Overview of Government-Regulated Retirement Savings Plans
by Shane Flait (2010)

Over the years, the government has allowed a variety of tax-advantaged savings plans to come into existence so you can save for your retirement. This article overviews the types of plans you can choose from as an employee or as a business owner.

All these plans require you to contribute to them from working income. The main tax advantage offered by these plans is untaxed growth of their earnings. This increases their compounding rate compared to ‘taxable’ investments that lose part of their earning to taxes; so hopefully they’ll grow faster. But there are other tax-advantages that depend on the plan type you choose.

Whatever the tax-advantages are, you’re penalized from withdrawing your money from these plans before turning 59½ in keeping with the government’s incentive for you to save for retirement. There are some exceptions to this but that’s not the concern here.

The questions you need to answer are:

·         What are the advantages and disadvantages of each plan?

·         What do I have to do to participate in the plan?

·         How much can I contribute?

To sift out these answers, I’ll characterize and discuss the plans as:

·         Before-tax vs after- tax contribution plans

·         Defined benefit vs defined contribution plans

·         Personal (non-company) plans

·         Employee plans

·         Self-employed plans

Before-tax vs after-tax contribution plans

Before-tax contribution plans allow you to make tax-deductible contributions from your working income. These contributions will grow tax-deferred. When you eventually make withdrawals from your plan, you’ll pay income tax on everything you withdraw. After you turn 70½ you’re obligated to make required minimum distributions (RMDs) from the plan.

Tax-deductible contribution plans help you to contribute more to your plan. You’ll also get a break if your tax bracket for withdrawals is lower than when you contributed.

After-tax contribution plans are referred to a ‘Roth’ plans. You can only contribute with after-tax working income, so it’s harder to contribute to them. But earnings grow truly tax free (not just tax-deferred) and your withdrawals are tax free, too. No RMDs are due if you keep - or transfer- your plan money into your own Roth IRA.

Defined benefit vs defined contribution plans

The traditional company pension is on the wane. It guaranteed you a specific monthly pension payout – taxable as income - based on your last years’ salaries and the number of years you worked for the company. That’s a ‘defined’ benefit. Tax-deductible contributions were made to your pension only by your company and in an amount necessary to guarantee the defined benefit. 

If you’re self-employed, you can set up a Keogh plan which is a defined benefit plan for yourself. Since your contributing to achieve a guaranteed ‘pension’ income, you’re allowed to make rather high tax-deductible annual contributions to the plan. You can save a lot this way in relatively few years – but you have to have a high business income to do so.

Defined contribution plans limit the contribution you can make to your plan each year.  And what you eventually accumulate in your plan depends on both the amount you contributed and its investment performance. Nothing’s guaranteed. Poor investment results can leave you with nothing.

Let’s see the company and noncompany plans to participate in. Company plans can offer employees matching contributions and sometimes profit sharings plans.

You can participate in a company plan as well as personal individual retirement account (IRA) (noncompany) plan, unless your income is too high for you to contribute to your own IRA.

Personal IRA plans are:

• Traditional IRA (a defined, before-tax contribution plan)
• Roth IRA (a defined, after-tax contribution plan)

The 2010 contribution limit is $5,000 ($6,000 if you’re over 50).

Typical employee plans are:

• 401(k) (a defined, before-tax contribution plan)
• 403(b) (a defined, before-tax contribution plan)
• 457 (a defined, before-tax contribution plan)
• 'Roth' Versions (after-tax contribution) of these.

The 2010 contribution limit is $16,500 ($22,000 if you’re over 50)

Especially advantageous about such plans is that your company may match your contribution into your plan at least to some percentage of your income.

Self-employed owner plans with or without employees are (2010 limits):

• SEP (or SEP IRA) – (profit sharing plan) contribute lesser of $49,000 or 20% of self-employment income.
• SIMPLE (or SIMPLE IRA OR SIMPLE 401(K)) (defined tax-deductible contribution, profit sharing) contribute to $11,500 ($14,000 if over 50)
• Sole 401(k) (defined, tax-deductible and profit sharing plan) contribute lesser of $49,000 or 20% of self-employment income, and up to $16,000 ($22,000 if over 50) of contribution)
• Keogh (Defined benefit plan/before-tax contribution) lesser of $195,000 or 100% of 3-yr average compensation)

Of course you need the business income to support the contributions. That’s the hard part. Now you can choose what’s best for you.

 

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com