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Retirement Planning — Which Vehicle Is Right For You?

It's been almost 2 months since I sent my last Woody's Goodies.  I've been struggling to find the right topic, and then I realized it was right in front of my eyes - Retirement Planning (my specialty).  With all the new tax law changes in effect, I have been inundated with questions on which retirement vehicle is right for what purpose.  Accordingly, I have summarized these thoughts.  Hope this helps with the massive tax law changes currently in effect.  Overall, they are very favorable.

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IRA:

Right For Who – (1) Taxpayers who are not “active participants” (defined as an employee in a DC plan if amounts are contributed or allocated to the employee’s account for the plan year); (2) Taxpayers expecting to be in a significantly lower margin tax bracket when funds are withdrawn; (3) Taxpayer who is close to retirement and needs to withdraw funds in a few years; (4) Those uncertain about the future should probably contribute to an IRA as this follows conventional financial planning wisdom because there is an immediate tax deductible benefit; and (5) Taxpayers who are active participants in a DC plan, and do not fall outside the income limitations.

Advantages:  Current year deduction, distributions may be taxed at a lower rate for those who anticipate a lower tax bracket after retirement, may be used for qualified college expenses (tuition,fees,books,supplies) without penalty.

Dis-Advantages:  Must qualify based on income levels for active participants, income taxes paid on distributions after retirement will offset some of the tax-free earnings, at age 70 ½ no loner able to make contributions.

Nondeductible IRA:

Right For Whom: - (1) Taxpayers who do not qualify for a regular IRA or ROTH IRA do to income limitations, and who want extra tax deferred earnings growth.

Advantages:  Not subject to income phase outs, earnings accumulate tax deferred, may be used for qualified college expenses without penalty.

Dis-Advantges:  No current tax deduction.

ROTH IRA:

Right For Who: - (1) Taxpayers who are “active participants” and exceed income limitations for a regular IRA, but do not exceed income limitations for a ROTH; (2) Taxpayers who do not exceed ROTH income limitations and are eligible to participate in a company sponsored plan should first do the $2,000 ROTH if the company does not match and the person has at least 10 years before they will need to touch the money; (3) Taxpayers who expect to be in a significantly higher tax bracket when distributions begin.

Advantages:  Tax free growth (the longer they have to grow the better – we say at least 10 years, No age requirements for when a taxpayer must start taking withdrawals or stop making contributions, Income phase out limits are higher, Accumulations of earnings in a ROTH IRA can be transferred to beneficiaries tax free (beneficiaries pay tax on inherited traditional IRAs, More flexibility regarding withdrawals because withdrawals are deemed to come from contributions first and then from earnings. Therefore, no income tax or 10% penalty applies to any withdrawal until withdrawals exceed total contributions, ROTH may be established for minor children who meet the compensation requirement (namely about $7,000).

Dis-Advantges:  Not currently tax deductible, must meet 5 year holding period rule before distribution can be “qualified” and not subject to 10% penalty for early withdrawal (this is only applies to earnings portion, as basis never subject to tax or penalty no matter when withdrawn).

SEP:

Right For Who: (1) Anyone who does not already have another qualified plan in place, and that has self-employment income, including freelance fees, earnings from child care or a hobby, and earnings as a general partner in a partnership; (2) A SEP should be used where the majority of money is going to be allocated to the primary owners of the company.  In other words, based on a pro-rata salary allocation, at least 70% of the employer contribution will go to the owners (means that there can’t be many employees); (3) a company that does not expect to have significant employee growth within the next 5 years should use A SEP.

Advantages: (1) Employer contributions are tax deductible and tax deferred for the participant; (2) Maximum contributions are higher than that of IRAs (note a SEP is considered a qualified plan ONLY for purposes of the IRA deductibility limitations); (3) Lump-sum distributions generally qualify for five or ten-year averaging; (4) No annual reporting requirements – easy to administer; (5) Can still make contributions after age 70 ½ (6) Accounts opened as individual accounts for participants, allowing them to make their own investment choices; (7) Easy to establish (IRS Form 5305-SEP).

Dis-Advantages: (1) No special allocation methods available to benefit owners; (2) Does not allow participants to have loans from plan; (3) Does not offer employee deferral provision (SARSEPS that were established before 1997 include this feature); (4) SEP contributions must be made to the account of an eligible employee, even if that person is not working for the employer at the end of the year; (5) There is no vesting in SEPs – all the money place in a participant’s account belongs to that person.

SIMPLE IRA and SIMPLE 401(K):

Right For Whom:  (1) In very rare circumstances do I think this plan works.  Here it is – if you have 100 or fewer employees, and you as the owner really have no desire to participate in your own retirement program.  Also, people with very high turn over that anticipate a low participation rate from their employees, but again, don’t wish to participate may consider this plan.

Advantages:  (1) The 401(K) Simple allows for loans; (2) Allows employees to defer $7,000 per year (if over age 50, $7,500); (3) No discrimination testing required – therefore easy to administrate; (3) Available for self-employed individuals.

Dis-Advantages:  (1) A 401(k) with a safe harbor provision accomplished the same thing, but with higher limits and has more discretionary flexibility; (2) There is a required dollar for dollar match up to 3%, or contribute 2% of wage of all eligible employees even if employee does not elect to participate; (3) Employer cannot have any other plans (this will prevent the owner from ever reaching the $40,000 limit available with other plan types); (4) The elective deferral limit is lower than that in a regular 401(k); (5) No vesting allowed, the participant is 100% vested immediately; (6) No discretion.  Employer must make the contribution each year.

Regular 401(K) with Discretionary Profit Sharing:

Right For Who:  (1) Companies that want tremendous flexibility in the options they offer in a retirement program to their employees; (2) Companies that desire to have owners reach their $40,000 limit; (3) Companies that wish to create employee longentivity by tying employer contributions to a vesting schedule; (4) Companies that wish to have professionals involved with the management of their retirement program; (5) Companies that need to offer flexible benefits in order to be competitive in the recruiting market place.

Advantages: (1) Employers are allowed to match employee contributions at any level they choose as long as such match is not discriminatory (meaning it doesn’t favor the owners in a discriminatory manor). This requires various testing for such determination; (2) Allows employer to contribute an additional discretionary profit sharing contribution; (3) Allows employees to defer up to $11,000 of their own pay thru payroll deductions – forcing a disciplined savings program; (4) Creates a “dollar cost averaging” vehicle; (5) Allows employees the ability to borrow from themselves; (6) Allows employer contributions to be subject to vesting up to 6 years before an employee is fully vested; (7) Contributions by employee are tax deferred; (8) Contributions by employer are tax deductible, and tax deferred to employee.

Dis-Advantages: (1) More complex to establish.  Requires the preparation of a plan document; (2) More complex to administer.  Requires the engagement of professionals to assist both with the investment management and administration of the plan to assure compliance with ERISA rules; (3) Requires the filing of an annual Form 5500.

401(K) Safe Harbor:

Right For Whom: All of the above applies wit the exception of eliminating the discrimination testing.  Furthermore, this is the perfect alternative to the SIMPLE plans. It is perfect for those employers who wish to max out their $11,000 deferral limit for the “highly compensated” owners, but are concerned that they may be limited because of lack of participation in a regular 401(K). The safe harbor plan requires a 100% up to 3%, and 50% on next 2% match or a 3% non-elective contribution to be made to each employee.  These contributions are 100% vested, and must be communicated to the employees 30 days prior to each plan year. If these safe harbor contributions are made, that the plan is not subject to discrimination testing, and the highly compensated employees can contribute their maximum m deferral limit of $11,000.

Advantages (all of the above with the addition of): (1) Eliminates the need for discrimination testing; (2) Allows the highly compensated employees to reach their $11,000 deferral limit irregardless of the participation level; (3) Higher limits than the SIMPLE plans; (4) Offers discretion in that if the employer fails to make the safe harbor contribution, then the plan simply reverts back to a regular 401(K) subject to testing.

Dis-Advantages: (All of the above wit the addition of): (1) The safe harbor contributions (if made) are 100% vested.

Cross Testing/New Comparability: (My personal favorite – for the right candidate)

Right For Whom:  This is simply a method of allocating the employer contribution.  It allows the key owners to receive a majority of company contribution by using an average benefits age weighted test.  It is perfect for companies such as Dr. groups, or other companies where the owners make on average significantly more than the employees, and as a group, are older.  It will allow the owners to easily reach their $40,000 per year limitation.

Advantages (All of the above applies with the addition of):  Allows the use of a more liberal testing method that accomplishes a $40,000 allocation to each of the owners.  Typically, if a 5% contribution is given to the non-owner employee group (subject to vesting), than the owners will be able to receive a $40,000 allocation (combination of their 401(k) deferral, match and profit sharing contribution).

Dis-Advantages (All of above applies with the addition of):  Requires a “volume submitter” plan document to be submitted to the IRS for approval. Typically, this cost is higher than using a regular prototype document because there is a $125 IRS filing fee, and the plan document preparation fee is usually higher.  Also requires a sophisticated plan administrator who knows how to perform the various ERISA testing required. 

NOTE:  This needs to be analyzed on a case-by-case basis.

1.  IF YOU ALREADY HAVE A PLAN, DON’T FORGET TO COMMUNICATE TO YOUR EMPLOYEES ABOUT THE NEW LOW INCOME CREDIT FOR RETIREMENT CONTRIBUTIONS – SEE PAGE 3 OF HANDOUT. (THE CREDIT CAN BE UP TO 50% OF A CONTRIBUTION ON THE FIRST $2,000 OF CONTRIBUTION).

2.  PAY YOUR CHILDREN SO THEY CAN CONTRIBUTE TO A ROTH.

3. HAVE 14 BUSINESS MEETINGS AT HOME.

4.  FREE SUBSCRIPTION TO WOODY’S GOODIES EMAIL NEWSLETTER CHOCH FULLOF CONSUMER TIPS, TAX TIPS AND FINANCIAL ADVICE YOU WON’T EASILY FIND ELSEWHERE.  SUBSCRIBE AT: WWW.YOURWEALTH.COM  (CLICK ON SUBSCRIBE TO WOODY’S GOODIES).

5.  ASK US FOR A FREE ANALYSIS FOR YOUR COMPANY’S RETIREMENT PROGRAM.

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By Woody Alpern

CPA and Registered Investment Advisor