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A. Qualified Plans 1/4 1. 401(k) Plan and Other Profit Sharing Plans 1/5 2. Stock Bonus Plan 1/7 3. Money Purchase Pension Plan 1/7 4. Employee Stock Ownership Plan (ESOP) 1/8 5. Defined Benefit Plan 1/8 6. Target Benefit Plan 1/9 7. Self-Employed Plans (Keoghs) 1/9
B. Individual Retirement Accounts 1/10 1. Traditional Contributory IRA 1/10 2. Rollover IRAs 1/11 3. Simplified Employee Pension 1/12 4. SIMPLE IRA 1/12 5. Roth IRA 1/13
C. Almost-Qualified Plans 1/14 1. Qualified Annuity Plan 1/14 2. Tax-Deferred Annuity 1/14
D. Nonqualified Plans 1/15
How many people have warned you that you'll never see a penny of the hard-earned money you've poured into the Social Security system and that you'd better have your own retirement nest egg tucked away somewhere? Perhaps those doomsayers are overstating the case, but even if you eventually do collect Social Security, it is likely to provide only a fraction of the income you will need during retirement.
Congress responded to this problem several decades ago by creating a variety of tax-favored plans to help working people save for retirement. One such plan is set up by you, the individual taxpayer, and is appropriately called an individual retirement account or IRA. Another, which can be established by your employer or by you if you are self-employed, is referred to by the nondescript phrase, a qualified plan. A qualified plan is one that qualifies to receive certain tax benefits as described in Section 401 of the U.S. Tax Code.
There are other types of retirement plans, too, which enjoy some of the same tax benefits as qualified plans but are not technically qualified, because they are defined in a different section of the Tax Code. Many of these other plans closely follow the qualified plan rules, however. The most common of these almost-qualified plans are tax-deferred annuities (TDAs) and qualified annuity plans. (Don't be thrown by the name. Even though it may be called a qualified annuity plan, it is not defined in Section 401 and therefore is not a qualified plan in the purest sense.) Both of these plans are defined in Section 403 of the Tax Code. Because many of the rules in Section 403 are similar to those in Section 401, TDAs and qualified annuity plans are often mentioned in the same breath with qualified plans.
All qualified plans, TDAs and qualified annuity plans have been sweetened with breaks for taxpayers to encourage them to save for retirement. And working people have saved, often stretching as far as they can to put money into their retirement plans. The government's job is to make sure the plans are used as they were intended-to help participants fund their own retirement-not to help them avoid current income tax obligations or to transfer wealth from one generation to another. One way the government ensures that retirement plan money is distributed to the plan participant and taxed during that person's lifetime is to require that the participant take money or assets out of the plan at specified times. To achieve that end, Congress has enacted a host of laws dictating the form and timing of distributions.
What does this mean for you? If you or your employer has ever put money into a retirement plan and received tax benefits as a result, then you cannot simply take the money out whenever you want, nor can you leave it in the plan forever. Instead, you must follow a complex set of rules for withdrawing money, or taking distributions, from the plan during your lifetime and even after your death. If you don't follow the rules, you will have to pay penalties-sometimes substantial ones.
But as is so often the case when Congress enacts highly restrictive laws, attached to each is a passel of exceptions. Will you qualify for any of them? Quite possibly. The tax rules, regulations, explanations, guidelines and exceptions relating to distributions from retirement plans fill many unsightly volumes with language far too complex for bedtime reading. And yet every person who has ever contributed to a retirement plan, or who acquires one through inheritance or divorce, needs to know the rules for taking money out of the plan.
This first chapter identifies and briefly describes the types of retirement plans to which these specialized distribution rules apply. If you have a retirement plan at work or if you have established one through your own business, you should find your plan listed below. Also, if you have an IRA, you will find your particular type among those described below.
There is also an entire category of plans known as nonqualified plans to which these rules do not apply. Such plans are used by employers primarily to provide incentives or rewards for particular-usually upper management-employees. These plans do not enjoy the tax benefits that IRAs and qualified plans (including TDAs and qualified annuities) do, and consequently are not subject to the same distribution restrictions. Although this chapter helps you identify nonqualified plans, such plans have their own distribution rules, which fall outside the scope of this book.
Identifying your particular retirement plan probably won't be as difficult as you think. Although there is indeed a large variety of plans earning a mention in the Tax Code, each with its own set of mindnumbing rules and regulations, every plan fits into one of four broad categories:
• qualified plan
• IRA
• plan which is neither an IRA nor a
qualified plan, but which has many
of the characteristics of a qualified
plan, or
• plan which is neither an IRA nor a
qualified plan, and which does not
have the characteristics of a qualified
plan.
A. Qualified Plans
As mentioned above, a qualified plan is one that is described in Section 401 of the U.S. Tax Code. Practically speaking, it is a forced savings plan established by an employer to benefit its employees. To encourage employers to set up and contribute to these plans, and to encourage employees to direct some of their pay into them when offered the opportunity, the law provides monetary incentives. Perhaps the most significant advantage to the employer is that the contributions it makes to the plan on behalf of its employees are tax deductible.
The advantages to you, the employee, are not only the opportunity to accumulate a retirement nest egg, but also to postpone paying income taxes on money contributed to the plan. Neither the contributions you make nor any of the investment returns are taxable to you until you take money out of the plan. In tax jargon, the income tax is deferred until the money is distributed and available for spending-usually during retirement. Congress built in some safeguards to help ensure that your plan assets are around when you finally do retire. For example, the assets are required to be held in trust and are generally protected from the claims of creditors.
In return for these tax benefits, the plan must comply with a number of procedural rules. First, the plan must not discriminate in favor of the company's highly compensated employees. For example, the employer may not contribute disproportionately large amounts to the accounts of the company honchos. Also, the employer may not arbitrarily prevent employees from participating in the plan or from taking their retirement money with them when they leave the company. Finally, the plan must comply with an extremely complex set of distribution rules, which is the focus of this book.
Seven of the most common types of qualified plans are described below.
1. 401(k) Plan and Other Profit Sharing Plans
A profit sharing plan is designed to allow employees to share in the profits of the company and to use those profits to help fund their retirement. Despite the plan's title and description, an employer doesn't have to make a profit in order to contribute to a profit sharing plan. Similarly, even if the employer makes a profit, it does not have to contribute to the plan. Each year, the employer has discretion over whether or not to make a contribution, regardless of profitability.
When the employer contributes money to the plan on behalf of its employees, the contributions are generally computed as a percentage of all participants' compensation. The annual contribution into all accounts can be as little as zero or as much as 25% of the total combined compensation of all participants. For the purposes of making this calculation, the maximum compensation for any individual participant is capped at $200,000. (The $200,000 will increase from time to time for inflation.) No individual participant's account can receive more than $40,000 in a single year.
EXAMPLE: Joe and Martha participate in their company's profit sharing plan. The company contributed 25% of their respective salaries to the plan for 2002. Joe's salary was $120,000 and Martha's was $190,000. The company contributed $30,000 for Joe (25% x $120,000). The company's contribution for Martha is limited to the $40,000 ceiling, however, because 25% of Martha's salary is actually $47,500, which is too much.
In 2003, the company's profits tumbled, so the company decided not to make any contributions to the profit sharing plan for that year. Thus, the company will not contribute any money to the plan on Joe or Martha's behalf.
A special type of profit sharing plan, called a 401(k) plan, is named imaginatively after the subsection of the Tax Code that describes it. All 401(k) plans allow you to direct some of your compensation into the plan, and you do not have to pay income taxes on the portion of your salary you direct into the plan until you withdraw it.
The plan may or may not provide for employer contributions. Some employers make matching contributions, depositing a certain amount for each dollar the participant contributes.
EXAMPLE: Fred participates in his company's 401(k) plan. His company has promised to contribute $.25 for each dollar of Fred's salary that he directs into the plan. Fred's salary is $40,000. He directs 5% of his salary, which is $2,000, into the plan. The company matches with a $500 contribution (which is $.25 x $2,000).
Other employers contribute a fixed percentage of compensation for each eligible employee, whether or not the employee chooses to contribute to the plan.
EXAMPLE: Marilyn's salary for the current year is $60,000. Her company has a 401(k) plan which does not match employee contributions. Instead, the company contributes a flat 3% of each eligible employee's salary to the plan. Marilyn is saving to buy a house, so she is not currently directing any of her salary into the 401(k) plan. Nonetheless, the company will contribute $1,800 (which is 3% x $60,000) to the plan for Marilyn.
Continue...
Excerpted from IRAs, 401(k)s & Other Retirement Plans by Twila Slesnick John C. Suttle Copyright © 2002 by Twila Slesnick and John C. Suttle
Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
| Who Should Read Chapter 1 | |
|---|---|
| Read this chapter if you aren't certain which types of retirement plans you have-either through your employer or as a self-employed person. Also read this chapter if you have an IRA but aren't sure which type. | |
| Helpful Terms | |
| Adjusted Gross Income (AGI). Total taxable income reduced by certain expenses such as qualified plan contributions, IRA contributions and alimony payments. Beneficiary. The person or entity entitled to receive the benefits from an insurance policy or from trust property, such as a retirement plan or IRA. Deductible Contribution. A contribution to a retirement plan that an employer may claim as a business expense to offset income on the employer's tax return. You may know it as simply the employer's contribution. In the case of an IRA, a deductible contribution is one that an individual taxpayer may use to offset income on the individual's tax return. Distribution. A payout of property (such as shares of stock) or cash from a retirement plan or IRA to the participant or a beneficiary. Earned Income. Income received for providing goods or services. Earned income might be wages or salary or net profit from a business. Eligible Employee. An employee who has met certain conditions of an employer's retirement plan, such as years of service, | and now qualifies to participate in the plan. Nondeductible Contribution. A contribution to a retirement plan or IRA that may not be claimed as a business expense or used as an adjustment to offset taxable income on an income tax return. Nondiscrimination Rules. The provisions in the U.S. Tax Code that prohibit certain retirement plans from providing greater benefits to highly compensated employees than to non-highly compensated employees. Participant or Active Participant. An employee for whom the employer makes a contribution to the employer's retirement plan. Tax-Deductible Expense. An item of expense that may be used to offset income on a tax return. Tax Deferral. The postponement of tax payments until a future year. Vested Benefit. The portion of a participant's retirement plan accumulation that is nonforfeitable. In other words, the portion a participant may keep after separating from service; or the portion that goes to a participant's beneficiary if the participant dies. |
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