Qualified Retirement Plans
For business owners, the funding of a qualified retirement plan is possibly the best deduction that exists. You get immediate tax savings benefits since the dollar amount funded can be written off against your other income. Also, any income made while in the retirement plan is not subject to current taxes, so the tax-deferral effect on the compounding of this money over the years can be quite significant compared to saving outside the retirement plan.
Unfortunately, the majority of small businesses do not take advantage of this tax saving opportunity. In fact, according to 1997 statistics from the US Census Bureau, only 29% of small businesses have any form of qualified retirement plan.
Profit Sharing
This is the most common type from a statistical standpoint. The contributions to the plan are based on a percentage of the profits of the business. You can set the profit percentage within allowable guidelines. If there are no profits for any given year, there are no retirement fund contributions. In fact, for most profit-sharing plans, even if there are profits, you can usually "elect out" of making retirement plan contributions anyhow. So this type of plan affords the small business owner more flexibility than most others. In effect, you can fund the plan or not in any given year at your discretion.
Money Purchase
With this plan, the contribution is a stated amount, or a stated formula amount that is not so discretionary as the profit sharing. It is not based on profits so much as it is on compensation or earnings. Therefore, retirement plan contributions must usually be made on a regular basis whenever any qualified earnings and compensation occur for the given year. In short, this type of plan locks you in much more so than the profit sharing plan.
Stock Bonus Plan
This is similar to a profit sharing plan except that company stock is used to fund the retirement plan instead of money. This option is primarily only available to corporations.
The Most Common Retirement Plans
Once you have established the kind of qualified plan-defined contribution vs defined benefit-you select the particular retirement plan vehicle to implement the plan. This choice depends in part on the type of business you have (unincorporated vs incorporated), and how complicated you elect the plan to be. Listed below is an overview of the three most commonly-used qualified retirement plan choices.
Keogh Plan
This is available to sole proprietorships (unincorporated businesses) and partnerships. Corporations cannot use a Keogh plan. You do not have to have employees to set this up. In the eyes of the IRS a sole proprietor is both an employer AND an employee, so the Keogh can be used whether or not you have employees.
Keogh Contribution Amounts
The amount you can contribute for each plan participant varies according to the type of plan-defined contribution vs defined benefit. For a defined contribution (the most common type) the maximum amount per year you can fund is $42,000 (2005). This is subject to further limitations depending on if the plan is a profit sharing or money purchase and depending on the compensation/net earnings for the year.
A profit sharing Keogh allows for a maximum of 25%(before adjustments) of up to $210,000 in compensation adjusted for inflation. A money purchase allows for a maximum contribution of 25% of up to $210,000 in compensation.
A defined benefit plan may allow for higher retirement plan contributions depending on the actuarial calculations set forth within the plan and the other customized features. However, the contribution is usually limited to a calculation based on a maximum defined benefit of $170,000 per year, adjusted for inflation.
A Keogh plan usually requires an annual filing of the details of the plan and its activities with the IRS. This is a 5500 series filing, and it can be quite simple or quite complex depending on the type of plan, and the participants covered.
SEP. Simplified Employee
As the name indicates, this is a simpler plan than the Keogh in several ways. First, it is usually simpler to set-up. Second, you do not have to file complicated annual IRS returns similar to the 5500 return required for a Keogh. In addition, a SEP is available for corporations as well as unincorporated businesses.
The drawbacks to this plan center around three main issues compared to a Keogh: The SEP has a more limited allowable contribution amount per employee; it has stricter rules on which employees can be excluded from the plan, and how much must be contributed on behalf of the qualifying ones; and, certain lump-sum income tax averaging methods are not available like they are in a Keogh. Like the Keogh, you contribute a percentage of the net compensation/earnings from the business on behalf of each participant. In this case, however, the maximum amount you can contribute is limited to the smaller of either 25%(before adjustments) of the employee compensation/earnings amount or $42,000. Like the Keogh, this compensation amount is further limited to a maximum of approximately $210,000 per year. Similar to a Keogh profit sharing plan, employer contributions are not required each year; they can be at the discretion of the business owner. So this gives some flexibility from a cash flow standpoint.
401(k) Plans
A 401(k) is designed to be a tax-deferred investment vehicle specifically for retirement. Once the money is in your 401(k), you generally cannot make a withdrawal prior to age 59½ unless certain conditions are met, such as retirement, death, disability or separation from service. You may, however, have limited access to these amounts before retirement. Just like an IRA, ordinary income taxes are generally due upon withdrawal. Taxable withdrawals prior to age 59½ may be subject to a 10% tax penalty. Some plans allow you to borrow against your 401(k) money, but repayment must be made within a set amount of time or the amounts are considered withdrawn and the tax liability kicks in. If certain "hardship" criteria are met-such as withdrawals for medical emergencies or college tuition-you may be able to withdraw monies, but you still have to pay taxes on the money withdrawn and a 10% tax penalty may apply prior to age 59½. To be sure you understand the consequences, talk to your employer's 401(k) plan advisor and your tax consultant before you make any withdrawals.
SIMPLE 401(k) Plans
A SIMPLE 401(k) is a mechanism for employers with no more than 100 employees, earning at least the amounts shown in the SIMPLE plan chart for the preceding year, to provide a tax-deferred retirement savings vehicle to their employees. If eligible you can contribute annually up to the amount shown in the SIMPLE plans chart to a SIMPLE 401(k) and your employer generally must match contributions up to certain levels. SIMPLE 401(k) plans generally are not subject to non-discrimination tests or top-heavy rules but are subject to other qualification rules of a 401(k) plan.
403(b) Plans
Somewhat similar to the 401(k), the 403(b) is a tax-deferred retirement program that can only be established for employees of public education systems and certain other not-for-profit hospitals and charitable organizations.
Deferred Annuities
Fixed Annuities, Variable Annuities, Equity Index Annuities.
Traditional IRAs
IRAs were established by the federal government to encourage people to save for retirement. Generally you can contribute in the aggregate the lesser of the amount in the IRA chart below or 100% of compensation per year into a traditional IRA
| Year | Contribution Amount |
|---|---|
| 2002 | $3000 |
| 2004 | $3000 |
| 2005 | $4000 |
| 2006 | $4000 |
| 2007 | $4000 |
| 2008 | $5000 |
| Limit to be indexed for inflation in $500 increments beginning in calendar years after 2008. | |
Individuals age 50 and over are also permitted to make additional "catch-up" contributions. The additional contribution is $500 for 2002 through 2005 and $1,000 in 2006 and beyond.
A full deduction is allowed for incomes at or below the first of the two numbers shown on the chart. No deduction is allowed for incomes at or above the second number shown. In the range between the numbers, the maximum deductible amount phases out. If you are covered by a qualified retirement plan but your spouse isn't, your spouse is governed by different AGI limits (more about this later). Keep in mind that these income levels are subject to change. Check with your tax advisor to be sure you have the most current information.
| Year | Joint Returns(AGI) | Single Returns(AGI) |
|---|---|---|
| 2002 | $54,000-64,000 | $34,000-44,000 |
| 2003 | $60,000-70,000 | $40,000-50,000 |
| 2004 | $65,000-75,000 | $45,000-55,000 |
| 2005 | $70,000-80,000 | $50,000-60,000 |
| 2006 | $75,000-85,000 | $50,000-60,000 |
| 2007+ | $80,000-100,000 | $50,000-60,000 |
Generally, traditional IRAs require that ordinary income taxes are due upon withdrawal (except for the return of non-deductible contributions). There may also be penalties for taxable withdrawals before age 59½. Two exceptions to the 10% penalty tax include: qualifying educational expenses and up to $10,000 used for the purchase of a first home. Traditional IRAs require withdrawals to begin by April 1 after turning age 70½, or the taxpayer faces additional penalties.
Roth IRAs
Generally, you can contribute up to the amount in the IRA chart per year to a Roth IRA if you have earned income of amounts shown or more and your adjusted gross income does not exceed $150,000 for joint filers or $95,000 for single filers (contributions are phased out between $150,000-$160,000 for joint filers and $95,000-$110,000 for single filers). Any contribution made to a traditional IRA by the same taxpayer reduces the dollar amount permitted per year available for a Roth IRA contribution, dollar-for-dollar.
The tax appeal of Roth IRAs is the opportunity to receive tax-free earnings, provided the withdrawal of earnings is five taxable years after establishing the Roth IRA and the withdrawal is made:
Distributions of Roth IRA earnings that do not meet both of these tests are taxable and may be subject to a 10% penalty if under age 59½. Unlike traditional IRAs, Roth IRAs allow contributions to continue beyond age 70½ and pre-death minimum distributions are not required while you are alive. Rollovers from one Roth IRA to another are allowed once per year. You can convert your traditional IRA to a Roth IRA if your modified adjusted gross income does not exceed $100,000. Please note: This option is not available to married taxpayers who file separately. The amount rolled over from your traditional IRA (excluding non-deductible contributions) will be included in income. Withdrawals prior to age 59½ of taxable converted amounts, within five taxable years from such conversion, will (unless you meet an exemption) be subject to the 10% premature penalty tax.
Spousal IRAs
The non-active participant spouse of a person covered by a qualified retirement plan may be able to deduct his or her contribution, if the combined taxpayers' adjusted gross income does not exceed $150,000. The deductibility of contributions is phased out if their combined adjusted gross income is between $150,000 and $160,000 (at or under $150,000 fully deductible, at or over $160,000 nothing is deductible). The working spouse generally may make eligible contributions to an IRA for the non-working spouse if they have compensation at least equal to their contribution, if they file a joint tax return for the year, and the amount of the non-working spouse's compensation, if any, includable in gross income is less than that of the working spouse. If both spouses have IRAs, the IRAs generally must be separate. The working spouse can generally deduct a maximum of the amounts shown in the IRA chart a year for a cash contribution to the traditional IRA of the non-working spouse. Although the deduction for each spouse is calculated separately, a married couple may be able to deduct up to twice the amount allowed.
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