2000 Tax Guide: Long-Term Savings

Table 5-1 showed the benefits of deferring income over long periods of time. Figure 6-1 below shows very simply the power of long-term deferral, comparing the first alternative (receiving income, paying tax, and investing the after-tax proceeds for 10 years) with the second (deferring income, receiving credit for annual income on the whole amount, and paying tax at the end of the 10-year period). Even in this situation, in which the tax rates are the same in the current year and the future year, the benefit of deferral is substantial.

Qualified Retirement Plans: Most employees have the opportunity to participate in some form of qualified retirement plan, typically a pension, profit-sharing, or savings plan. Generally, a plan is "qualified" if it provides for participation in a nondiscriminatory manner and complies with certain restrictions. The restrictions are mainly limits on employer and employee contributions and distributions from the plans.

If you participate in a qualified retirement plan (or plans), you have a significant opportunity to help provide for your eventual retirement security and for the security of your survivors. Consequently, one very important aspect of your participation in a plan is designating a beneficiary to receive the proceeds of the plan when you die. This designation should be made only after you carefully review your overall estate plan to ensure the coordination of assets, including employee benefit plan balances. In general, you may want to designate your spouse, your children, other family members, your estate, and often a trust.

Defined Benefit Pension Plans: If you have a defined benefit pension plan, you are generally entitled to an annual pension when you retire. The benefits are typically based on a formula that considers your length of service with the employer, your age at retirement, your annual Social Security income, your preretirement earnings, the period over which you elect to take benefits (that is, your life expectancy), and whether you elect survivor benefits. Figure 6-2 below shows the most common distribution options available under most qualified plans. In some cases, you may be able to take a lump-sum distribution at retirement instead of taking annual amounts.

FIGURE 6-2
Common Distribution Options

Single Life. A monthly annuity will be paid to the retired employee for life. This is usually the basic form of benefit under a pension plan.
Joint and Survivor. A reduced monthly annuity will be paid to the retired employee for life, with a percentage of that reduced benefit paid to the surviving spouse or other beneficiary. The larger the continuing percentage, the smaller the initial benefit.
Term Certain. Based on a single life or joint life annuity, a reduced monthly annuity will be paid for life (or joint life), coupled with a guaranteed minimum payment period, such as five, 10, or 15 years.
Lump Sum. A single sum, rather than an annuity, will be paid to the retired employee. This amount is a present-value equivalent of the stream of otherwise available annuity payments in a pension plan or, in the case of a defined contribution plan, simply the balance accumulated in the retiree’s account at the time of distribution.

Defined Contribution Pension, Profit-Sharing, and Savings Plans: Many employer-provided savings plans permit the employee to elect to contribute a specified percentage or dollar amount of pretax income to a retirement savings account. Some of these plans also allow after-tax contributions.

Many employers (but not all) "match" employee contributions in cash or employer stock to augment employees’ accounts. Under the terms of many of these plans, you may have significant, or even total, responsibility for investing your contributions.

The importance of electing the maximum contribution amount to these savings plans cannot be overstated. Anytime you have the ability to contribute pretax (or post-tax) income to an account that will grow at a tax-deferred rate, you should do so unless you clearly cannot afford to do so.

To the extent your employer matches any portion of your contribution, it becomes even more important to contribute. Receiving an employer match is the same as receiving an annual increase in pay.

Keogh/Retirement Plans for Self-Employed Taxpayers: Keogh plans are the primary retirement savings opportunity for self-employed individuals. The maximum annual tax deduction for this type of plan is the lesser of $30,000 or 15 percent of net self-employment income (not in excess of $170,000). The percentage limitation may be increased to 25 percent by using a money purchase pension plan or a combination of both types of plans. Net self-employment income is your self-employment income reduced by 50 percent of the self-employment tax, as well as by the Keogh contribution itself.

Keogh plans can be established by all self-employed individuals. People who received compensation as company directors and other part-time self-employed consultants are also allowed to establish a Keogh plan with respect to that income, even if they are covered by an employer’s qualified retirement plan. Keep in mind that, if your self-employment income is derived from a business that has employees, the employees generally must be included in the plan.

Simplified Employee Pensions: Another alternative available to the self-employed individual, as well as to small employers, is a simplified employee pension (SEP). It is similar to an IRA with regard to distributions, but provides for contributions of 15 percent of net self-employed compensation, subject to some dollar limitations, in the case of an unincorporated individual. One advantage of a SEP over a Keogh plan is that it can be established any time, including extensions, before the related tax return is required to be filed. The Keogh plan, on the other hand, must be established before the end of the individual’s tax year, generally December 31.

Remember, the IRS dictates when you must begin taking payouts from qualified retirement plans and IRAs. Generally, distributions must start no later than April 1 of the year following the year in which you reach age 70½. IRS regulations dictate the dollar amounts of the distributions.

Nonqualified Retirement Plans: Generally, nonqualified plans are available only to more highly compensated employees. Nonqualified plans are not subject to the same tax and labor law restrictions as qualified plans, such as limitations regarding discrimination in contributions and distributions or funding requirements. However, since these plans generally either are not currently funded or are tied to the performance of employer stock, they can be much riskier than qualified plans.

Almost any plan designed to increase an employee’s retirement income or savings available for retirement can be considered a nonqualified retirement plan. These plans can be provided by an employer or established by an employee. Because these plans are nonqualified, employers who provide them do not receive any income tax deduction until the funds are actually paid to employees, and there is some risk that the funds will not be available to the employee at retirement. If you participate in this type of plan, you may want to consider this risk when determining your projected retirement income.

There may be less risk with employee-funded nonqualified retirement plans, but there is still generally some risk. For example, if you purchase a deferred annuity or a cash-value life insurance contract for tax-deferred growth, there is still some investment risk, as well as the risk that the company selling the product will not perform as expected.

Stock Option Plans: Stock options are often granted to executives as incentive compensation and to encourage and assist in the ownership of stock in the employer company. Stock appreciation rights (SARs) accomplish much the same results by rewarding executives with the increase in stock value, paid in cash or shares of stock or both.

These plans typically provide for the options/SARs to vest from one to five years following the date of grant and to expire, if unexercised, 10 years from the date of grant. Employee stock options generally are not taxable at the time of grant, but instead at the time of exercise and at the time of sale of the acquired stock.

Nonqualified stock options are subject to income tax at the time of exercise; the difference between the fair market value on the date of exercise and the grant price (the bargain element) is treated as additional compensation and taxed as ordinary income. Incentive stock options (ISOs) provide a major benefit because there is no ordinary income taxation at date of grant or date of exercise. However, the ISO bargain element is an adjustment for alternative minimum tax. You are allowed long-term capital gain treatment for the entire option gain (initial spread at exercise plus any subsequent appreciation) if you hold the stock for at least two years from the date of grant and at least one year from the date of exercise.