Trieschmann, Hoyt & Sommer

Employee Benefits: Retirement Plans

Chapter 20

©2005, Thomson/South-Western

22

Chapter Objectives • Describe the factors important in determining Social Security

retirement benefits and explain the implications of the Social Security retirement test for retirees

• Differentiate between defined benefit and defined contribution pension plans, and describe the cash balance version of the defined benefit pension

• Explain the basic pension qualification rules regarding eligibility, retirement ages, form of payment, maximum benefits, maximum contributions, and vesting

• Explain the importance of actuarial cost assumptions• Describe the nature and purpose of deferred profit-sharing plans• Distinguish between thrift plans and 401(k) plans and explain the

tax advantages associated with each of them• Describe the special purposes for which SIMPLE, Keogh, and

403(b) plans were designed

33

Introduction • The traditional approach to retirement planning involves three

pieces– Social Security– Personal savings– One or more employer-sponsored retirement plans

• Can be especially crucial element in individuals’ plans for dealing with their loss of income upon leaving the workforce

• Numerous types of retirement income benefits can be provided to employees – Many employees offer more than one type of benefit

• Some benefits can be given to all employees – Whereas others may be provided as options to supplement basic

retirement plans• When combined with Social Security and supplemented with

personal savings – Many retirement plans make it possible for individuals to maintain their

standard of living after their exit from the workforce

44

Social Security Retirement Benefits

• The level of retirement income that can be expected from Social Security depends on many factors including – The age an individual elects to begin receiving benefits – The number of years he or she worked in employment

subject to Social Security taxes – The wages earned in such employment

• The age at which retirees can begin collecting their full retirement benefit amounts has historically been 65 – However, this age is gradually increasing and is scheduled

to reach 67 for those born in 1960 or later – See Table 20-1

55

Table 20-1: Future Social Security Normal Retirement Ages

66

Social Security Retirement Benefits

• Workers retiring at the Social Security normal retirement age after a lifetime of full-time employment at salaries equal to the OASDI wage base – Can now expect to receive a benefit of approximately 25% of

what they earned just before retirement

• Workers with a lower earnings history can expect a benefit that is relatively higher in relationship to prior earnings

• Workers can retire earlier than their Social Security normal retirement age – But their benefits will be relatively lower than would otherwise be

the case

77

Relationship of Work History to Benefit Amount • Social Security retirement benefits are based on average

earnings in employment subject to Social Security taxes • The period for computing average earnings begins with

the year 1950 (or the year in which an individual reaches age 22, if later) and it ends in the year before the individual’s attaining age 62 – The actual earnings during this period are adjusted for changes

and average wage levels – The resulting figure is called the average indexed monthly

earnings (AIME)• From this number is calculated the primary insurance amount (PIA)

on which all retirement benefits are based – The formula for transforming the AIME into the PIA is intentionally

designed to weight lower earnings more than higher earnings

88

Benefits Payable to Retired Workers • The initial monthly Social Security benefits for a retired

worker equal that person’s PIA if he or she begins receiving benefits at the Social Security normal retirement age

• Many retirees elect to begin collecting benefits before that age – However, age 62 is the earliest age at which benefits may begin

• An actuarial reduction of 0.555% occurs in each of the first 36 months that a worker retires “early” – Plus an additional 0.4167% for each additional month early – This reduced benefit will continue to be payable even after an

early retiree reaches the normal retirement age • Benefits for workers who delay benefits until after the

normal retirement age are also adjusted– Through increases for each month “late”

99

Benefits Payable to Retired Workers• It is also possible to receive Social Security retirement

benefits without totally exiting the workforce – But limits are placed on how much younger retirees [those under

the Social Security normal retirement age] may earn before a reduction in Social Security benefits is triggered

• Can earn up to $11,640 per year without penalty • For earnings exceeding this limit, the worker’s Social Security

benefit is reduced by $1 for every $2 in wages

– Once retirees reach their Social Security normal retirement age, they may earn an unlimited amount of income and still collect Social Security benefits to which they’re entitled

• Only earned income is counted – Funds received from investments, pensions, annuities, and

interest are not considered in applying the retirement test

1010

Benefits Payable to Retired Workers• After an individual begins receiving

retirement benefits, those benefits are automatically increased annually for changes in the cost of living – Measured by the Consumer Price Index for All

Urban Wage Earners and Clerical Workers – As published by the U.S. Department of Labor

1111

Benefits Payable to Spouses and Children • A retired worker’s spouse and dependent children may

be entitled to Social Security benefits based on the worker’s earnings

• The benefit amount for a spouse who has attained the normal retirement age is 50 percent of the worker’s PIA

• However, spouses can elect to collect as early as age 62 – At an actuarially reduced level or at any age if they’re caring for

children under age 16

• The spouse is not required to be financially dependent on the retired worker in order to collect the benefit– But spouses who have earned income are impacted by the

retirement test in the same manner as for retirees

1212

Benefits Payable to Spouses and Children• An increasingly common situation is for both

husband and wife to be entitled to Social Security retirement benefits on the basis of their own earnings history – The question arises as to whether such people are

still entitled to receive spouse’s benefits from Social Security

– The basic rule governing these cases • An individual is entitled to receive only the one Social

Security benefit that will pay the greatest monthly income

1313

Benefits Payable to Spouses and Children• In some cases, children of retired workers

are young enough to be entitled to Social Security benefits – The child’s benefit is 50% of the worker’s PIA– Eligibility is generally limited to unmarried

children under the age of 18 • Extended to 19 if a child is a full-time student in

elementary or high school • Age limit is removed entirely for unmarried children

who become severely disabled before age 22 and who continue in that condition

1414

Taxation of Benefits

• Social Security retirement benefits are not subject to federal income tax unless one’s adjusted gross income exceeds certain limits – For example, if half of an individual’s Social

Security benefit + investment income exceeds $25,000

• Then 1/2 of the Social Security benefit is taxable

1515

Pension Plans

• An employer-sponsored arrangement

• Established with the primary goal of systematically providing retirement income for employees

1616

Traditional Defined Benefit Pension

• A traditional defined benefit plan has a formula for determining the monthly pension payments during retirement

• Often, an employee’s salary history and number of years of service are inputs for the formula

• It is up to the employer to make sure that enough money has been set aside to fund the promised pension at the level indicated by the benefit formula

1717

Defined Contribution Pension

• Employer’s annual contribution to the pension is specified – The exact amount of eventual retirement benefit left undetermined

until each person retires • Contributions will be invested during the employee’s

working career • Pension amount will depend on level of yearly

contributions and on investment return earned on the contributions

• Many employees favor these plans because it is easier to budget the definite costs involved

• Many employees prefer knowing the value of their accounts throughout their working years – Also, employees who anticipate changing jobs several times in

their careers prefer these plans because accumulated amounts are usually easily cashed out or rolled over to a new employer’s plan

1818

Cash Balance Pension

• Starting in the late 1990s, many large employers with traditional defined benefit pension plans begin converting them into cash balance pension plans

• They are still technically considered to be defined benefit plans for IRC purposes – But they look like defined contribution pensions in

many ways • In particular, employees with cash balance pension plans

have individual accounts that grow annually for both employer contributions and investment earnings

1919

Cash Balance Pension

• The cash balance plan is utilized to address perceived problems with the other pension structures – Many employees find defined benefit pensions difficult

to understand – Employees cannot see the dollar value of their

accounts in a traditional defined benefit arrangement – Traditional defined benefit plans are most valuable to

employees working 30 or 35 years for same employer • Most prevalent situation in today’s work environment is for an

employee to work for several employers over the course of their careers

2020

Cash Balance Pension

• Participants in a defined contribution plan may be uncertain as to whether they will have sufficient funds to provide themselves with an adequate pension

• Investment earnings influence the ultimate size of the defined contribution pension fund – No guarantees can be made about how large this

fund will be at retirement • Due to uncertainty about the performance of the securities

markets over many years • This uncertainty is reduced with cash balance plans

– Due to the guaranteed minimum return

2121

Plan Qualification

• Pension plans can be set up so that they are qualified plans – They meet the qualification rules in the Internal

Revenue Code for favorable tax status • Employers sponsoring qualified pension plans can

deduct their contributions from current taxable income • Employees do not have to report employer contributions

as taxable income before receiving benefits – At retirement, as pension income is received, it is considered

taxable to the extent that the income was funded by the employer

2222

Plan Qualification

• If a pension plan is contributory, employees are not allowed to deduct their contributions from taxable income – But when benefits are received, a portion of

each pension benefit payment escapes taxation until the total amount of the employee’s contribution has been recovered tax-free

2323

Plan Qualification

• The qualification rules for pension plans were established in 1974 by the landmark Employee Retirement Income Security Act (ERISA)– Many changes have occurred since the original

passage, with each new tax law making several adjustments in the qualification rules

– Generally, the rules for pension plans are more extensive than for other benefits due to

• The sizable dollar amounts involved • The magnitude of the tax advantages granted • The overall importance of pensions to individual risk

management plans

2424

Eligibility

• Employers must establish eligibility standards for participation in pension plans

• Employers do not have to use the same eligibility rules as used for other benefit programs – Many employers have stricter eligibility requirements

for pension plan participation • It is not unusual to exclude part-time personnel and those

working in specified job classifications • Many employers also use both minimum age and minimum

service requirements

2525

Eligibility

• Although employers are relatively free with other benefits to establish whatever logical eligibility requirements may be desired – Their choices with respect to pensions are

more limited – For example, the qualification rules prohibit

use of a minimum age requirement exceeding age 21 or a minimum service requirement of more than a year

2626

Eligibility

• In establishing pension eligibility rules, employers are particularly constrained by qualification rules designed to eliminate the favoring of very highly paid employees – Generally they establish two categories of

workers • Highly compensated • Nonhighly compensated

– If participation is not sufficient in this group then the pension plan may lose its qualified status

2727

Retirement Ages

• All qualified pension plans specify a normal retirement age – The earliest age at which employees can retire and receive full

pension benefits • Often, the normal retirement age is specified to be a

particular age – Other times the normal retirement age is whatever age an

employee is when he or she completes a specified number of years of service

• Many pension plans provide special early retirement options – Various age and service requirements usually exist before early

retirement benefits are payable – The early pension benefit is usually at a reduced level to reflect

the increased cost to the plan of early retirement

2828

Retirement Ages

• Unless the early retirement benefit is reduced to its full actuarial equivalent – A company will have to pay additional money

into the plan to pay for the increased costs associated with early retirement

– By making appropriate assumptions about interest and mortality rates

• Actuaries can compute the reduced early retirement benefit that is mathematically equivalent to the benefit payable at the plan’s normal retirement age

2929

Retirement Ages

• Retirement after the normal retirement age is classified as late retirement – Before 1986 many employers were able to

specify a mandatory retirement age of 70 years (or higher)

• All workers could be forced to retire if they had not already done so

– However, a mandatory retirement age is now prohibited for most jobs

• Thus, many pension plans experience instances in which workers do not retire at the normal age specified for the plan

3030

Retirement Ages

• When a worker does not retire by the normal retirement age – A logical argument can be made for actuarial

increases for late retirement benefits – Such increases are not required by law

• Hence, they are rarely granted by employers • Benefit increases associated with late retirement

are primarily found in plans sponsored by employers seeking to provide additional incentives to encourage employees to continue working past normal retirement age

3131

Form of Payment

• Pensions are usually paid in some form of annuity

• If an employee is married when pension benefits begin – The qualification rules specify that the benefit will be a

joint and survivor annuity in which the survivor’s portion is at least 50% of the joint portion

• However, employees can select a different form of payment under various circumstances

– For example, if the employee’s spouse agrees in writing, the joint and survivor pension can be waived in favor of a single life annuity paying a greater monthly benefit

3232

Form of Payment

• Sometimes employers offer an additional option – An employee reaching retirement age can

elect to receive some or all of the promised pension immediately

• Known as a lump-sum distribution option • Most commonly provided in defined contribution

pensions – Because the dollar value of the employee’s pension

account is easily determinable at the time of retirement

3333

Form of Payment

• Employees who are offered the lump-sum distribution options should carefully analyze several factors before accepting – The possibility exists that you may outlive

your income if you take the lump sum – Income taxes

3434

Benefit and Contribution Limits

• By law, the annual defined benefit pension for newly retiring individuals is limited to a specified dollar amount that is adjusted each year as average wages increase

• For defined contribution plans, the yearly contribution to the plan is limited, not the annual pension – Currently, annual contributions are limited to the lesser of 100% of

that person’s salary or $41,000

• Also, only the first $205,000 in earnings can be considered in either the benefit or contribution formula – The significance of these limits is primarily important for highly paid

employees

3535

Inflation Protection • When pension benefits or contributions are a function of salary,

some inflation protection before retirement is automatically built into the plan

• But once a person retires the situation is often different • The Social Security portion of a worker’s retirement income is

subject to annual adjustments for inflation • But most employer sponsored plans are not protected from inflation

once the pension payments have begun – Resulting in severe erosion of the retiree’s purchasing power overtime

• See Table 20-2• To counteract inflation impacts, some employers make periodic

adjustments in pensions paid – So that retirees receive the same or similar increases as awarded to

active workers • Other employers make annual adjustments to correspond to

changes in the cost of living – Usually with some annual limit

3636

Table 20-2: Effect of Inflation on Retirement Income

3737

Permitted Disparity • The benefit or the contribution in a pension plan may be affected by

Social Security • Once called Social Security integration but now known in federal tax

law as permitted disparity – This concept can be incorporated into a pension plan to allow the

employer to “take credit” for the Social Security taxes paid on behalf of employees

• Employers pay half of the total Social Security tax for their employees – However, no taxes are paid for earnings above an established level – Also, at retirement, Social Security benefits restore a larger proportion

of the wages of lower-paid workers than of higher-paid workers • These factors form the basis for the rationale of allowing pension plans to be

more generous to higher-income employees • The combined retirement benefit from Social Security and the private

pension replaces approximately the same percentage of pre-retirement income for everyone

– For lower-paid workers, a proportionately greater share of the total will be from Social Security

3838

Vesting

• The degree to which a plan participant’s pension rights are nonforfeitable is called vesting – Regardless of whether the employee continues working for a

particular employer • The vesting provisions in a pension plan are relevant

only for the contributions or benefits associated with the employer’s contributions – The employee’s contributions are always fully refundable with

interest when terminating inclement • The most common vesting provision is to have full

vesting take place after five years – Also known as the five-year cliff vesting – Prior to that time, workers who terminate employment are not

vested at all and have no pension rights under the plan

3939

Vesting

• Overtime, the laws governing vesting have been modified several times – Making it possible for more employees to

achieve full vested pension rights much more quickly than was often the case in the past

• This fact, and the probability that many employees will change jobs several times during their working careers

– Make it likely that many future retirees will collect retirement income from many employers’ plans

4040

Disability Provisions

• Pension plans may provide special benefits if an employee dies or becomes disabled before retirement

• Employees who have achieved at least some degree of vesting will have death benefits available to a surviving spouse either as a lump sum or as a survivor’s pension – If the pension is funded using life insurance, then an

extra benefit may be available

4141

Disability Provisions

• With respect to disability, some pension plans make no special provisions and treat employment termination due to disability in the same way as any other termination – Future pension is payable only if the participant

achieved vested pension rights before the termination • In other plans the pension may become payable

immediately if the employee becomes disabled • For those employers electing to provide

disability benefits apart from their pension plans– A decision must be made regarding the continued

accrual of pension rights during disability

4242

Pension Funding

• An employer cannot wait until an employee retires before contributing funds to pay his or her pension – The funds must be set aside in advance

• Each qualified pension plan has a funding agency that handles plan contributions – Approximately 2/3 of all pension assets are in

trust fund plans

4343

Pension Funding

• Trust fund plans – The employer places monies to pay plan benefits with a trustee,

which manages and invests the pension assets– The trustee pays benefits to retirees or other beneficiaries – Assets are not allocated to particular employees but rather are

held and managed for the benefit of all employees as a group – The main advantage of the trust fund plan is its flexibility

• The trustee has a wide range of investments in which assets may be placed and they can be given instructions regarding

– How the investments will be made – How the benefits are to be paid – How eligibility and other provisions of the plan should be administered

– The trustee does not guarantee investment results, safety of principal of the assets invested, or mortality rates assumed in making annuity calculations

• Insured pension plans frequently guarantee minimum interest rates, safety of principal, and mortality costs

4444

Pension Funding

• Allocated plans – A record is kept of the account of each employee – Each dollar the employer contributes is associated with

a particular worker

• Unallocated plans – No monies accrue for individually specified employees

during their careers – The fund is kept in trust for the employees as a group

• At retirement the pension is paid from the unallocated fund

4545

Pension Funding

• Although employees are affected by funding decisions made in connection with the pension plans – They frequently have little control over most of

these decisions

• The major consideration with defined contribution plans is the manner in which the plan assets are invested – Because the rate of return will greatly

influence the size of the eventual pension

4646

Pension Funding• With defined benefit plans additional decisions are important

– For example, actuarial cost methods must be selected for computing how much money must be contributed each year to fund the promised pension

– Many actuarial cost assumptions must be made about the future including • The likely rates of investment earnings• The pattern of salary increases if the benefit formula is based on employees’

salaries• The expenses likely to be incurred by the plan• The distribution of actual ages at which employees will choose to retire in the

future• The rates of death, disability, and employee turnover

– If these assumptions are incorrect, then underfunding or overfunding will result

– Actuaries are required to periodically examine the plan and its assumptions

• To certify that the assumptions are reasonable and to make recommendations regarding the fund’s adequacy for future pension obligations

4747

Plan Termination Insurance

• Coverage is mandatory for and limited to qualified defined benefit plans

• A federal agency called the Pension Benefit Guaranty Corporation (PBGC) was established to oversee this insurance

• Premiums for the coverage are based on the number of participants and the degree of funding for particular plans

• If planned funds are insufficient to cover promised benefits to employees – PBGC takes over and pays the benefits, subject to

various limitations

4848

Deferred Profit-Sharing Plans

• Formal arrangements for sharing employer profits with employees on a tax-advantaged basis

• The word deferred is used to distinguish these kinds of plans from bonus arrangements in which profits are distributed to employees and taxed in the same way as employees’ salaries

• Most employers establish deferred profit-sharing plans to enhance employees’ financial security in planning for income needs associated with retirement, death, disability – Some employers design plans to emphasize retirement benefits

• While others have plans with a broad emphasis

4949

Deferred Profit-Sharing Plans

• In most deferred profit-sharing plans – The employer expects that the direct link between

profits and contributions will motivate employees to work efficiently

– An even stronger motivational device is possible when employer contributions to qualified plans are made in the form of employer’s common stock

• Two versions of this approach are stock bonus plans and employee stock option plans (ESOPs)

– ESOPs usually invest in stock issued by the employer, whereas stock bonus plans have more flexibility regarding plan assets

5050

Deferred Profit-Sharing Plans

• Although some employers tend to contribute the same percentage of profits to their deferred profit-sharing plans each year – No specific contribution formula is mandated by law

• An employer is required only to make substantial and recurring contributions to the plan over time – With no minimum contribution required each year

• Deferred profit-sharing plans provide fewer guarantees for employees about the eventual level of retirement income that likely will be paid from the plans

5151

Deferred Profit-Sharing Plans

• The sponsor of a deferred profit-sharing plan must specify an allocation formula to be used in distributing wha ever amounts are contributed to the plan – A popular allocation method is based on employees’ salaries

• Within limits, employers may allow participants to specify their choice of investments for funds allocated to their deferred profit-sharing accounts

• Employers are often more liberal in designing the preferred profit-sharing plans than in designing their pension plans – Employers can be more generous in designing their plans without

increasing the cost – Employers hope to benefit from the link employees perceive

between work efficiency and plan contributions • So it is logical for employers to include more workers in deferred

profit-sharing plans than in pension plans

5252

Deferred Profit-Sharing Plans

• Some deferred profit-sharing plans are designed primarily as retirement income vehicles – Whereas others are broader in their intent – Participating employees should be aware of the circumstances

in which distribution of some or all of their account balances is allowed

• Federal qualification rules specify distributions from deferred profit-sharing plans can be made for many more reasons than is the case with pensions

– Although employers may choose not to make distributions under all the circumstances permitted by law

• Situations in which distributions are allowable include – Retirement, death, disability, layoff, illness, termination of employment,

the attainment of a specified age, the passage of at least two years since the contribution was made, and the existence of a financial hardship

» Noteif an employee receives a distribution before age 59.5, he or she may have to pay an extra 10% tax on the amount received

5353

Employee Savings Plans

• Employees can enjoy the benefit of tax deferral of retirement contributions for more than one type of qualified plan simultaneously

• An employer may provide one leg of the three-legged retirement income stool through the regular pension plan – And also facilitate the individual employee’s savings required for

the third leg • Employees who are eligible to participate in one or more

employee savings plans should seriously consider doing so – Because the tax advantages, “forced savings” element and

possible employer matched contributions associated with many such plans can help individuals accumulate the savings required to assure an adequate income during retirement

5454

Thrift Plans

• Designed as a special form of a contributory, deferred profit-sharing plan

• Subject to most of the rules governing such plans • Presented as ways to encourage employees to save

their own money • Plans may be designed to emphasize retirement savings

or general purpose savings – The encouragement for employee savings comes in the form of

matching contributions from the employer – These employer matching contributions, as well as all

investment earnings in the plan, are tax deferred until distribution to the employee

5555

Thrift Plans

• No immediate income tax deduction is provided for employee contributions – But the tax deferred employer matching

contributions and investment income can be quite valuable over time

– This tax advantage is particularly attractive to higher-income employees

• Who are subject to the highest rates of income tax • Such persons also may be the ones most able to

participate in contributory plans

5656

Section 401(k) Plans

• Similar to a thrift plan that offers the added advantage of an immediate income tax deduction for employee contributions

• Known as a cash or deferred arrangement or a 401(k) plan – After IRC code that provides for it

• Can be structured in several ways – Usually they allow employees to choose the types of assets in

which their accounts will be invested – Investment selections can be modified periodically as goals or

market conditions change – In many plans employers match employee contributions – All contributions grow tax deferred until distributed to the

employee

5757

Section 401(k) Plans

• Extra rules govern 401(k) plans with respect to income tax deductions for elective deferrals

• Each year the plan must pass special tests designed to guard against favoring highly paid employees – The employer can avoid this annual testing by

designing the plan so that it passes at least one of the safe harbor provisions specified in the IRC

5858

Section 401(k) Plans

• Employees age 50 and older are allowed to make specified additional pre-tax contributions above the normal elective deferral limit – Called catch-up contributions

• The rules regarding distributions of 401(k) funds before age 59.5 are somewhat restrictive – Some provision for early distribution are made if an employee

experiences extreme financial hardship and other resources are not reasonably available

• Vesting rules applied to thrift plans and 401(k) plans – For these plans the maximum period for cliff vesting is three

years rather than five • Employees are always 100% vested in their own

contributions

5959

Individual Retirement Accounts (IRAs)• Designed to supplement other sources of

retirement income • Sometimes employers facilitate employee

savings through IRAs – Primarily by offering their employees the opportunity

to make the IRA contributions through payroll deductions

• The establishment of an IRA is not dependent on employer sponsorship – The only requirement is that the individual must have

earned income and some cases must not yet be 70.5 years old

6060

Traditional IRA • Created as part of ERISA• For many years, the maximum limit an individual could

contribute was $2,000 annually – $4,000 if married and filing a joint tax return

• In 2001 these limits were raised to $3,000 for individuals ($6,000 for couples )– Will rise to $4,000 ($8,000 for couples) in 2005 – $5,000 ($10,000 for couples) in 2008

• IRA funds may be invested in most types of financial securities and will accumulate on a tax-deferred basis until distributed

• If an individual is not an active participant in a qualified retirement plans sponsored by an employer – Contributions are fully tax deductible

• However, if the individual is an active participant in a qualified retirement plan, the taxability of the contributions is as shown in Table 20-3

6161

Table 20-3: Tax Deductibility of IRA Contributions for Active Participants …

6262

Traditional IRA

• Except in the case of death or disability, funds withdrawn from the traditional IRA before age 59.5 usually result in a 10% early distribution penalty tax on the amount withdrawn – Designed to discourage the use of IRA funds for

purposes other than retirement – Amounts withdrawn after age 59.5 are taxed as ordinary

income • Except to the extent that they are attributable to contributions

that were not fully tax deductible when made

6363

Roth IRA

• First became available in 1998 as an alternative to the traditional IRA

• The same annual limitations apply to contributions, but a major difference exists regarding taxation – Contributions to a Roth IRA are never deductible from taxable

income • But the entire amount can be withdrawn tax free at retirement

– All investment earnings and growth in principal may fully escape income taxation if all relevant rules are met

» Tax status is especially attractive for young workers who have many years for their savings to grow before withdrawal

• Income limitations exist regarding who is eligible to establish a Roth IRA – As of 2004, the limit was $110,000 for single taxpayers

6464

Rollover IRA

• A rollover occurs when the owner takes funds out of one account and places them in another

• Two types of rollover IRAs exist – A transfer from one IRA to another – A distribution from an employer-sponsored retirement

plan into an IRA set up to receive such proceeds

• If certain requirements are met, funds involved in rollovers escape current income taxation – And are not subject to the annual contribution limit

that applies to other IRA contributions

6565

SIMPLE Plans

• A retirement option intended to be attractive to small businesses employing 100 or fewer employees

• Called the savings incentive match plan for employees • Can be set up either as part of a 401(k) plan or through

individual IRAs– For both variations, the rules eliminate much of the

administrative work (and expense) that otherwise might prevent small employers from setting up retirement benefits at all

• For example, a SIMPLE 401(k) plan is exempt from the rules regarding testing for discrimination in favor of highly paid workers

• In exchange for this exemption the employer sponsoring the SIMPLE 401(k) plan must generally match up to 3% of its employees’ contributions

• All full-time employees must generally be eligible to participate and vesting of employer contributions must be full and immediate

6666

Keogh Plans

• Designed for persons with self-employment income • Frequently people with “side jobs” shelter part of their

earnings in these plans • The tax-sheltered contributions and accumulating

investment returns are not subject to current income taxation

• The annual amounts that can be contributed and deducted from taxes are based on a person’s income from self-employment – With the specific limits dependent on the type of Keogh plan

established• Keogh plans can also be deferred profit-sharing plans or

defined benefit pension plans

6767

Section 403(b) plans

• Also called a tax-sheltered annuity, a tax-deferred annuity or a section 501(c)(3) annuity

• Specifically designed for certain types of nonprofit institutions – In general, employees of public schools, universities, hospitals,

and nonprofit organizations operated exclusively for religious, scientific, charitable, literary, educational, cruelly prevention, or public safety testing purposes are eligible

– Because such organizations are usually exempt from income taxes and often lack the financial resources necessary to fund adequate retirement incomes for their employees

• Special rules exist to assist employees of such organizations in saving for retirement on their own

6868

Section 403(b) Plans

• In setting up a plan, an employee typically enters into a contract with the employer to reduce his or her contractual salary by the amount the employee wishes to save – The amounted contributed can be deducted

from the employee’s current taxable income – Investment income on the contributions

accumulates tax-free until distribution

• The maximum annual contributions are the same as for 401(k) plans