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Retirement Plan Primer
There is no minimum or required IRA contribution, and all earnings on the amounts in an IRA are untaxed until withdrawn. In the case of the Roth IRA, withdrawals may even be tax-free provided certain minimum rules discussed later are met. Contributions to a Roth IRA are never tax-deductible. Contributions to a traditional IRA 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 traditional 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 as shown in the following table.
A working spouse not covered by a retirement plan through employment may make a tax-deductible contribution to an IRA despite the other spouse's coverage under an employer-provided retirement plan. When the couple's AGI reaches $150,000, deductibility for such contributions begins to decline, and it reaches zero at a joint AGI of $160,000. Money may be withdrawn from an IRA at any time, but on withdrawal it may be taxed and/or penalized. Withdrawals from a traditional IRA will always be taxed, either in whole or in part, at ordinary income tax rates. Except as noted below, withdrawals from a traditional IRA prior to age 59 1/2 will result in a 10% excise tax as well as an ordinary income tax. The potential income taxes and early withdrawal penalties on Roth and Education IRAs (now known as Coverdell Education Savings Accounts) are discussed below. If nondeductible contributions were made to a traditional IRA, part of any withdrawal from that IRA will not be taxed. The calculations for deriving the taxable and nontaxable part of the withdrawal are too complicated to cover here. For those who may face this problem, the IRS has a handy way to make that calculation. It is called Form 8606, a tax document that must be completed and filed with your income tax return to report both nondeductible traditional IRA contributions and withdrawals whenever they occur. Mandatory distributions for traditional IRAs 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. Roth IRAs have no mandatory distribution requirement, but Education IRAs do as discussed below. There are eight exceptions to the 10% penalty for IRA withdrawals prior to age 59 1/2. The early withdrawal penalty does not apply to distributions that:
There are 11 types of IRAs:
Profit-Sharing Plan The most popular type of qualified defined contribution plan, in 2002 and thereafter annual contribution limits are 25% of pay or $40,000, respectively. The dollar limit will be adjusted for inflation in $1,000 increments beginning in 2003. 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 in 2001 are capped at the lesser of $35,000 or 25% of an individual's annual salary. In 2002 and thereafter, these limits increase to 25% of pay or $40,000. The dollar limit will be adjusted for inflation in $1,000 increments beginning in 2003. Contributions and earnings accumulate tax-free until withdrawn by the participant. Cash Balance Plan While technically a defined benefit plan, a cash balance plan is actually a hybrid plan. In such plans, the employer credits the participant's account with a "pay credit" (such as 5% of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer. When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. For example, assume that a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to an annuity. Such an annuity might be approximately $10,000 per year for life. In many cash balance plans, however, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit equal to the $100,000 account balance. In addition to generally permitting participants to take their benefits as lump sum benefits at retirement, cash balance plans often permit vested participants to choose (with consent from their spouses) to receive their accrued benefits in lump sums if they terminate employment prior to retirement age. 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. In 2001, a participant's pre-tax contributions are limited to the lesser of 25% of pay or $10,500. Many plans impose a lower percentage limit on contributions. That percentage limitation varies from employer to employer depending on a number of factors, but generally ranges from 12% to 20% of annual compensation. In 2002, a plan participant may contribute up to the lesser of 100% of pay or the annual dollar limit shown for each of the following years: 2002: $11,000 2003: $12,000 2004: $13,000 2005: $14,000 2006: $15,000 In 2007 and thereafter, the $15,000 limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed. In addition to the normal contribution limits outlined above, starting in 2002 those over the age of 50 may make an additional "catch-up" contribution in the following amounts: 2002: $1,000 2003: $2,000 2004: $3,000 2005: $4,000 2006: $5,000 In 2007 and thereafter, the $5,000 "catch-up" limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed. Beginning in 2006, 401(k) plans may allow participants to make contributions through those plans to a Roth-401(k) account. Th e decision to offer this option is entirely up to the employer. Under this new arrangement, contributions to the Roth-401(k) account will be taxed in the year made, but future qualified distributions from that account will not be taxed. Contributions to a Roth-401(k) account may be made up to the $15,000 maximum yearly limit. 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. A plan participant may contribute up to the lesser of 100% of pay or the annual dollar limit shown for each of the following years: 2002: $11,000 2003: $12,000 2004: $13,000 2005: $14,000 2006: $15,000 In 2007 and thereafter, the $15,000 limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed. 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, 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. These "catch-up" rules, though, are repealed as of January 1, 2002. In 2002 and later, 403(b) plan participants who are age 50 or older may make an additional "catch-up" contribution each year in the following amounts: 2002: $1,000 2003: $2,000 2004: $3,000 2005: $4,000 2006: $5,000 In 2007 and thereafter, the $5,000 "catch-up" limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed. Beginning in 2006, 403(b) plans may allow participants to make contributions through those plans to a Roth-403(b) account. The decision to offer such a plan is entirely up to the employer. Under this new arrangement, contributions to the Roth-403(b) account will be taxed currently, but future qualified distributions from that account will not be taxed. Contributions to a Roth-403(b) account may be made up to the $15,000 maximum yearly limit. 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. The contribution limits are as follows: 2002: $11,000 2003: $12,000 2004: $13,000 2005: $14,000 2006: $15,000 In 2007 and thereafter, the $15,000 limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed. In addition to the normal contribution limits outlined above, starting in 2002 those over the age of 50 may make an additional "catch-up" contribution in the following amounts: 2002: $1,000 2003: $2,000 2004: $3,000 2005: $4,000 2006: $5,000 In 2007 and thereafter, the $5,000 "catch-up" limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed. While governmental 457 plans have special catch-up provisions for those age 50 or older as noted above, they enjoy an even greater contribution amount in the three years before retirement. The catch-up provisions three years prior to retirement will amount to double the normal amount for allowable maximum contributions. This means that in 2006, if you're planning retirement in 2009 or earlier, your maximum contribution to a governmental 457 plan could total $30,000. Until withdrawn, 457 plan 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. In 2002 and later years, proceeds from a governmental 457 plan may be transferred to an IRA or a new employer's 401(k), 403(b) or 457 plan that accepts transfers from an old employer's plan. On withdrawal from an IRA or from the new plan, the distribution will be subject to immediate taxation at ordinary income tax rates. Keogh (HR-10) Plan A Keogh plan is a qualified retirement plan established 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. In 2001, contributions are limited to the smaller of $35,000 or 25% of taxable compensation per year for employees, and to the smaller of $35,000 or 20% of taxable compensation for owner-employees. In 2002 and later, the dollar limit increases to $40,000, with subsequent adjustments for inflation in $1,000 increments thereafter. 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. Since, 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. Annual maximum contribution limits, to include "catch-up" contribution limits, are identical to those shown above for 401(k) plans. As of 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. In 2001, employees may defer any percentage of compensation up to $6,500 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. In 2002 and later, employees may make the following maximum contributions to their SIMPLE account: 2002: $7,000 2003: $8,000 2004: $9,000 2005: $10,000 In 2006 and thereafter, the $10,000 limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed. In addition to the normal contribution limits outlined above, starting in 2002 those over the age of 50 may make an additional "catch-up" contribution in the following amounts: 2002: $500 2003: $1,000 2004: $1,500 2005: $2,000 2006: $2,500 In 2007 and thereafter, the $2,500 "catch-up" limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed. 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 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. |
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