Retirement Account

401(k) Plans

A 401(k) plan is self-directed, qualified retirement plan established by an employer to provide future retirement benefits for employees. Employee contributions are made on a pre-tax basis, and employer contributions are often tax deductible. [Roth 401(k) contributions are made after-tax, but qualified withdrawals in retirement are free of federal income tax.] Many employers are now enrolling new hires automatically in 401(k) plans, allowing them to opt out later if they choose not to participate. This is done in the hope that more employees will participate and will start saving for retirement at an earlier age.

If you elect to participate in a 401(k) plan, you can allocate a percentage of your salary to your plan every month. The maximum annual contribution is $15,500 in 2007. If you will be 50 or older before the end of the tax year, you can contribute an additional $5,000. Contribution limits are indexed annually for inflation. The funds in your account will accumulate tax deferred until you begin taking distributions in retirement.

Employer contributions are often subject to vesting requirements. Employers can determine their own vesting schedules, making employees partially vested over time and fully vested after a specific number of years. When an employee is fully vested, he or she is entitled to all the contributions made by the employer when separating from service.

In plans that offer loans, you may also be allowed to borrow money from your account (up to 50% of the account value or $50,000, whichever is less) with a five-year repayment period. Of course, if you leave your job, the loan may have to be repaid immediately.

The funds in a 401(k) plan are portable. When you leave your job or retire, you can move your funds or take a taxable distribution. However, if you leave a company before you are fully vested, you will be allowed to take only the funds that you contributed yourself plus any vested funds, as well as any earnings that have accumulated on those contributions.

Within certain limits, the funds in your 401(k) plan can be rolled over directly to your new employer's retirement plan without penalty. Alternatively, you can roll your funds directly to an individual retirement account (IRA) instead.

403(b) Plan

A 403(b) plan is a special tax-deferred retirement savings plan that is often referred to as a tax-sheltered annuity, a tax-deferred annuity, or a 403(b) annuity. It is similar to a 401(k), but only the employees of public school systems and 501(c)(3) organizations are eligible to participate in 403(b) plans.

Employees can fund their accounts with pre-tax contributions, and employers can also make contributions to employee accounts. Employer contributions can be fixed or discretionary. Eligible employees may elect to defer up to 100% of their salaries, as long as the amount does not exceed $15,500 (in 2007). A special "catch-up" contribution provision enables those who are 50 and older to save an additional $5,000. Total combined employer and employee contributions cannot exceed $45,000 (in 2007). Contribution limits are indexed annually for inflation.

Employees have the option of choosing the types of investments utilized in their funds. A 403(b) can be an annuity contract, a custodial account, or a retirement income account. It is a good idea to do a little research before selecting how you would like to invest your funds. Your employer can provide you with a list of the investments that are available.

Distributions from 403(b) plans are taxed as ordinary income and, if made before the age of 59½, may be subject to a 10% federal income tax penalty unless a qualifying event occurs, such as death or disability.

As with other retirement plans, once you reach age 70½, you must begin taking annual required minimum distributions. You can receive regular periodic distributions on a schedule that is calculated based on your life expectancy, or you can collect your entire investment as a lump sum.

Participating in a 403(b) plan may be a good way to save for retirement. Contact your employer to find out what type of plan is offered and how you can take advantage of this retirement funding vehicle.

IRA Plans

Individual retirement accounts are available to virtually any wage earner at any salary. They are funded completely by individual contributions. IRAs are usually held in an account with a bank, brokerage firm, insurance company, mutual fund company, credit union, or savings association. They provide either a lump-sum payment or periodic withdrawals upon retirement. There are two basic types of IRAs: traditional and Roth. Contributions to traditional IRAs may be tax deductible and are taxed upon withdrawal, whereas contributions to Roth IRAs are not tax deductible but qualified withdrawals are tax-free.

Traditional IRA

Traditional individual retirement accounts (IRAs) can be a good way to save for retirement. If you do not participate in an employer-sponsored retirement plan or would like to supplement that plan, then a traditional IRA could work for you.

A traditional IRA is simply a tax-deferred savings account that is set up through an investment institution and has several investing options. For instance, an IRA can include stocks, bonds, mutual funds, cash equivalents, real estate, and other investment vehicles.

One of the benefits of a traditional IRA is the potential for tax-deductible contributions. In 2007, you may be eligible to make a tax-deductible contribution of up to $4,000 ($5,000 if you are 50 or older). The regular contribution limit increases to $5,000 in 2008 ($6,000 for those 50 and older) and will be indexed for inflation in future years.

You can contribute directly to a traditional IRA or you can transfer assets directly from another type of qualified plan, such as a SEP or a SIMPLE IRA. Rollovers may also be made from a qualified employer-sponsored plan, such as a 401(k) or 403(b), after you change jobs or retire.

Not everyone contributing to a traditional IRA is eligible for a tax deduction. If you are an active participant in a qualified workplace retirement plan — such as a 401(k) or a simplified employee pension plan — your IRA deduction may be reduced or eliminated, based on your income.

Roth IRA

Roth IRAs are tax-favored financial vehicles that enable investors to save money for retirement. They differ from traditional IRAs in that taxpayers cannot deduct contributions made to a Roth. However, qualified Roth IRA distributions in retirement are free of federal income tax and aren't included in a taxpayer's gross income. That can be advantageous, especially if the account owner is in a higher tax bracket in retirement or taxes are higher in the future.

A Roth IRA is subject to the same contribution limits as a traditional IRA ($4,000 in 2007 and $5,000 in 2008). Special "catch-up" contributions enable those nearing retirement (age 50 and older) to save at an accelerated rate by contributing $1,000 more than the regular annual limits.

Another way in which Roth IRAs can be advantageous is that investors can contribute to a Roth after age 70½ as long as they have earned income, and they don't have to begin taking mandatory distributions due to age, as they do with traditional IRAs.

Roth IRA withdrawals of contributions (not earnings) can be made at any time and for any reason; they are tax-free and not subject to the 10% federal income tax penalty for early withdrawals. After a minimum five-year holding period but before age 59½, tax-free and penalty-free withdrawals of earnings can be made due to a qualifying event, such as death or disability or to purchase a first home (up to a $10,000 lifetime cap).

Although college expenses are not a qualifying event, Roth IRA account owners can withdraw earnings penalty-free for qualifying higher-education expenses (for the account owner, a spouse, a child, or a grandchild). However, these withdrawals would be subject to ordinary income tax.

To qualify for a tax-free and penalty-free withdrawal of earnings in retirement (after age 59½), a Roth IRA must have been in place for at least five tax years.

Keep in mind that even though qualified Roth IRA distributions are free of federal income tax, they may be subject to state and/or local income taxes. Eligibility to contribute to a Roth IRA phases out for taxpayers with higher incomes.

If you're looking for a retirement savings vehicle with some distinct tax advantages, the Roth IRA could be appropriate for you.

SEP IRA

A simplified employee pension plan (SEP) is a deferred-compensation arrangement that is similar to a profit-sharing plan. It can be set up by employers and self-employed individuals, as well as sole proprietorships and partnerships. Employers receive tax deductions for plan contributions made to employees' accounts, and employees do not pay taxes on SEP contributions until they begin taking distributions in retirement. Thus, SEPs can be attractive to both the employer and the employee.

Companies that institute SEPs agree to contribute on a nondiscriminatory basis to IRAs maintained by employees. Employers are required to provide benefits to all employees who are eligible. Employees are eligible if they are at least 21 years old, earn at least $500 each year (indexed for inflation), and have been employed by the company for three out of the five years prior to the year for which the contribution is being made. Employers also have the option of selecting eligibility requirements that are less restrictive, but they must be applied to every employee.

Employer contributions are limited to the lesser of $45,000 or 25% of an employee's compensation (in 2007). Contributions are made on a discretionary basis, which means that the employer can decide each year whether or not to contribute, as well as how much to contribute.

SEP contributions are made to separate IRAs for eligible employees. Employees are responsible for setting up their own traditional IRAs to receive employer contributions, which are immediately 100% vested, and employees direct their own account investments.

When participants start taking distributions from a SEP IRA, the rules are essentially the same as those for a traditional IRA. Distributions are taxed as ordinary income and cannot be taken before the age of 59½ without incurring a 10% federal income tax penalty, except in the case of extenuating circumstances. [For example, penalty-free distributions are allowed if an individual is unemployed, buying a first-time home ($10,000 lifetime max), or cannot pay medical expenses.] SEP IRA account owners must begin taking minimum distributions after reaching age 70½.

If you are a small-business owner or are self-employed, a SEP IRA may be a good option for you, because contributions may be tax deductible and this type of plan is easy to establish and administer. If you are an employee of a company that offers a SEP IRA, you can benefit by the potential to receive employer-paid contributions. If you are a business owner, always make sure to discuss your retirement plan options with a financial professional before deciding on a method.

SIMPLE IRA

There are many types of employer-sponsored retirement plans. One that may appeal to small businesses and to self-employed individuals is the savings incentive match plan for employees of small employers (SIMPLE) because, as the name implies, it is easy to set up and administer, and employers are allowed to take a tax deduction for the contributions that are made.

SIMPLEs can be established by small businesses that have 100 or fewer employees (who were paid at least $5,000 or more in compensation during the previous year) and do not maintain other retirement plans. They can be structured as an IRA for each eligible individual or as part of a qualified cash or deferred arrangement such as a 401(k) plan. Typically, they are structured as SIMPLE IRAs.

Eligible employees (those who earned at least $5,000 in the preceding year) can make pre-tax contributions to their plans each year. Participants may contribute 100% of their salaries up to $10,500 in 2007. Those who are 50 or older during the year can elect to make $2,500 catch-up contributions. These amounts are indexed annually for inflation.

Administrators of SIMPLE IRAs are required to make either matching contributions equal to employee contributions (up to 3% of employee salaries) or nonelective contributions, which set a flat 2% contribution rate for all eligible employees. Employees are immediately 100% vested in contributions made by the employer, and they direct their own investments.

Distribution rules are similar to most IRA plans. Withdrawals are taxed as ordinary income and are also subject to a 10% federal income tax penalty if withdrawn prior age 59½, unless there are extenuating circumstances as outlined by the IRS. Required minimum distributions also must begin after the participant reaches age 70½.

An additional rule for SIMPLE plans is that there is a two-year waiting period after the date when an employee enrolls in the plan to transfer contributions to another IRA on a tax-deferred basis. Any withdrawals taken during the first two years of an employee's participation in the plan are subject to a 25% tax penalty in addition to ordinary income taxes. After the first two years, early withdrawals are generally subject to the 10% early-withdrawal penalty prior to age 59½. Of course, the IRS sometimes allows exceptions under special circumstances.

SIMPLE IRAs may be a good choice for small-business owners because the responsibility for funding the plan is shared between the employer and the employee. The start-up and maintenance costs also may be lower than for other qualified plans. If you are considering whether to establish a retirement plan for your business, you may want to make it SIMPLE.

© 2007 Emerald Publications