Retirement planning will play a crucial role in providing a source of income in our later years. The traditional thinking is of a "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. With the odds of Social Security being a reliable source of funds to carry you through retirement, and many companies doing away with or limiting their retirement benefits, it is becoming more and more important that you have a personal plan for retirement savings. These plans serve many purposes for employers and employees alike, and come in many varieties. Yet few people really understand the plans that are available, despite the critical function they play in our lives. To help increase that understanding, below is an overview of the most common retirement plans. 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.
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 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 within a company. Because these plans allow a broader flexibility to the employer, they do not receive the same favorable tax treatment as qualified plans. Employers receive no tax deduction until the employee receives proceeds from the plan. Except for a governmental 457 plan (discussed below), on receipt, the proceeds of a nonqualified plan are taxed to the employees and are ineligible to be transferred into an IRA.
Defined Benefit Plan A defined benefit plan is the traditional company pension plan. As the name implies, retirement benefits are definite and determined as a dollar amount or a percentage of wages. To determine these amounts, defined benefit plans usually rely on a calculation of 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 investments to fund that benefit rests with the employer.
Benefits are usually not payable until normal retirement age and usually are paid in the form of a lifetime annuity. However, some plans permit a 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. When transferred into an IRA, the proceeds are subject to all the usual IRA rules and regulations.
Under normal circumstances you may not take money from a retirement plan free of an early withdrawal penalty unless you are age 59 1/2. But that's not always true. If you leave your job in the year you reach age 55, you may take your qualified retirement plan benefits from that job without any early withdrawal penalties. However, you must pay ordinary income taxes on any money not transferred to a traditional IRA. Anyone under 55 who receive qualified retirement plan benefits as income in a form other than a lifetime annuity are subject to an excise tax based on a premature distribution from that plan. The excise tax will continue until the retiree reaches age 59½. If you happen to be in this unfortunate camp, you'll be taxed on that benefit at ordinary rates and will be assessed an additional 10% of that sum as an early distribution penalty. Clearly not a good situation to be in.
Defined Contribution Plan A defined contribution plan is a qualified retirement plan in which the contribution is defined, but the total benefits to be paid out are not clearly defined. In these type of plans, each participant has an individual account. The benefit paid upon retirement depends on the amount of money contributed and on the overall investment performance of that account as time goes by. In such plans, the investment risk may rest solely with the employee because there is the opportunity to choose from a variety of investment options. These plans take many forms and are known by names such as money purchase, profit sharing, 401(k), or 403(b) plans.
Upon retirement, defined contribution plan benefits are usually paid out in several installments, as a lump sum, or they may also be paid as an annuity. Income tax complications and IRA 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 Account (IRA). An Individual Retirement Account is a personal retirement savings plan available to anyone, regardless of age, who receives taxable compensation during the year. For IRA contribution purposes, 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. A person's annual contribution, whether made to just one or to multiple IRAs, is limited to the lesser of total taxable compensation or to the normal yearly amount shown in the following table. Persons age 50 or older may make an additional catch-up contribution in the amount indicated for the year concerned.
Traditional and Roth IRA Annual Contribution Limits
Year |
Normal |
Catch-up |
2006 |
$4,000 |
$1,000 |
2007 |
$4,000 |
$1,000 |
2008 |
$5,000 |
$1,000 |
2009+ |
Indexed* |
$1,000 |
*Normal contribution limits will increase by $500 each year whenever cumulative inflation exceeds the next higher $500 increment
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, 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.
Money may be withdrawn from an IRA at any time, but depending upon the amount and dime of the 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 59½ will result in a 10% excise tax as well as a tax on ordinary income.
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 simple way to make that calculation. It's 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 withdrawals for traditional IRAs must begin no later than April 1 of the year following the year the IRA owner reaches age 70½. 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
There are eight exceptions to the 10% penalty for IRA withdrawals prior to age 59½. The early withdrawal penalty does not apply to distributions that:
This is just a broad overview of the retirement plans available to you . Obviously some plans are better than others when it comes to building wealth and saving for retirement. Please visit our home page to learn more about retirement planning.