for educational expenses such as tuition, fees, books, supplies, computers, and Internet access. The money must be used for primary and secondary school expenses and college expenses and all distributions must be made no later than 30 days after the beneficiary turns age 30.
Limitations. ESA contributions may be made only by individuals whose adjusted gross income is less than $110,000 (single) or $220,000 (married).
Example : Dr. Ellena and her husband have an adjusted gross income of $250,000. Her office manager, Linn, earns $55,000. Dr. Ellena can’t contribute to an ESA, but Leslie can set up two ESAs for her two minor kids and contribute $2,000 to each ESA every year.
Other plans. You can set up an ESA even if you maintain and contribute to any other retirement plans. Most tax rules are the same for ESAs as they are for IRAs. See IRS Publication 970, Tax Benefits for Education, for details, and to learn about the Lifetime Learning Credit, the Hope Scholarship Credit, and the Higher Education Tuition and fee
The SIMPLE plan (Savings Incentive Match For Employees) is hardly true to its acronym, as you’ll see below. There are two choices, the SIMPLE IRA and SIMPLE 401(k). As mentioned above, the SIMPLE 401(k) is too complicated, so we’re only going to cover the SIMPLE IRA. The two distinguishing features for the SIMPLE IRA compared to traditional and Roth IRAs is that it is designed to cover businesses with employees, and it allows larger annual contributions and deductions.
Caution: Contributions for all qualified employees are required. The employer must make an annual SIMPLE contribution for each employee (see below). This rule could make this type of plan too costly for many small business owners with employees
As with traditional IRAs, earnings in SIMPLE IRAs are not taxed until the funds are withdrawn. Contribution limits. Business owners and employees may contribute up to $10,500 (in 2007) of their earnings to a SIMPLE IRA. In addition, the business owner must either match each employee’s entire contribution (up to 3% of the employee’s wages) or contribute 2% of the employee’s wages. The boss can also match her own contribution (and the business can deduct it). The employer’s matching contribution can’t be more than the employee’s contribution—which is limited to $15,000, for a total of $21,000. Plus, participants age 50 or older can make an additional contribution of $2,000 per year, making their total contribution limit $25,000 if the catch-up contribution is matched (2007).
FYI: Contributions are not taxed to the employee until the SIMPLE account funds are withdrawn, along with any earnings on investments within the accounts (the same as with a regular IRA).
Eligibility and participation rules. Business owners must contribute funds to the plans of all long-term employees who earned at least $5,000 that year and who also earned at least that much from the business in up to three prior years.
Withdrawal rules. Withdrawal rules and penalties are the same as for traditional IRAs; see “Traditional IRAs,” above.
Setting Up and Maintaining an IRA-Type Plan
Traditional IRAs, Roth IRAs, Coverdell ESAs, and SIMPLE IRAs can be established by most mutual fund companies, banks, and stock brokerages. The cost may be nominal, or even free, to set up and maintain the account every year. IRA accounts are self-directed, meaning you make the investment decisions among stocks, bonds, funds, or bullion. No annual tax reporting for these plans is required, other than showing the amount of the contribution on the individual’s personal tax return.
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