IRAs, pensions and other retirement savings vehicles

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1 from Personal Financial Services IRAs, pensions and other retirement savings vehicles February 27, 2014 In brief Qualified plans and IRAs are an essential part of retirement and tax planning for many individuals. A comprehensive and well-suited retirement vehicle can be one of the best ways to grow and preserve wealth while enjoying the benefits of tax-deferral and other incentives. But in order to get the greatest benefit from qualified plans and IRAs, you need to comply with the restrictions, requirements, and tax rules that apply in varying degrees to each retirement option. Below is a brief discussion of some of the retirement options available as well as some important issues to consider with respect to each one. In detail Plans for self-employed persons and small business owners Individuals who own their own business have a multitude of options available to them for setting aside funds for retirement, both for themselves and for their employees. The following discussion describes some of the most popular retirement plans. Depending on the circumstances, a small business owner may be considered an employee of their business within the context of these plans. Qualified plans Qualified plans, including defined benefit plans and defined contribution plans, are available to both large companies, and selfemployed individuals. These plans share many common characteristics, such as taxdeductible contributions by the employer and possibly the employee, tax-deferred growth of plan earnings, and distributions that are not required by the participant until April 1 st following the calendar year during which the participant reaches age 70 ½, or upon the participant s retirement in certain circumstances. Qualified plans typically allow for the largest taxdeductible contributions of all tax-advantaged plans, and qualified plans usually allow for more operating flexibility by the plan sponsor. Employers can adopt more than one qualified plan under certain circumstances, and in many cases employer contributions can vest over a period of time, rather than immediately. For these and other reasons, many business owners find qualified plans present greater benefits to both employers and their employees. However, all qualified plans must adhere to strict Internal Revenue Code and ERISA (Employee Retirement Income Security Act of 1974) requirements concerning participation in the plans, vesting, funding, nondiscrimination, disclosure, and fiduciary matters. Because of this, qualified plans are generally more expensive to administer than employer-sponsored IRA plans or nonqualified plans. Qualified defined benefit plans One category of qualified plans is the defined benefit plan, which is sometimes referred to as a pension plan.

2 The defined benefit plan guarantees the employee a specified level of benefits at retirement, typically expressed as some percentage of final average pay. Such plans are generally funded solely by the employer. Although their popularity has waned in recent years, defined benefit plans can still be attractive options for some business owners, or even sole proprietors. They allow a higher level of deductible contributions than most other types of plans, up to the required contribution amount established by the plan actuary. This required contribution amount is determined annually and is a function of the promised retirement benefit. The annual retirement benefit received by the employee can be as high as $210,000 (for 2014). Therefore, a defined benefit plan may be the right fit for older business owners seeking to maximize contributions made closer to retirement age. Defined benefit plans can be highly advantageous for business owners, but adopting such a plan is a significant decision. Defined benefit plans require an actuary to determine contribution amounts, as well as PBGC (Pension Benefit Guaranty Corporation) insurance, in addition to the requirements applicable to all qualified plans. Also, if the investments inside the defined benefit plan decline in value, the employer generally must make up any shortfall, which may place the employer in a difficult cash flow position. While they can present substantial benefits, the administrative complexities and responsibilities of defined benefit plans for employers require careful consideration. Qualified defined contribution plans Defined contribution plans have become the predominant type of employer-sponsored qualified retirement plan. There are many varieties of defined contribution plans, including profit sharing plans, stock bonus plans, employee stock ownership plans (ESOPs), and 401(k) plans. These plans offer business owners the ability to offer a taxdeferred retirement savings vehicle, while shifting the investment risk to the employee. Contributions to defined contribution plans are deductible to the employer, provided they do not exceed 25% of the compensation otherwise paid or accrued during the taxable year. Some defined contribution plans, referred to as 401(k) plans, allow for employee pre-tax or after-tax elective deferral contributions, up to $17,500 (for 2014), subject to an additional $5,500 if the employee is age 50 or older. The overall contribution to an employee s account, taking into account both employer contributions and employee elective deferrals, cannot exceed $52,000 per eligible employee (for 2014). As the name suggests, the amount of the employer contribution is the predetermined amount with respect to a defined contribution plan, rather than any set benefit obligation upon retirement. For this reason, defined contribution plans are typically less expensive to administer than a defined benefit plan. The most common type of defined contribution plan is a 401(k) plan. A 401(k) plan permits an employee to defer some of their current compensation into the plan, typically on a pre-tax basis. This feature of a 401(k) plan is referred to as a cashor-deferred arrangement. Because most 401(k) plans do not require employers to contribute to the plan in any given year, their funding costs can mitigate some of the administrative costs associated with qualified plans. Safe harbor 401(k) plans can be implemented in order to avoid the administrative complexities of certain discrimination testing of the plan. Employers can establish a safe harbor 401(k) plan by either making a specified matching contribution for all eligible employees or a non-elective contribution. Both the matching option and the non-elective option must be fully vested to the employee. Employees like these plans because of the combination of employer contributions with the added flexibility of electing to defer additional amounts at the employee s discretion. The ability to avoid certain aspects of discrimination testing through this alternative has made safe harbor plans extremely popular with business owners, even if the requirements mean they lose some employee retention leverage by virtue of immediate vesting. Roth 401(k) plans offer the employees the ability to fund the plan with aftertax dollars while gaining the benefit of tax-free withdrawals of earnings during the distribution phase of the plan. Self-employed business owners with no other employees may opt for individual 401(k) plans, which generally allow larger deductible contribution amounts than are available under Simplified Employee Pensions (SEP) or Savings Incentive Match Plan for Employees (SIMPLE) IRAs. Tax-advantaged plans Several tax-advantaged plans are also available to self-employed persons and small business owners. While these plans often do not have the same level of flexibility as qualified plans, they offer tax deferral and low cost administration to the employer. These tax-advantaged plans include SEP IRAs and SIMPLE IRAs. Simplified employee pension IRAs A SEP, or SEP IRA, is an employersponsored variant of an IRA, and this 2 pwc

3 plan may be a beneficial option for small business owners. A SEP allows employers to contribute money to individual IRA accounts for eligible employees, including themselves if self-employed. Contributions to a SEP are made by exclusively by the employer, and cannot exceed $52,000 (for 2014) to any one participant. Employers like SEPs because contributions are tax-deductible, subject to a limit of 25% of covered employees compensation (20% of self-employment income), and such contributions are not subject to employment taxes. Additionally, they are easy to establish and are not subject to the same compliance responsibilities as qualified plans. In fact, a SEP can be established after the employer s tax year end, up to the extended due date of the employer s tax return, unlike qualified plans. Employees like these plans due to their immediate vesting of benefits, the ability to withdraw amounts at any time, and the tax-deferred savings they offer. Amounts contributed to the SEP by the employer are excluded from the employee s taxable income. One drawback about SEPs is that employer contributions must generally be made in an equal percentage to all eligible employees. Eligible employees can potentially include part-time and seasonal workers, a requirement that many small business owners find incompatible with their workforce composition. Savings incentive match plan for employees IRAs A SIMPLE IRA, like a SEP, is established by an employer for the benefit of employees. SIMPLE IRAs allow employees to defer, on a pre-tax basis, up to $12,000 (for 2014) by contributing to an IRA. Employees age 50 and older may make an extra catch-up contribution of $2,500 (for 2014). An employer is required to either make matching contributions of up to 3% of the contributing employee s wages, or a non-elective fixed contribution of 2% for all employees. With a SIMPLE IRA, an employee can elect to defer up to 100% of their compensation (provided such amount does not exceed the dollar limit for the applicable year). This type of plan is generally limited to employers with no more than 100 employees. Employees like SIMPLE IRAs because they allow for elective deferrals, which can give them more control over their retirement savings amounts than SEPs. Employers like these plans because they are easier to administer than qualified plans, as they do not have the same testing requirements such as nondiscrimination, minimum participation, vesting, and top-heavy rules. However, the mandatory annual contribution requirement for SIMPLE IRAs means that such plans can be less financially flexible for an employer. Moreover, if an employer maintains a SIMPLE IRA plan, they cannot offer any other retirement plan (i.e., SEP, 401(k), etc.). Comparison For the following examples assume that all eligible employees are receiving proportionately equal contributions (i.e. all eligible employees equally receive 25% of compensation as a deductible employer contribution). In addition, it is assumed that all employees are under the age of 50. Example 1: Employee A earns $20,000 in 2014 SIMPLE IRA - A could elect to defer up to $12,000 in employee earnings tax-free. Additionally, A as employer would make either a matching contribution of up to $600 (100% of A s deferrals up to 3% of compensation) or a non-elective contribution of up to $400 (2% of A s compensation, regardless of whether A deferred any amount). SEP A would not be permitted to make a contribution, because SEPs are funded exclusively by the employer. A s employer would be able to contribute and deduct up to $5,000, or 25% of A s compensation. make a tax deductible contribution of up to $5,000 ($600 of which is required to be immediately vested). Additionally, A could elect to defer up to $15,000. Therefore, of the options described here, the 401(k) plan allows for the greatest tax deductible contribution. Example 2 Employee A earns $100,000 in 2014 SIMPLE IRA - Would limit A s elective deferral to $12,000, and either a $3,000 matching contribution or a $2,000 non-elective contribution. SEP - Would allow for a tax deductible employer contribution of $25,000 (25% of A s compensation). potentially make a tax deductible contribution of $25,000 ($3,000 of which is required to be immediately vested). Additionally, A could elect to defer up to $17,500 (for 2014), for a total of $42,500 in tax-free contributions to the 401(k) plan. Example 3: Employee A earns $250,000 in 2014 SIMPLE IRA - Would limit A s potential deferral to $12,000, combined with either a $7,500 3 pwc

4 matching contribution or a $5,000 non-elective contribution. SEP Would allow for tax deductible employer contribution of $52,000 (since 25% of A s compensation exceeds the $52,000 limit). potentially make a tax deductible contribution of $52,000 ($3,000 of which is required to be immediately vested). As is demonstrated by the preceding examples, the 401(k) plan offers tax free deferral of greater amounts than either of the IRA plans, due to the high employer contribution limit as well as employee elective deferrals, which can be significant in cases where one wishes to defer amounts in excess of 25% of compensation. Keep in mind, however, that if an employer is willing to take on the additional compliance responsibility, a defined benefit plan will likely present the greatest deductible contribution for the employer, as the deductible amount can be as high as the actuarially determined amount necessary to provide for a $210,000 annual retirement benefit. While IRA plans can be a great fit for some, the abovementioned restrictions limit their appeal for many business owners. Contributions to employer sponsored IRAs are generally limited to lesser amounts than are available under qualified plans, and plan loans to participants are prohibited. Additionally, because employer contributions to IRA plans vest immediately to their employees rather than over a period of time, they may adversely affect employee retention. For these and other reasons, many business owners turn to qualified retirement plan options for themselves and their employees. Plans for employees In addition to a retirement plan established by their employer, employees may potentially benefit from either a traditional or Roth IRA. Traditional IRAs Traditional IRAs are one of the simplest retirement planning vehicles to implement. An individual can contribute up to $5,500 (for 2014, $6,500 for individuals age 50 or older) to a traditional IRA, provided that such contribution does not exceed the individual s earned income, which does not include investment income such as interest and dividends. Contributions can be made until the year in which IRA owner reaches age 70 ½. Value within an IRA accumulates and grows tax-free until distribution, which normally commences between age 59 ½ and 70 ½. At distribution, all or a portion of the withdrawals are subject to tax, depending upon whether the contributions were tax-deductible. Roth IRAs Roth IRAs have similar dimensions to traditional IRAs, with the distinction that they are in all cases funded with after-tax dollars. Value in a Roth IRA accumulates and grows tax-free, but unlike its traditional counterpart, qualified distributions are wholly taxfree. There is no age limit on contributions to a Roth IRA, provided that such individual still has earned income out of which to make contributions. Additionally, amounts never have to be withdrawn during the Roth IRA owner s lifetime. The takeaway Choosing which retirement plan is right for your circumstances is an important decision with several considerations. The options discussed here represent many but not all of the retirement plan choices available, including certain nonqualified plans. No two circumstances are exactly alike, and different clients may find completely different retirement plan approaches to be their perfect fit. There are both benefits and limitations with respect to each plan regarding contribution limits, administrative requirements, and plan loans among others. These issues require thoughtful consideration, and our team of professionals is here to understand your situation and to make you aware of and appreciate your retirement plan options. 4 pwc

5 Let s talk For more information, please contact one of the individuals listed below, or your local PFS Contact: Personal Financial Services Brittney Saks (312) brittney.b.saks@us.pwc.com Bill Zatorski (973) william.zatorski@us.pwc.com Scott Wasserman (214) scott.a.wasserman@us.pwc.com 2014 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. SOLICITATION This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 5 pwc