Using tax incentives for a golden retirement
Lawmakers have loaded the tax code with incentives for saving for retirement. You may need these tax-advantaged retirement vehicles to build your nest egg unless you can count on a generous defined benefit plan to take care of your retirement needs.
Defined benefit plans set a future pension benefit and then actuarially calculate the contributions needed to attain the benefit. Because they are actuarially driven, the contribution limits are often higher than other types of plans. But fewer and fewer employers are offering them.
Fortunately, the tax code provides a number of tax-advantaged defined contribution options to help you build enough wealth to live comfortably in retirement. Even if you’ve already amassed your fortune, you may want to leverage as many retirement tax incentives as possible to mitigate your tax burden.
Defined contributions plans
Defined contribution plans let you control how much is contributed. They come in employer-sponsored versions like 401(k)s, 403(b)s, 457s, SIMPLE IRAs and SEP IRAs, or in non-employment versions like Individual Retirement Accounts (IRAs). All of these accounts have contribution limits, and some allow extra “catch-up” contributions if you’re 50 or older. (See chart 9 for these limits.)
Because of their tax advantages, contributing the maximum amount allowed is likely a smart move. The tax benefits of these accounts (in the traditional versions) are twofold. Contributions are usually pretax or deductible, so they reduce your taxable income. And assets in the accounts grow tax-deferred — meaning you pay no income tax until you make distributions.
Unfortunately, you must begin making annual minimum withdrawals from most retirement plans at age 70½. These required minimum distributions (RMDs) are calculated using your account balance and a life expectancy table. They must be made each year by Dec. 31 or you can be subject to a 50-percent penalty on the amount you should have taken out (although your initial RMD can be deferred until April 1 the following year). You may not be required to make distributions if you’re still working for the employer who sponsors your plan. (See Tax planning opportunity 14 to find out when it makes the most sense to make distributions and read more about 2009 RMD relief.)
Employer-sponsored defined contribution accounts have several advantages over IRAs. For one, many employers offer matching contributions for these accounts, and there are no income limits for contributing. IRAs have strict income limits, but many high-income taxpayers maintain accounts that were opened when they were earning less or consist of rollovers from employer-sponsored plans.
When to choose a Roth version
Three of the defined contribution plans — 401(k)s, 403(b)s and IRAs — offer “Roth” versions. The tax benefits of Roth accounts are slightly different from traditional accounts. They allow for tax-free growth and tax-free distributions, but contributions are not pretax or deductible.
The difference is in when you pay the tax. With a traditional retirement account, you don’t pay tax on the contributions — you only pay taxes on the back end when you take your money out. For a Roth account, you pay taxes on the contributions up front, but never pay tax again if distributions are made properly.
A traditional account may look like the best approach because it often makes sense to defer tax as long as possible. But this isn’t always the case. Roth plans can save you more if you’re in a higher tax bracket when making distributions during retirement, or if tax rates have gone up. Plus, there are no required minimum distributions for Roth IRAs. (See Tax planning opportunity 15 for the benefits of setting up a Roth IRA for a child, and check Tax planning opportunity 16 to learn about a new opportunity to roll over from a traditional IRA into a Roth IRA.)
Set up your own plan
If you’re a business owner or self-employed, you have more flexibility because you can set up a retirement plan that allows you to maximize your contributions. Keep in mind that if you have employees, they generally must be allowed to participate in the plan.
One option is a profit-sharing plan. This is a defined contribution plan that allows discretionary employer contributions and offers increased flexibility in plan design. The maximum 2009 contribution is $49,000 or, for those who include a 401(k) arrangement in the plan and are eligible to make catch-up contributions, $54,500. Your specific contribution limit is a function of your income. You can make deductible 2009 contributions as late as the due date of your 2009 income tax return, including extensions — provided your plan exists on Dec. 31, 2009.
A Simplified Employee Pension (SEP) is a defined contribution plan that provides benefits similar to those of a profit-sharing plan. The maximum 2009 contribution is the lesser of $49,000 or 25 percent of your eligible compensation (net of the deduction for the contributions), which means you can contribute $49,000 if your eligible compensation exceeds $245,000. Catch-up contributions aren’t available with SEPs.
You can establish the SEP in 2010 and still make deductible 2009 contributions as late as the due date of your 2009 income tax return, including extensions. Another benefit of a SEP is that it’s much easier to administer than a profit-sharing plan. So if you have eligible compensation in excess of $245,000 and would be ineligible to make catch-up contributions to a profit-sharing plan, setting up a SEP may be a better option.
Considerations after a job change
When you change jobs or retire, you’ll need to decide what to do with your employer-sponsored plan. You may have several options.
It is generally not a good idea to make a lump sum withdrawal. You’ll have to pay taxes on the withdrawal, as well as a 10-percent penalty if you’re under the age of 59½. Your employer is also required to withhold 20 percent for federal income taxes.
If you have more than $5,000 in your account, you can leave the money there. You’ll avoid current income tax and any penalties and the plan assets can continue to grow tax-deferred. This may seem like the simplest solution, but it may not be the best. Keeping track of both the old plan and a plan with a new employer can make managing your retirement assets more difficult. Plus, you’ll have to be mindful of any rules specific to the old plan.
You can still avoid any penalties and continue to defer taxes if you roll over to your new employer’s plan. And this may leave you with only one retirement plan to keep track of. It can be a good solution, but be sure to first compare the new plan’s investment options to the old plan’s options.
Rolling over into an IRA may be the best alternative. You avoid penalties and continue to defer taxes, and you have nearly unlimited investment choices. Plus, you can roll over new retirement plan assets into the same IRA if you change jobs again. Such consolidation can make managing your retirement assets easier. If you choose a rollover, request a direct rollover from your old plan to your new employer’s plan or IRA. If the funds from the old plan are instead paid to you, you’ll need to make an indirect rollover to your new plan or IRA within 60 days to avoid the tax and potential penalty on those funds. The check you receive from your old plan will be net of federal income tax withholding, but if you don’t roll over the gross amount you’ll be subject to income tax and a potential 10-percent penalty on the difference.
Avoid early distribution penalties
Most withdrawals from tax-deferred retirement plans before age 59½ will be subject to a 10-percent penalty in addition to the normal income tax on the distributions. There are a few exceptions to the early withdrawal penalty. You won’t have to pay if:
- You become disabled.
- The distributions are a result of inheriting the plan account.
- You take distributions as substantially equal periodic payments for at least five years, with the last payment received on or after age 59½.
- Distributions begin because of early retirement or other job separation, and the separation occurs during or after the year you reach age 55 (except IRAs).
- The distribution is used for deductible medical expenses exceeding 7.5 percent of adjusted gross income.
- You get divorced and the distributions (except from IRAs) are made pursuant to a qualified domestic relations order (QDRO).
401(k) plans have their own “hardship” distribution rules based on “immediate and heavy financial need.” But those rules merely allow a participant to get funds out, not to escape the income tax or the 10-percent penalty.
