A common message from financial planners, to young and old alike, is that to achieve a financially comfortable retirement, one must systematically save and invest throughout one's career by taking full advantage of available defined-contribution qualified retirement plans. Investing through such plans is important today, because relatively few workers can rely on receiving benefits from a traditional defined-benefit pension plan on reaching retirement. In addition, no one should rely on Social Security as the sole means of providing a financially secure retirement. 

 

 

A plethora of account-balance-type retirement plans is available under the tax law. These plans can be used to accumulate retirement assets to provide beneficial tax treatment for individuals.

 

Potential tax benefits include:

Participation in multiple types of retirement plans can maximize accumulated wealth. For example, a college professor who also operates a consulting practice may be able to participate in a defined-benefit plan of the employer, a Sec. 403(b) or 457 plan, a Keogh plan and/or a traditional IRA.

 

Also, financially astute taxpayers will likely save a portion of their disposable income in taxable investments outside of qualified retirement plans. These funds can be accessed without the restrictions that apply to most such plans; many taxable investments are eligible for the favorable rates on capital gains and qualified dividends.

 

 

These plans are commonly available to employees and self-employed individuals.

 

Money-purchase plan: One type of defined-contribution plan, sometimes referred to as a money-purchase plan, allows for regular contributions (flat-dollar or formula-based) to an account maintained for the participant. Contributions may be made by the employer and/or employee.

 

Pension, profit-sharing and cash-match plans under Sec. 401(a): These plans provide for contribution of a stated or formula-based amount to an account for the employee's benefit. Contributions may be made by the employer, the employee or both. Employee contributions may be voluntary or mandatory. Distributions must begin by the later of age 70½ or retirement, except in the case of certain business owners. "Late" distributions are those that begin (1) after the time required by statute or (2) on a timely basis, but the amount distributed is less than the amount required by statute. (In this article, "later of age 70½ or retirement" means the Sec. 401(a)(9)(C)(i) requirement that the distribution begin by April 1 of the calendar year following the later of the calendar year in which the employee (1) attains age 70½ or (2) retires.)
 
Sec. 401(k) plan: This is a plan (sometimes referred to as a cash or deferred arrangement) in which employees of private employers have the option to set aside a portion of current compensation in a qualified retirement plan. Neither the portion of the salary deposited in the Sec. 401(k) plan, nor the earnings generated on the deposits, is taxed to the employee until withdrawn. In many Sec. 401(k) plans, the employer will "match" the employee's contributions up to a certain percentage of salary. Like other retirement plans, access to the accumulated balance is restricted during the account owner's career; required minimum distributions (RMDs) generally must begin by the later of age 70½ or retirement, under Sec. 401(a)(9)(C)(i).

 

Sec. 457 plan: This is a deferred-compensation plan established for the benefit of government employees. Such plans are maintained by a state, a political subdivision of a state, or an agency or instrumentality of a state. Sec. 457 plans are also available to employees of certain nongovernmental organizations exempt from tax under Sec. 501 (e.g., trade associations, private hospitals, labor unions). Under Sec. 402(g)(1), the 2007 contribution limit is the same as that for Sec. 403(b) plans. Distributions must begin by the later of age 70½ or retirement.

 

 

The plans are commonly available to individuals with self-employment (SE) income.

 

Keogh plan: Such plans are commonly used by sole proprietors and partners to defer current taxation of income from their trade or business activities and by employees who also generate earned income from SE activities (e.g., a member of a corporate board of directors). Under Sec. 415(c)(1) and (d), the contribution limit for 2007 is the smaller of SE income or $45,000. Distributions must begin by the later of age 70½ or retirement, except in certain cases of benefits held for owners.

 

SEP plan: A simplified employee pension (SEP) is a type of IRA used by small businesses (sometimes referred to as a SEP/IRA). These accounts are similar to Keogh plans in that they accept retirement savings from nonemployee income, but generally are not subject to as many restrictions and offer greater flexibility. The maximum 2007 employer contribution for an employee is the lesser of $45,000 or 25 percent of the employee's earned income. Elective deferrals by an employee are limited to the lesser of earned income or $15,500 for 2007. However, under Sec. 408(k)(6), starting in 1997, elective deferrals by an employee are permitted only if the employer plan was established before that year. Distributions must begin by the later of age 70½ or retirement.

 

 

Other commonly encountered retirement plans include:

 

Traditional IRA: IRAs are available primarily to individuals who receive earned income. They are designed primarily to benefit employees who do not qualify to participate in an employer's qualified plan or who work for an employer that does not provide one. In addition, anyone generating compensation income can contribute to a traditional IRA. Depending on the taxpayer's adjusted gross income (AGI), filing status and whether the taxpayer (or spouse) is an active participant in a qualified employer-sponsored retirement plan, the contributions may be deductible.
 
The annual deadline for making contributions to a traditional IRA is the return filing date (i.e., April 15th for a calendar-year taxpayer). The IRA must be established by that date.

 

Roth IRA: Like a traditional IRA, Roth IRA contributions are derived from compensation income (a spousal account option is also available). Contributions may be made depending on the taxpayer's AGI, filing status and whether contributions were made to traditional IRAs during the year.
 
Unlike a traditional IRA, contributions to a Roth IRA may continue beyond age 70½ as long as the taxpayer generates compensation income and is not barred by AGI limits. The income generated by these contributions will receive tax-free treatment. A retired taxpayer who is age 70½ or over may want to work part-time, so that he or she can continue to make Roth IRA contributions.

 

 

With the exception of Roth and nondeductible traditional IRAs, when withdrawals or distributions are made from qualified retirement accounts, the recipient must include the full proceeds (less basis created through after-tax contributions) in gross income at ordinary income rates. In addition, penalties may be levied if the distributions are "early" (usually defined as prior to the recipient reaching age 59½).

 

The penalty mechanism is at the heart of the government's attempt to discourage early withdrawals from retirement accounts, so that assets will be available during retirement. As discussed later in this article (under "Distributions after Age 59½"), reasons other than penalty avoidance could prompt a taxpayer to make withdrawals from taxable investments prior to taking assets from qualified retirement accounts. Nonetheless, after considering all relevant issues, the penalty could be avoided simply because a taxpayer's taxable accounts are sufficient to meet his or her cashflow requirements, thereby leaving qualified retirement accounts untouched.

 

Penalties may also be levied if distributions are "late," generally after the later of age 70½ or retirement.

 

Distributions Before Age 59½

 

In general, amounts invested in an employer's plan may not be accessible before the owner reaches age 59½, unless the employee terminates employment. Unless withdrawals are rolled over into another qualified plan, they are subject to ordinary income taxation. But, if an employee terminates employment and withdraws amounts from the qualified retirement account, they may be subject to penalty if they occur prior to age 55 or fail to meet the exception for substantially equal periodic payments made over a single or joint life expectancy under Sec. 72(t)(2)(A). Other qualified retirement accounts, such as IRAs, can be accessed at any time; however, if distributions are premature or early, the Sec. 72(t) penalty may apply. As a result, subject to the exceptions discussed below, 59½ is a critical age; distributions occurring before that age are generally subject to a 10 percent penalty under Sec. 72(t)(1). That penalty applies only to amounts included in gross income (i.e., it does not apply to distributions associated with a taxpayer's after-tax contributions, which are tax-free returns of capital).

 

Penalty exceptions: There are many exceptions to the 10 percent penalty on pre-age 59½ distributions from qualified retirement accounts. Most are narrowly defined and may not be readily available to the typical taxpayer. Nonetheless, many taxpayers may be able to structure their affairs to qualify.

 

Roth IRA: Roth IRAs, which are relatively new retirement savings vehicles, are funded with after-tax dollars. Thus, under Sec. 408A(d)(1), contributions can be withdrawn tax free at any time. Because the 10 percent penalty applies only to amounts includible in gross income, its reach is limited with respect to Roth IRAs. The penalty can have an effect, however, on certain distributions of earnings. If distributions are made in excess of amounts contributed, the amount in excess is deemed made from account earnings. Under Sec. 408A(d)(2)(B) and (d)(4), only nonqualified or early distributions from a Roth IRA are subject to tax (see below), and then only to the extent of earnings distributed. In such an instance, the earnings portion of the early distribution is included in gross income and is subject to the 10 percent penalty.

 

 

A late distribution from a qualified retirement is one that commences (1) after the time required by statute or (2) on a timely basis, but is less than the amount required by statute. To be a timely distribution, one of the following must be satisfied, under Sec. 401(a)(9)(A):

• An employee's entire interest will be distributed not later than the required beginning date.
  
  
  
• An employee's entire interest will be distributed, beginning not later than the required beginning date, in accordance with regulations, over the life of such employee or over the lives of such employee and a designated beneficiary (or over a period not extending beyond the life expectancy of such employee or the life expectancy of such employee and a designated beneficiary).

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