Types of Tax-Favored Private Retirement Plans

Pension Plans

A traditional pension plan (sometimes called a "defined benefit" pension plan) gives the plan participant a specificdollar benefit commencing at retirement and is payable over the post-retirement life of the employee (or in a lesser amount over the joint lives of the employee and his or her spouse).  I participate in a pension plan as a University faculty member.

Most pension plans provide a normal retirement age of 65 although earlier retirement at a reduced benefit level is frequently permitted.  When I retire, I will receive a maximum benefit of 60% of my final annual compensation averaged over a three-year period prior to my retirement.  This sounds like a very good deal and pension plans are still popular with large governmental employers like mine or with unionized groups of employees.

Although the pension plan is a desirable retirement plan, it suffers in a few respects.  As noted, the ultimate pension benefit is not a function of how much money has been contributed to the plan over the working life of the employee but rather is a function of the compensation level at retirement and the number of years of service preceding that retirement.  Thus, the pension plan participant does not directly benefit from robust economic times as participants in profit-sharing plans and Section 401(k) plans (discussed below) do.  Additionally, once the pension benefit is annuitized on retirement, the monthly payment to the employee is often fixed in amount and may not keep pace with post-retirement inflation and buying power. More information on pension plans is available by going to my Website, clicking on Retirement Planning and then Types of Retirement Plans.

Profit-Sharing Plans

Under a profit-sharing plan (sometimes referred to as a "defined contribution" plan), the employer will make a contribution to the participating employee's account that will be a percentage of the employee's compensation.  Thus, if the employee's compensation level is $40,000 and the employer is contributing 10% of compensation, that particular employee will have a $4,000 contribution made to his or her account that year by the employer.  Despite the name, the employer does not necessarily have to be in a profitable year to contribute to the plan.

A profit-sharing plan, as well as a Section 401(k) plan, is an individual account plan.  An individual account plan receives a contribution that is directly credited to the individual account of the plan participant.  Unlike the pension plan, the ultimate retirement benefit in an individual account plan is not known.  Whereas the employer assumed all investment risk in the pension plan, the employee assumes all investment risk in individual account plans.  The ultimate retirement benefit will be equal to the dollar value of the participant's individual account at retirement.  This benefit will consist of the contributions made on the participant's behalf plus (or minus) the investment return on those contributions.

Additionally, the plan participant will generally have the ability to direct the investment of his or her account.  The participant will then have the ability to pursue different investment strategies as we discussed above when commenting on the miracle of compounding interest and the different rates of return depending on that investment strategy. More information on profit-sharing plans is available by going to my Website and clicking on Retirement Planning and then Types of Retirement Plans.

Section 401(k) Plans

Section 401(k) of the Internal Revenue Code provides the rules governing the most popular form of employer-provided retirement plan in America, the Section 401(k) Plan (sometimes referred to as a “Cash or Deferred” Plan).

The Section 401(k) Plan is really a profit-sharing plan with a major twist.  It is like a profit-sharing plan in that it is a defined contribution and individual account plan.  That is, we know what is going into the Plan by way of contribution and whatever wealth accumulates is owned by the participant.  As with profit-sharing plans, the ultimate retirement benefit will be a function of the total amount of contributions to the Plan participant's account, the rate of return on that account, and time .

The twist is in the method of funding the contributions to the Plan.  Unlike a profit-sharing plan, where only the employer makes the contribution, in a Section 401(k) Plan the contribution to the participant’s account is typically triggered by the employee/participant.  The participant may contribute a percentage of his or her compensation for the year to the Section 401(k) Plan, often up to 15% of compensation (upper income Plan participants will not be able to elect to contribute more than a set amount — $12,000 for the year 2003, $13,000 for the year 2004, and $14,000 for the year 2005).  The employer may then match the employee’s contribution to the Plan.  For example, the employer may make an additional contribution of twenty-five or fifty cents for each dollar the employee has elected to contribute.  If the employee contributes nothing for the year, the employer makes no matching contribution to that employee’s account.

You MUST set up your budget (see page 4) so as to maximize your permitted contribution to the Section 401(k) Plan.  Here are some simple Examples illustrating why you must optimize your contributions to your Section 401(k) Plan.

Example 1:  Jack is an employee of the Acme Company.  Jack is eligible to participate in the Company's Section 401(k) Plan under which the Company makes a fifty-cent on the dollar matching contribution.  Jack could have elected to contribute $6,000 to the Plan but does not.  The $3,000 matching contribution that the Company would have made is thus never received by Jack.  Additionally, the $6,000 Jack takes as salary rather than contributing to the Plan is currently taxed.  Say Jack is in the 28% federal income tax bracket and he incurs an additional 5% net income taxation under his state income tax.  Jack ends up with $4,000 after tax.

More likely than not, Jack will spend the $4,000 and a year from now will have no recollection of what he spent it on.  But let's say Jack decides to invest the $4,000 in a mutual fund (discussed below) that one year later has generated a 15% rate of return.  One year down the road Jack's mutual fund is worth $4,600 (his $4,000 investment plus one year's earnings of $600).  Since his mutual fund investment is not within a tax-deferred retirement plan, the $600 of earnings will be currently taxed.  Even if all the $600 is taxed at the more favorable federal capital gain tax rate of 15%, Jack will have earned after tax only about $500 after paying the federal capital gain tax and his state income tax.  When the dust settles, after one year, Jack has accumulated about $4,500 after tax.

Example 2:  Jane is a co-worker with Jack at the Acme Company.  Jane is also eligible to contribute $6,000 to the Company's Section 401(k) Plan, which she does.  The Company makes the $3,000 matching contribution on top of Jane's $6,000 contribution.  Because these monies are contributed to a Section 401(k) Plan there is no current federal or state income taxation.  Nor will there be any current taxation of the investment earnings.  Jane will not be income taxed until she actually withdraws the money, for example, 30 years from now upon her retirement.  Jane directs the Plan trustee to invest her $9,000 in the same mutual fund that Jack invested in.  One year down the road, Jane has accumulated $10,350 of wealth in her account attributable to this year's transaction.  Although Jane will eventually pay income tax on her plan accumulation when she retires, the effect of having so much more principal working for her over the next 30 years to retirement puts her in an immeasurably better position than Jack ends up with in Example 1 (again presuming that Jack invests the money rather than spends it). 

If your employer makes a Section 401(k) plan available to you, the exact amount the employee is allowed to elect to contribute, and the employer-matching contribution, are established under the Plan document and described in the Summary Plan Description for the Plan (the SPD has been distributed to you and is always available to you from your employer’s human resources or benefits person). More information on Section 401(k) plans is available by going to my Website and clicking on Retirement Planning and then Types of Retirement Plans.

Also, if you are age 50 or over, you may be able to make an additional "catch-up" contribution to your Section 401(k) plan.  These additional "catch-up" contributions are not effected by your current contribution limits.  For 2003, the catch-up contribution amount is $2,000 ($3,000 for 2004 and $4,000 for 2005).  Take advantage of this option, especially if you have not been fully participating in your Section 401(k) plan.

Individual Retirement Accounts –Traditional IRAs

Probably the most common form of tax-favored retirement plan is the Individual Retirement Account.  The traditional IRA that we will talk about now has been around for many years.  You, not an employer, will make contributions to the IRA.  A traditional IRA is one that has its tax-advantage at the front-end rather than the back-end.  You get to tax deduct your IRA contribution as an Above-the-Line Deduction - you can get your deduction even if you are not an itemizer (review Exhibit 1 in the Tax Planning section of the book on page 9).

How much can your contribute to an IRA?  The lesser of $3,000 per year for 2003 and 2004 (for 2005-2007 - $4,000, for 2008 - $5,000) or $100% of your earned income for the year.  Earned income must be worked for unlike unearned income like interest income from a savings account.  Also, individuals age 50 and over are permitted to make additional annual "catch up" IRA contributions of $500 for 2002-2005 and $1,000 for 2006 and thereafter.  For a majority of people contributing to an IRA this means a $3,000 per year maximum tax-deductible contribution.

Once your money goes into an IRA, it grows tax-deferred.  This phenomena of tax-deferred growth is common with the other tax-qualified retirement plans that we just talked about – the pension, profit-sharing and Section 401(k) plans – as well as the IRA.  In all these plans and the IRA, income generated off of the plan wealth is not currently taxed.  Rather, the tax liability on the income growth, as well on the principal amounts contributed, are deferred until the wealth is paid out in the future.

NOTE:  If withdrawals are taken from tax-qualified retirement plans prior to age 59½ (other than for death, disability and certain other limited events), not only is the taxpayer income taxed on the wealth withdrawn, there is an additional add-on 10% penalty tax to contend with.  Why?  The tax rules are designed to compel us to wait until we are at or near retirement to draw wealth from the plan.

What if your spouse is at home with the kids or otherwise not generating $3,000 of earned income?  A wonderful new pro-family development in the law now allows the stay-at-home spouse to fully fund his or her own IRA if the couple's joint Adjusted Gross Income (pages 9-10) is less than $150,000.

Can you still make a contribution to a traditional IRA if you are a participant in your company's pension, profit-sharing or Section 401(k) plan?  The answer will depend on whether you and your spouse are both participating in company sponsored retirement plans and on the amount of your Adjusted Gross Income.  Let's look at the latter situation first.

If you are a participant in a company sponsored pension, profit-sharing or Section 401(k) plan and your AGI is less than $60,000 ($40,000 if single) for 2003 ($65,000 - $75,000 for 2004), you may make a full $3,000 tax-deductible contribution to your traditional IRA.  Your ability to make a $3,000 tax-deductible IRA contribution is phased out to zero dollars if your AGI goes from $60,000 to $70,000 ($40,000 to $50,000 for single taxpayers) for 2003.

Now on to the other rule- you are married, one spouse is working and participating in a company-sponsored pension, profit-sharing or Section 401(k) plan, but the other spouse is not.  In this scenario, the second spouse can make a $3,000 tax deductible contribution to his or her traditional IRA as long as the couple's joint income is less than $150,000.  The second spouse is not considered participating in a company plan because the first spouse does.

Roth IRAs

Now for the new kid on the block – the Roth IRA.  The Roth IRA is the hottest thing to come on the retirement planning scene since Section 401(k) plans became popular.  The tax benefit afforded through the Roth IRA is exactly opposite from that of the traditional IRA and the other plans we have studied.  As I already mentioned, these earlier analyzed plans provide an up-front tax benefit by way of a deduction for the IRA owner or company or employee contributing to the plan as well as tax-deferral on the invested funds (income taxation is not due and owing until wealth is tapped at retirement).

With the Roth, there is an opposite and (for many) much more potent tax benefit.  When you make your contribution to the Roth IRA (up to $3,000 per year as with the traditional IRA) you get no tax deduction.  In other words, you are funding it with after-tax dollars.  But after that up-front tax negative, things become beautiful.  Why?  You will never pay any income tax if you wait until retirement (or death, disability and some hardship withdrawals) to take your wealth out.  In addition, your actual contributions (not the earnings on the contribution, but the actual contribution itself) may be withdrawn from a Roth IRA at any age without penalty.

You can make a full $3,000 contribution to a Roth even if you participate in a company sponsored retirement plan as long as your AGI is less than $150,000 ($95,000 if single).  For taxpayers age 50 and older, a "catch-up" contribution of $500 may be made to their Roth IRAs.  The Roth makes most sense for people who will have a longer period until retirement and/or people who are in a lower marginal tax bracket (see page 11) when funding the Roth but who will be in a higher tax bracket when taking withdrawals.

Example:  Bryan is a 15-year-old High School student who makes $2,000 each year working a summer job.  Pursuant to his Dad's intelligent advice, Bryan (who is in the lowest 10% marginal tax bracket) makes a $2,000 contribution to a Roth IRA beginning in 2003 for each of the four years he is in High School.  Therefore, Bryan will currently be taxed $200 ($2,000 x 10%) in each of the four years with regard to his Roth contributions.  After contributing $8,000 in total to the Roth, Bryan never contributes another dollar to it and for 45 years keeps it invested in a stable stock mutual fund yielding an average of 12% over a 45 year period of time.  Upon retirement at age 62, Bryan finds that his $8,000 of principal invested years ago has grown to $1,500,000, all of which he can withdraw from the Roth entirely income tax-free.

 

NOTE:  The Example I just gave you is also a wonderful illustration of what would occur if Americans were allowed to privatize Social Security contributions (or a portion of them).  Recall from our Social Security discussion earlier that if you and your spouse have earnings of only $50,000 per year, the combined employer and employee contribution to Social Security is about $6,200 every year.  Wouldn't it be nice if younger workers could divert that Social Security tax and invest it as was just illustrated in the Example.

For a much more detailed analysis of Traditional and Roth IRAs, go to my Web site, click on Altieri Articles and Other Publications, then the "Individual Retirement Accounts After TRA 1997" article.  Also, for an interesting Web-based tool that helps you determine what form of IRA would be better for you and your family, go to Web site, click on Retirement Planning and then IRA Tool.  Additionally, general information on IRAs is available by going to my Web site and clicking on Retirement Planning and then Types of Retirement Plans.

Section 403(b) Annuity

If you are an employee of an educational institution or a Section 501(c)(3) charitable or religious organization, you may be eligible to contribute to a Section 403(b) Annuity.  Even if there is no employer match as in the Section 401(k) Plan, under the 403(b) Annuity rules you can elect to contribute up to $12,000 every year ($13,000 for 2004 and $14,000 for 2005), with the federal and state income taxation deferred until retirement.  The Section 403(b) Annuity acts exactly like a Traditional IRA, except that the contribution limit is much higher than $3,000.  More information on Section 403(b) Annuities is available by going to my Web site and clicking on Retirement Planning and then Types of Retirement Plans.

Self-Employed Plans

If you are self-employed, rather than working as an employee, you have the ability to set up your own pension, profit-sharing, and/or Section 401(k) plan.  Bear in mind that you will have to cover your employees who work for you more than 1,000 hours per year.