Retiring successfully takes years of planning to fund a targeted lifestyle. The task is daunting. According to a widely used rule of thumb, savings should equal the first year's retirement needs multiplied by twenty-five. For example,
While social security can be properly deducted from needs, for most people, it comes nowhere near covering them. For 2016, the maximum
Over time, building net worth, or the excess of assets over liabilities, makes retirement feasible. Net worth is computed as cash, investments, and assets to be sold at retirement, less credit card debt, consumer loans, and real estate mortgages. The amount to add to net worth annually equals the difference between the retirement savings target and net worth, divided by remaining working years.
For example, if at age 55 retirement needs are
Trying to fund needs through normal savings and investments can be very costly. An attempt by someone in a 30% income tax bracket to put
Fortunately, there is a better way.
Retirement plans that are "Qualified" under the law, on the other hand, provide the means for tax-advantaged funding. Employee deferrals allow employees to make pre-tax contributions out of their paychecks. Employer contributions, on the other hand, are deductible against company income taxes. Other benefits include:
* Earnings on investments are taxdeferred.
* Beneficiaries are taxed only when withdrawing the funds.
* Accounts are protected from outside creditors.
While certain types are lower, the annual limit on additions for 2016 for participants in defined contribution plans is
Employee deferral plans allow employees to elect to defer income through voluntary contributions out of their paychecks, which are not subject to income tax until withdrawn at retirement.
The most basic type of plan is an Individual Retirement Account, or IRA, set up and funded directly by the beneficiary. Through a special bank account, individuals can set aside earned income of up to
Savings Match Plan for Employees of Small Employers, or SIMPLE, is available to companies having less than 100 employees. This type of plan minimizes administrative costs and complexity. Employee elective deferrals are limited to
Cash or Deferred Arrangements, or CODA, also known as 401 (k) plans, come with much higher limits than IRAs or SIMPLE, but at a cost of more complexity, including an administrator and more thorough government reporting. Depending on compensation, an employee may withhold up to the
Employer contributions are deductible to the employer and not taxed as compensation to the employee. Plans with employer contributions, such as profit-sharing, often add employee deferral features, such as 401 (k).
The nature of employer contributions varies depending on the type of plan. Under defined contribution plans, the employer has discretion over contributions, but lack of one for several years may cause the
As to defined contribution, Simplified Employee Pension, or SEP, plans are economical and straightforward. They offer the
Also defined contribution, profitsharing plans allow much more flexibility in meeting retirement objectives but require formal plan documents and administration. Options for allocating employer contributions can increase benefits to certain categories of employees. These include:
* Salary ratio: A uniform percentage allocation may optionally include a permitted disparity for integrating
* Age-weighted: These plan provisions provide extra benefits to older employees.
* Comparability: This plan design provides differing benefit levels to identifiable groups, such as divisions or managers.
Defined benefit plans, on the other hand, obligate the company to pay a certain retirement benefit. In middlemarket companies, these plans have become a rarity. Use today is most common for the self-employed or companies with very few employees, in which the owner is near retirement and desires to quickly accumulate a large amount of retirement funds. Defined benefit plans may be used in tandem with employee deferral plans, such as a DB/K plan, which includes a 401 (k), for companies with up to 500 employees. Administration is costly.
More so than defined contribution plans, defined benefit plans require government approval to terminate. If a company is being sold, the buyer most likely would insist on termination, as otherwise, the buyer becomes plan sponsor and takes on all of the associated funding and other risks.
A hybrid plan, known as a target benefit plan, offers similar benefits but fewer risks in termination. It is a variant of a profit-sharing plan known as a money purchase pension plan, which predefines contributions as either a fixed amount or a percentage of compensation. However, unlike under defined benefit plans, employers are not obligated to achieve a certain benefit amount.
Keeping 'qualified' status
To have a Qualified plan, the Internal Revenue Code specifies employee coverage, participation by age and hours of service, minimum vesting, non-discrimination, and "top heavy" restrictions, among others. The rules are designed to prevent an excessive imbalance in benefits of owners and key employees in comparison to other employees. Failure to comply results in loss of Qualified status and its benefits, unless corrected.
Minimum vesting, meaning an employee's right to dollars set aside in his or her account, is required. Employee contributions to qualified plans vest immediately, whereas employer contributions in defined contribution plans may vest 100% cliff after three years of service, or be graded to 100% over six years of service. Defined benefit plans allow vesting over a somewhat longer period than for defined contribution plans. Employer contributions in less complex plans, including SIMPLE and SEP, vest immediately. Participant balances must also fully vest at retirement, or if the plan terminates.
Non-discrimination relates to current deferrals and contributions to the plan. So long as these are a uniform percentage of compensation, as in a SEP plan, discrimination is not an issue. Also, under permitted disparity, compensation in excess of the
However, beyond this an employer must demonstrate among other tests that 70% of eligible non-highly compensated employees receive benefits comparable to the highly compensated. A highly compensated employee is one who owns at least 5% of the company, earns as a corporate officer at least
An alternative non-discrimination test favors older highly compensated employees. Because testing can be based upon the annual benefit accrual at the time of retirement, older employees, having fewer years to compound the return on investment, need significantly higher contributions than younger employees do. Compared to compensation, an employee who is 15 years younger may need only one-quarter the rate of contribution; one who is 35 years younger may take one-fifteenth the contribution. In such a case, a current contribution of 25% of compensation to an older employee equates to 6% and under 2% to the others.
Tax law also places special restrictions on "top heavy" plans, defined as those in which over 60% of the plan's assets relate to owners and key employees. The idea is to assure that other participants have a minimum benefit. "Top heavy" status is highly likely in plans with ten of fewer participants. Testing must be annual and include all plans sponsored by the employer. SIMPLE plans are exempt.
In light of the various restrictions, safe harbor 401 (k) plans offer another option. A safe harbor 401 (k) allows key employees maximum elective deferrals by mandating the employer contribute either 3% of compensation or up to 4% deferral match immediately vested to all participants. If lower, the highest contribution percentage including deferrals among key employees may be used. For added benefits, a safe harbor 401 (k) can be combined with certain employer contribution plans.