Why is this law so important?
Under legislation passed by Congress, the new law allows participants to contribute more dollars to virtually any retirement plan. Also, by contributing more money towards retirement, the law allows our money to grow tax-free. Plans such as the IRA and 401(k) are appealing because they allow for a 30-year delay on our tax bills. With the advantage of compound interest, money can be invested for long periods of time while deferring our tax liability until a later date. Using our intelligence to have our money work for us is a great tool towards a better retirement.
Individual Retirement Accounts (IRAs): For more than 20 years, the amount of money we have been allowed to contribute to an IRA has been limited to $2,000 per year. Accordingly, $38.46 per week would pay for a fully funded IRA; however, starting next year, an additional $19.23 per week can be saved to fully fund an IRA. I know it does not sound like much, but if you look behind the numbers, you may be surprised. If you invested the extra $19.23 each week over 20 years at a rate of 8%, one year’s extra contribution would equal $4,660.96. Granted, this will not make you rich overnight, but over the course of several years this adds up to a sizable chunk of change.
Most people understand what an Individual Retirement Account (IRA) is and how it operates as a retirement savings plan. But for those who do not understand this concept, an IRA is exactly what it says it is. These plans allow individuals to currently set aside up to $2,000 per year in an investment growing, tax-deferred account until the individual reaches the age of 59 1/2. In addition, these plans allow certain individuals to deduct all or a portion of their contributions to the IRA. An IRA applies to almost anyone who works (employed or self-employed) and is extremely easy to set up. The most common ways to launch an IRA are through a bank, mutual fund, or even a life insurance company.
A traditional IRA provides a triple-tax benefit. First, by contributing to a traditional IRA, the cash is invested and tax deferred until you are ready to start withdrawing. Second, the cash invested continues to grow tax-free pending your withdrawal schedule. Since each year’s growth will not be taxed, you will have more money working for you in the upcoming years. As a result, of next year’s growth not being taxed, more money will be working for you the following year. The effect of compounded interest can increase funds drastically into the hundred of thousands of dollars. Third, once you have reached the age to finally withdrawal from the fund, your income tax bracket may be less than your current rate, thus lowering the rate of tax on your investments.
Beginning in 2002, the new tax law has increased the cap on contributions to IRAs from $2,000 to $3,000. (This is the first increase to IRAs since it was introduced in 1975.) The law has also enabled those who are 50 years old and above to make additional contributions to “catch-up” to help invest more for retirement. The chart below shows the future increases in the upcoming years.
Recently, the IRS published temporary regulations 142499-01 that change the catch-up contribution levels. They are $500 in 2002; $1,000 in 2003; $1,500 in 2004; $2,000 in 2005; and $2,500 thereafter. It should be noted that these proposed regulations are temporary and may be amended until the final regulations are published.
A new feature will be available in 2003 and should make investments in IRA’s more convenient for all employees. Employers will be authorized to set up IRA-type of accounts for employees in addition to 401(k) plans. This new feature should add a lot of employees to those eligible to participate in IRA’s
To encourage employers who have less than 100 employees and are thinking about starting new retirement plans, the new law will issue a tax credit equal to 50% of start-up and administrative costs for the first three years of the plan’s operation. This usually adds up to a total credit of $500 annually. Although this credit sounds minimal, it represents about 50% to 75% of all set-up fees.
Roth IRAs: In contrast, the Roth IRA is similar, but the date of tax on your fund differs. The Roth contributions are not deductible. However, the withdrawals from the account, including the compound interest, are tax-free as long as the withdrawals are made for five years or more after the account is opened. This type of fund benefits those individuals who figure to be paying a higher tax bracket when withdrawals from the Roth occur. To qualify for a Roth you must not earn more than $95,000 (phased out at $110,000) in adjusted gross income if you are single or $150,000 (phased out at $160,000) of adjusted gross income for a couple.
Have we seen the last of the Keogh plans?
Another avenue in which an individual may chose to invest for retirement is a Keogh plan or a money purchase plan. Historically, these plans have been appealing to self-employed professionals (doctors, attorneys, and accountants) because such individuals may contribute a greater amount than most retirement saving plans. With a Keogh, you can shelter up to 25% of your self-employment income. Besides getting a current deduction for your contribution, all the money in the plan is allowed to grow and compound tax-free until you withdraw on it. There are primarily two different plans which self-employed professionals may choose from: profit-sharing plans and money-purchase plans.
Profit sharing plans permit a business owner to make annual contributions up to 15% of the earned income to each plan participant. The business owner may change the percentage of contributions each year, which allows the flexibility of making no contributions in certain years. In comparison, money purchase plans allow business owners to invest up to 25% of earned income for each participant each year. The benefit of this plan is that once a specific percentage is selected, then annual contributions must be made at that level each year.
In view of the above plan limits, an increasing number of companies have promoted a combination of the two plans. The reason being is that these plans provide maximum annual flexibility for contribution amounts, at the same time allowing the self-employed professional to defer the maximum amount of income. In other words, the hybrid plan does not require annual contributions up to 25% of earned income each year. Additionally, distributions from Keogh plans are taxed as ordinary income or in the same manner as distributions from any other qualified plan.
In some people’s opinion, the new tax law has done little in the area of self-employed plans. The law does raise the contributions limit for self-employed Keogh plans from $35,000 to $40,000. (If you keep the rate of inflation in mind, the new law has done virtually nothing.) However, while a lot of attention has been given to the increase in the individual contribution limits, little has been mentioned about the provision in the tax code that increases the combination of employer and employee contributions to all retirement plans to 25% of the total compensation. To some people, this could be the most important change in the new law Congress has made. As a result, self-employed professionals can obtain the same flexibility and maximum deferral with just the profit sharing plan, making combined Keogh plans obsolete in the future.
401k Plans: This contribution-matching plan between employer and employee has been greatly affected by the new law. As mentioned earlier, a bright spot concerning the new tax law lies in the ability to add more to retirement funds and the 401(k) plans are no exception. The new tax code has imposed new ceilings on the amount a participant is able to add to a 401(k) plan. The aftermath of the law has increased the amount of contribution to $11,000 in 2002, with increases of $1,000 each year until 2006. Even if you cannot contribute the maximum amount, it is foolish not to contribute what you can afford because in essence, it is like passing up free money. Furthermore, Congress has given individuals the power to play catch-up for not saving enough in the past. For those Americans 50 and over, they may contribute a maximum of $12,000 in 2002, $14,000 in 2003, $16,000 in 2004, $18,000 in 2005 and $20,000 in 2006 and later. The provision is equal for both men and women.
So what are the benefits of the 401(k) over the IRA you might ask: first, your reportable income is reduced by the amount of before-tax deductions placed in the fund. Second, the participant has the luxury of postponing tax on income that is invested in the 401(k) plan. Third, oftentimes employers are willing to match a portion of the employee’s contribution up to a specific percentage of salary.
For those who are interested in this type of plan, there is more! An employer may wish to adopt a safe-harbor 401(k) plan. Under this approach, the employer may choose between one of two plan strategies. First, those eligible employees may receive an employer contribution of 3% of compensation. The employer’s contribution is 100% vested. Every employee is then free to contribute as much as he/she can, up to the maximum amount by law.
Second, the employer matches dollar for dollar the first 3% of employee contributions, plus 50 cents for each dollar of employee contributions for the next 2% of salary. The employer’s contribution is 100% vested. Every employee is then free to contribute as much as he or she can, up to the maximum amount allowed by law. Another added benefit in the new law, allows employees changing jobs the ability to make rollovers between different types of employer plans or from a regular IRA to an employer plan.
Congress has also introduced a 401(k) that is very similar to a Roth IRA. Beginning in 2006, you will be able to open and start contributing to a Roth-type 401(k). Employees can elect to have the salary subject to tax when the contribution is made in exchange for the right to withdraw the money tax-free at retirement. As you know, currently contributions from your salary can be placed into a traditional 401(k) plan causing it to be exempt from tax until withdrawn. The new plan will result in tax-free withdrawals. This concept will assist those in low tax brackets now if they expect their tax bracket to increase upon retirement. It is anticipated that this plan will be very popular for young people beginning their work career.
After looking at what the new law brings to the proverbial retirement planning table, Congress has allowed Americans a much needed contribution increase in virtually all retirement accounts. In addition, the new changes in the distribution of qualified retirement plans and IRAs pose many opportunities. However, this is only true if we take advantage of what is available to us now because all of the new provisions are only valid until 2010. This is the date the law expires and we revert to the laws in effect on December 31, 2001.
A few things are important to remember when planning for your retirement:
- Take advantage of the new reforms in the tax law as soon as they become available.
- Look at all factors that equate to tax planning (age, projected annual earnings, and distributions needed during retirement).
- Most importantly, let your money work for you by deferral.
If you have any questions pertaining to retirement planning or any other financial matter contact Bart Basi at The Center for Financial, Legal & Tax Planning, Inc.; 108 E. DeYoung, Marion, Ill. 62959; 618-997-3436; fax 618-997-8370; www.taxplanning.com; e-mail: firstname.lastname@example.org.
(Next month: a look at the new retirement distribution rules.)