Trieschmann, Hoyt & Sommer
Employee Benefits: Retirement Plans
Chapter 20
©2005, Thomson/South-Western
Chapter Objectives
• Describe the factors important in determining Social
Security retirement benefits and explain the implications of
the Social Security retirement test for retirees
• Differentiate between defined benefit and defined
contribution pension plans, and describe the cash balance
version of the defined benefit pension
• Explain the basic pension qualification rules regarding
eligibility, retirement ages, form of payment, maximum
benefits, maximum contributions, and vesting
• Explain the importance of actuarial cost assumptions
• Describe the nature and purpose of deferred profit-sharing
plans
• Distinguish between thrift plans and 401(k) plans and
explain the tax advantages associated with each of them
• Describe the special purposes for which SIMPLE, Keogh,
and 403(b) plans were designed
2
Introduction
• The traditional approach to retirement planning involves three
pieces
– Social Security
– Personal savings
– One or more employer-sponsored retirement plans
• Can be especially crucial element in individuals’ plans for dealing with their
loss of income upon leaving the workforce
• Numerous types of retirement income benefits can be provided to
employees
– Many employees offer more than one type of benefit
• Some benefits can be given to all employees
– Whereas others may be provided as options to supplement basic
retirement plans
• When combined with Social Security and supplemented with
personal savings
– Many retirement plans make it possible for individuals to maintain their
standard of living after their exit from the workforce
3
Social Security Retirement Benefits
• The level of retirement income that can be
expected from Social Security depends on many
factors including
– The age an individual elects to begin receiving benefits
– The number of years he or she worked in employment
subject to Social Security taxes
– The wages earned in such employment
• The age at which retirees can begin collecting
their full retirement benefit amounts has
historically been 65
– However, this age is gradually increasing and is
scheduled to reach 67 for those born in 1960 or later
– See Table 20-1
4
Table 20-1: Future Social Security
Normal Retirement Ages
5
Social Security Retirement Benefits
• Workers retiring at the Social Security normal retirement
age after a lifetime of full-time employment at salaries
equal to the OASDI wage base
– Can now expect to receive a benefit of approximately 25% of
what they earned just before retirement
• Workers with a lower earnings history can expect a
benefit that is relatively higher in relationship to prior
earnings
• Workers can retire earlier than their Social Security
normal retirement age
– But their benefits will be relatively lower than would otherwise be
the case
6
Relationship of Work History to
Benefit Amount
• Social Security retirement benefits are based on average
earnings in employment subject to Social Security taxes
• The period for computing average earnings begins with
the year 1950 (or the year in which an individual reaches
age 22, if later) and it ends in the year before the
individual’s attaining age 62
– The actual earnings during this period are adjusted for changes
and average wage levels
– The resulting figure is called the average indexed monthly
earnings (AIME)
• From this number is calculated the primary insurance amount (PIA)
on which all retirement benefits are based
– The formula for transforming the AIME into the PIA is intentionally
designed to weight lower earnings more than higher earnings
7
Benefits Payable to Retired
Workers
• The initial monthly Social Security benefits for a retired
worker equal that person’s PIA if he or she begins
receiving benefits at the Social Security normal
retirement age
• Many retirees elect to begin collecting benefits before
that age
– However, age 62 is the earliest age at which benefits may begin
• An actuarial reduction of 0.555% occurs in each of the
first 36 months that a worker retires “early”
– Plus an additional 0.4167% for each additional month early
– This reduced benefit will continue to be payable even after an
early retiree reaches the normal retirement age
• Benefits for workers who delay benefits until after the
normal retirement age are also adjusted
– Through increases for each month “late”
8
Benefits Payable to Retired
Workers
• It is also possible to receive Social Security retirement
benefits without totally exiting the workforce
– But limits are placed on how much younger retirees [those under
the Social Security normal retirement age] may earn before a
reduction in Social Security benefits is triggered
• Can earn up to $11,640 per year without penalty
• For earnings exceeding this limit, the worker’s Social Security
benefit is reduced by $1 for every $2 in wages
– Once retirees reach their Social Security normal retirement age,
they may earn an unlimited amount of income and still collect
Social Security benefits to which they’re entitled
• Only earned income is counted
– Funds received from investments, pensions, annuities, and
interest are not considered in applying the retirement test
9
Benefits Payable to Retired
Workers
• After an individual begins receiving
retirement benefits, those benefits are
automatically increased annually for
changes in the cost of living
– Measured by the Consumer Price Index for All
Urban Wage Earners and Clerical Workers
– As published by the U.S. Department of Labor
10
Benefits Payable to Spouses and
Children
• A retired worker’s spouse and dependent children may
be entitled to Social Security benefits based on the
worker’s earnings
• The benefit amount for a spouse who has attained the
normal retirement age is 50 percent of the worker’s PIA
• However, spouses can elect to collect as early as age 62
– At an actuarially reduced level or at any age if they’re caring for
children under age 16
• The spouse is not required to be financially dependent
on the retired worker in order to collect the benefit
– But spouses who have earned income are impacted by the
retirement test in the same manner as for retirees
11
Benefits Payable to Spouses and
Children
• An increasingly common situation is for both
husband and wife to be entitled to Social
Security retirement benefits on the basis of their
own earnings history
– The question arises as to whether such people are
still entitled to receive spouse’s benefits from Social
Security
– The basic rule governing these cases
• An individual is entitled to receive only the one Social
Security benefit that will pay the greatest monthly income
12
Benefits Payable to Spouses and
Children
• In some cases, children of retired workers
are young enough to be entitled to Social
Security benefits
– The child’s benefit is 50% of the worker’s PIA
– Eligibility is generally limited to unmarried
children under the age of 18
• Extended to 19 if a child is a full-time student in
elementary or high school
• Age limit is removed entirely for unmarried children
who become severely disabled before age 22 and
who continue in that condition
13
Taxation of Benefits
• Social Security retirement benefits are not
subject to federal income tax unless one’s
adjusted gross income exceeds certain
limits
– For example, if half of an individual’s Social
Security benefit + investment income exceeds
$25,000
• Then 1/2 of the Social Security benefit is taxable
14
Pension Plans
• An employer-sponsored arrangement
• Established with the primary goal of
systematically providing retirement income
for employees
15
Traditional Defined Benefit Pension
• A traditional defined benefit plan has a formula
for determining the monthly pension payments
during retirement
• Often, an employee’s salary history and number
of years of service are inputs for the formula
• It is up to the employer to make sure that
enough money has been set aside to fund the
promised pension at the level indicated by the
benefit formula
16
Defined Contribution Pension
• Employer’s annual contribution to the pension is specified
– The exact amount of eventual retirement benefit left undetermined
until each person retires
• Contributions will be invested during the employee’s
working career
• Pension amount will depend on level of yearly
contributions and on investment return earned on the
contributions
• Many employees favor these plans because it is easier to
budget the definite costs involved
• Many employees prefer knowing the value of their
accounts throughout their working years
– Also, employees who anticipate changing jobs several times in
their careers prefer these plans because accumulated amounts
are usually easily cashed out or rolled over to a new employer’s
plan
17
Cash Balance Pension
• Starting in the late 1990s, many large employers
with traditional defined benefit pension plans
begin converting them into cash balance
pension plans
• They are still technically considered to be
defined benefit plans for IRC purposes
– But they look like defined contribution pensions in
many ways
• In particular, employees with cash balance pension plans
have individual accounts that grow annually for both
employer contributions and investment earnings
18
Cash Balance Pension
• The cash balance plan is utilized to address
perceived problems with the other pension
structures
– Many employees find defined benefit pensions
difficult to understand
– Employees cannot see the dollar value of their
accounts in a traditional defined benefit arrangement
– Traditional defined benefit plans are most valuable to
employees working 30 or 35 years for same employer
• Most prevalent situation in today’s work environment is for an
employee to work for several employers over the course of
their careers
19
Cash Balance Pension
• Participants in a defined contribution plan may
be uncertain as to whether they will have
sufficient funds to provide themselves with an
adequate pension
• Investment earnings influence the ultimate size
of the defined contribution pension fund
– No guarantees can be made about how large this
fund will be at retirement
• Due to uncertainty about the performance of the securities
markets over many years
• This uncertainty is reduced with cash balance plans
– Due to the guaranteed minimum return
20
Plan Qualification
• Pension plans can be set up so that they are
qualified plans
– They meet the qualification rules in the Internal
Revenue Code for favorable tax status
• Employers sponsoring qualified pension plans can
deduct their contributions from current taxable income
• Employees do not have to report employer
contributions as taxable income before receiving
benefits
– At retirement, as pension income is received, it is considered
taxable to the extent that the income was funded by the
employer
21
Plan Qualification
• If a pension plan is contributory,
employees are not allowed to deduct their
contributions from taxable income
– But when benefits are received, a portion of
each pension benefit payment escapes
taxation until the total amount of the
employee’s contribution has been recovered
tax-free
22
Plan Qualification
• The qualification rules for pension plans were
established in 1974 by the landmark Employee
Retirement Income Security Act (ERISA)
– Many changes have occurred since the original
passage, with each new tax law making several
adjustments in the qualification rules
– Generally, the rules for pension plans are more
extensive than for other benefits due to
• The sizable dollar amounts involved
• The magnitude of the tax advantages granted
• The overall importance of pensions to individual risk
management plans
23
Eligibility
• Employers must establish eligibility standards for
participation in pension plans
• Employers do not have to use the same
eligibility rules as used for other benefit
programs
– Many employers have stricter eligibility requirements
for pension plan participation
• It is not unusual to exclude part-time personnel and those
working in specified job classifications
• Many employers also use both minimum age and minimum
service requirements
24
Eligibility
• Although employers are relatively free with
other benefits to establish whatever logical
eligibility requirements may be desired
– Their choices with respect to pensions are
more limited
– For example, the qualification rules prohibit
use of a minimum age requirement exceeding
age 21 or a minimum service requirement of
more than a year
25
Eligibility
• In establishing pension eligibility rules,
employers are particularly constrained by
qualification rules designed to eliminate
the favoring of very highly paid employees
– Generally they establish two categories of
workers
• Highly compensated
• Nonhighly compensated
– If participation is not sufficient in this group then the
pension plan may lose its qualified status
26
Retirement Ages
• All qualified pension plans specify a normal retirement
age
– The earliest age at which employees can retire and receive full
pension benefits
• Often, the normal retirement age is specified to be a
particular age
– Other times the normal retirement age is whatever age an
employee is when he or she completes a specified number of
years of service
• Many pension plans provide special early retirement
options
– Various age and service requirements usually exist before early
retirement benefits are payable
– The early pension benefit is usually at a reduced level to reflect
the increased cost to the plan of early retirement
27
Retirement Ages
• Unless the early retirement benefit is
reduced to its full actuarial equivalent
– A company will have to pay additional money
into the plan to pay for the increased costs
associated with early retirement
– By making appropriate assumptions about
interest and mortality rates
• Actuaries can compute the reduced early
retirement benefit that is mathematically equivalent
to the benefit payable at the plan’s normal
retirement age
28
Retirement Ages
• Retirement after the normal retirement age
is classified as late retirement
– Before 1986 many employers were able to
specify a mandatory retirement age of 70
years (or higher)
• All workers could be forced to retire if they had not
already done so
– However, a mandatory retirement age is now
prohibited for most jobs
• Thus, many pension plans experience instances in
which workers do not retire at the normal age
specified for the plan
29
Retirement Ages
• When a worker does not retire by the
normal retirement age
– A logical argument can be made for actuarial
increases for late retirement benefits
– Such increases are not required by law
• Hence, they are rarely granted by employers
• Benefit increases associated with late retirement
are primarily found in plans sponsored by
employers seeking to provide additional incentives
to encourage employees to continue working past
normal retirement age
30
Form of Payment
• Pensions are usually paid in some form of
annuity
• If an employee is married when pension benefits
begin
– The qualification rules specify that the benefit will be a
joint and survivor annuity in which the survivor’s
portion is at least 50% of the joint portion
• However, employees can select a different form of payment
under various circumstances
– For example, if the employee’s spouse agrees in writing, the
joint and survivor pension can be waived in favor of a single life
annuity paying a greater monthly benefit
31
Form of Payment
• Sometimes employers offer an additional
option
– An employee reaching retirement age can
elect to receive some or all of the promised
pension immediately
• Known as a lump-sum distribution option
• Most commonly provided in defined contribution
pensions
– Because the dollar value of the employee’s pension
account is easily determinable at the time of retirement
32
Form of Payment
• Employees who are offered the lump-sum
distribution options should carefully
analyze several factors before accepting
– The possibility exists that you may outlive
your income if you take the lump sum
– Income taxes
33
Benefit and Contribution Limits
• By law, the annual defined benefit pension for newly
retiring individuals is limited to a specified dollar amount
that is adjusted each year as average wages increase
• For defined contribution plans, the yearly contribution to
the plan is limited, not the annual pension
– Currently, annual contributions are limited to the lesser of 100% of
that person’s salary or $41,000
• Also, only the first $205,000 in earnings can be considered
in either the benefit or contribution formula
– The significance of these limits is primarily important for highly paid
employees
34
Inflation Protection
• When pension benefits or contributions are a function of salary,
some inflation protection before retirement is automatically built into
the plan
• But once a person retires the situation is often different
• The Social Security portion of a worker’s retirement income is
subject to annual adjustments for inflation
• But most employer sponsored plans are not protected from inflation
once the pension payments have begun
– Resulting in severe erosion of the retiree’s purchasing power overtime
• See Table 20-2
• To counteract inflation impacts, some employers make periodic
adjustments in pensions paid
– So that retirees receive the same or similar increases as awarded to
active workers
• Other employers make annual adjustments to correspond to
changes in the cost of living
– Usually with some annual limit
35
Table 20-2: Effect of Inflation on
Retirement Income
36
Permitted Disparity
• The benefit or the contribution in a pension plan may be affected by
Social Security
• Once called Social Security integration but now known in federal tax
law as permitted disparity
– This concept can be incorporated into a pension plan to allow the
employer to “take credit” for the Social Security taxes paid on behalf of
employees
• Employers pay half of the total Social Security tax for their
employees
– However, no taxes are paid for earnings above an established level
– Also, at retirement, Social Security benefits restore a larger proportion
of the wages of lower-paid workers than of higher-paid workers
• These factors form the basis for the rationale of allowing pension plans to be
more generous to higher-income employees
• The combined retirement benefit from Social Security and the private
pension replaces approximately the same percentage of pre-retirement
income for everyone
– For lower-paid workers, a proportionately greater share of the total will be from
Social Security
37
Vesting
• The degree to which a plan participant’s pension rights
are nonforfeitable is called vesting
– Regardless of whether the employee continues working for a
particular employer
• The vesting provisions in a pension plan are relevant
only for the contributions or benefits associated with the
employer’s contributions
– The employee’s contributions are always fully refundable with
interest when terminating inclement
• The most common vesting provision is to have full
vesting take place after five years
– Also known as the five-year cliff vesting
– Prior to that time, workers who terminate employment are not
vested at all and have no pension rights under the plan
38
Vesting
• Overtime, the laws governing vesting have
been modified several times
– Making it possible for more employees to
achieve full vested pension rights much more
quickly than was often the case in the past
• This fact, and the probability that many employees
will change jobs several times during their working
careers
– Make it likely that many future retirees will collect
retirement income from many employers’ plans
39
Disability Provisions
• Pension plans may provide special benefits if an
employee dies or becomes disabled before
retirement
• Employees who have achieved at least some
degree of vesting will have death benefits
available to a surviving spouse either as a lump
sum or as a survivor’s pension
– If the pension is funded using life insurance, then an
extra benefit may be available
40
Disability Provisions
• With respect to disability, some pension plans
make no special provisions and treat
employment termination due to disability in the
same way as any other termination
– Future pension is payable only if the participant
achieved vested pension rights before the termination
• In other plans the pension may become payable
immediately if the employee becomes disabled
• For those employers electing to provide
disability benefits apart from their pension plans
– A decision must be made regarding the continued
accrual of pension rights during disability
41
Pension Funding
• An employer cannot wait until an
employee retires before contributing funds
to pay his or her pension
– The funds must be set aside in advance
• Each qualified pension plan has a funding
agency that handles plan contributions
– Approximately 2/3 of all pension assets are in
trust fund plans
42
Pension Funding
• Trust fund plans
– The employer places monies to pay plan benefits with a trustee,
which manages and invests the pension assets
– The trustee pays benefits to retirees or other beneficiaries
– Assets are not allocated to particular employees but rather are
held and managed for the benefit of all employees as a group
– The main advantage of the trust fund plan is its flexibility
• The trustee has a wide range of investments in which assets may
be placed and they can be given instructions regarding
– How the investments will be made
– How the benefits are to be paid
– How eligibility and other provisions of the plan should be administered
– The trustee does not guarantee investment results, safety of
principal of the assets invested, or mortality rates assumed in
making annuity calculations
• Insured pension plans frequently guarantee minimum interest rates,
safety of principal, and mortality costs
43
Pension Funding
• Allocated plans
– A record is kept of the account of each employee
– Each dollar the employer contributes is associated with
a particular worker
• Unallocated plans
– No monies accrue for individually specified employees
during their careers
– The fund is kept in trust for the employees as a group
• At retirement the pension is paid from the unallocated fund
44
Pension Funding
• Although employees are affected by
funding decisions made in connection with
the pension plans
– They frequently have little control over most of
these decisions
• The major consideration with defined
contribution plans is the manner in which
the plan assets are invested
– Because the rate of return will greatly
influence the size of the eventual pension
45
Pension Funding
• With defined benefit plans additional decisions are important
– For example, actuarial cost methods must be selected for computing
how much money must be contributed each year to fund the promised
pension
– Many actuarial cost assumptions must be made about the future
including
• The likely rates of investment earnings
• The pattern of salary increases if the benefit formula is based on employees’
salaries
• The expenses likely to be incurred by the plan
• The distribution of actual ages at which employees will choose to retire in the
future
• The rates of death, disability, and employee turnover
– If these assumptions are incorrect, then underfunding or overfunding will
result
– Actuaries are required to periodically examine the plan and its
assumptions
• To certify that the assumptions are reasonable and to make
recommendations regarding the fund’s adequacy for future pension
obligations
46
Plan Termination Insurance
• Coverage is mandatory for and limited to
qualified defined benefit plans
• A federal agency called the Pension Benefit
Guaranty Corporation (PBGC) was established
to oversee this insurance
• Premiums for the coverage are based on the
number of participants and the degree of funding
for particular plans
• If planned funds are insufficient to cover
promised benefits to employees
– PBGC takes over and pays the benefits, subject to
various limitations
47
Deferred Profit-Sharing Plans
• Formal arrangements for sharing employer profits with
employees on a tax-advantaged basis
• The word deferred is used to distinguish these kinds of
plans from bonus arrangements in which profits are
distributed to employees and taxed in the same way as
employees’ salaries
• Most employers establish deferred profit-sharing plans to
enhance employees’ financial security in planning for
income needs associated with retirement, death,
disability
– Some employers design plans to emphasize retirement benefits
• While others have plans with a broad emphasis
48
Deferred Profit-Sharing Plans
• In most deferred profit-sharing plans
– The employer expects that the direct link between
profits and contributions will motivate employees to
work efficiently
– An even stronger motivational device is possible
when employer contributions to qualified plans are
made in the form of employer’s common stock
• Two versions of this approach are stock bonus plans and
employee stock option plans (ESOPs)
– ESOPs usually invest in stock issued by the employer, whereas
stock bonus plans have more flexibility regarding plan assets
49
Deferred Profit-Sharing Plans
• Although some employers tend to contribute the
same percentage of profits to their deferred
profit-sharing plans each year
– No specific contribution formula is mandated by law
• An employer is required only to make substantial
and recurring contributions to the plan over time
– With no minimum contribution required each year
• Deferred profit-sharing plans provide fewer
guarantees for employees about the eventual
level of retirement income that likely will be paid
from the plans
50
Deferred Profit-Sharing Plans
• The sponsor of a deferred profit-sharing plan must
specify an allocation formula to be used in distributing
wha ever amounts are contributed to the plan
– A popular allocation method is based on employees’ salaries
• Within limits, employers may allow participants to specify
their choice of investments for funds allocated to their
deferred profit-sharing accounts
• Employers are often more liberal in designing the
preferred profit-sharing plans than in designing their
pension plans
– Employers can be more generous in designing their plans
without increasing the cost
– Employers hope to benefit from the link employees perceive
between work efficiency and plan contributions
• So it is logical for employers to include more workers in deferred
profit-sharing plans than in pension plans
51
Deferred Profit-Sharing Plans
• Some deferred profit-sharing plans are designed
primarily as retirement income vehicles
– Whereas others are broader in their intent
– Participating employees should be aware of the circumstances in
which distribution of some or all of their account balances is
allowed
• Federal qualification rules specify distributions from deferred profitsharing plans can be made for many more reasons than is the case
with pensions
– Although employers may choose not to make distributions under all the
circumstances permitted by law
• Situations in which distributions are allowable include
– Retirement, death, disability, layoff, illness, termination of employment,
the attainment of a specified age, the passage of at least two years
since the contribution was made, and the existence of a financial
hardship
» Noteif an employee receives a distribution before age 59.5, he
or she may have to pay an extra 10% tax on the amount received
52
Employee Savings Plans
• Employees can enjoy the benefit of tax deferral of
retirement contributions for more than one type of
qualified plan simultaneously
• An employer may provide one leg of the three-legged
retirement income stool through the regular pension plan
– And also facilitate the individual employee’s savings required for
the third leg
• Employees who are eligible to participate in one or more
employee savings plans should seriously consider doing
so
– Because the tax advantages, “forced savings” element and
possible employer matched contributions associated with many
such plans can help individuals accumulate the savings required
to assure an adequate income during retirement
53
Thrift Plans
• Designed as a special form of a contributory, deferred
profit-sharing plan
• Subject to most of the rules governing such plans
• Presented as ways to encourage employees to save
their own money
• Plans may be designed to emphasize retirement savings
or general purpose savings
– The encouragement for employee savings comes in the form of
matching contributions from the employer
– These employer matching contributions, as well as all
investment earnings in the plan, are tax deferred until distribution
to the employee
54
Thrift Plans
• No immediate income tax deduction is
provided for employee contributions
– But the tax deferred employer matching
contributions and investment income can be
quite valuable over time
– This tax advantage is particularly attractive to
higher-income employees
• Who are subject to the highest rates of income tax
• Such persons also may be the ones most able to
participate in contributory plans
55
Section 401(k) Plans
• Similar to a thrift plan that offers the added advantage of
an immediate income tax deduction for employee
contributions
• Known as a cash or deferred arrangement or a 401(k)
plan
– After IRC code that provides for it
• Can be structured in several ways
– Usually they allow employees to choose the types of assets in
which their accounts will be invested
– Investment selections can be modified periodically as goals or
market conditions change
– In many plans employers match employee contributions
– All contributions grow tax deferred until distributed to the
employee
56
Section 401(k) Plans
• Extra rules govern 401(k) plans with
respect to income tax deductions for
elective deferrals
• Each year the plan must pass special tests
designed to guard against favoring highly
paid employees
– The employer can avoid this annual testing by
designing the plan so that it passes at least
one of the safe harbor provisions specified in
the IRC
57
Section 401(k) Plans
• Employees age 50 and older are allowed to make
specified additional pre-tax contributions above the
normal elective deferral limit
– Called catch-up contributions
• The rules regarding distributions of 401(k) funds before
age 59.5 are somewhat restrictive
– Some provision for early distribution are made if an employee
experiences extreme financial hardship and other resources are
not reasonably available
• Vesting rules applied to thrift plans and 401(k) plans
– For these plans the maximum period for cliff vesting is three
years rather than five
• Employees are always 100% vested in their own
contributions
58
Individual Retirement Accounts
(IRAs)
• Designed to supplement other sources of
retirement income
• Sometimes employers facilitate employee
savings through IRAs
– Primarily by offering their employees the opportunity
to make the IRA contributions through payroll
deductions
• The establishment of an IRA is not dependent on
employer sponsorship
– The only requirement is that the individual must have
earned income and some cases must not yet be 70.5
years old
59
Traditional IRA
• Created as part of ERISA
• For many years, the maximum limit an individual could
contribute was $2,000 annually
– $4,000 if married and filing a joint tax return
• In 2001 these limits were raised to $3,000 for individuals
($6,000 for couples )
– Will rise to $4,000 ($8,000 for couples) in 2005
– $5,000 ($10,000 for couples) in 2008
• IRA funds may be invested in most types of financial
securities and will accumulate on a tax-deferred basis
until distributed
• If an individual is not an active participant in a qualified
retirement plans sponsored by an employer
– Contributions are fully tax deductible
• However, if the individual is an active participant in a qualified
retirement plan, the taxability of the contributions is as shown in
Table 20-3
60
Table 20-3: Tax Deductibility of IRA
Contributions for Active Participants …
61
Traditional IRA
• Except in the case of death or disability, funds
withdrawn from the traditional IRA before age 59.5
usually result in a 10% early distribution penalty
tax on the amount withdrawn
– Designed to discourage the use of IRA funds for
purposes other than retirement
– Amounts withdrawn after age 59.5 are taxed as ordinary
income
• Except to the extent that they are attributable to contributions
that were not fully tax deductible when made
62
Roth IRA
• First became available in 1998 as an alternative to the
traditional IRA
• The same annual limitations apply to contributions, but a
major difference exists regarding taxation
– Contributions to a Roth IRA are never deductible from taxable
income
• But the entire amount can be withdrawn tax free at retirement
– All investment earnings and growth in principal may fully escape
income taxation if all relevant rules are met
» Tax status is especially attractive for young workers who have
many years for their savings to grow before withdrawal
• Income limitations exist regarding who is eligible to
establish a Roth IRA
– As of 2004, the limit was $110,000 for single taxpayers
63
Rollover IRA
• A rollover occurs when the owner takes funds
out of one account and places them in another
• Two types of rollover IRAs exist
– A transfer from one IRA to another
– A distribution from an employer-sponsored retirement
plan into an IRA set up to receive such proceeds
• If certain requirements are met, funds involved in
rollovers escape current income taxation
– And are not subject to the annual contribution limit
that applies to other IRA contributions
64
SIMPLE Plans
• A retirement option intended to be attractive to small
businesses employing 100 or fewer employees
• Called the savings incentive match plan for employees
• Can be set up either as part of a 401(k) plan or through
individual IRAs
– For both variations, the rules eliminate much of the
administrative work (and expense) that otherwise might prevent
small employers from setting up retirement benefits at all
• For example, a SIMPLE 401(k) plan is exempt from the rules
regarding testing for discrimination in favor of highly paid workers
• In exchange for this exemption the employer sponsoring the
SIMPLE 401(k) plan must generally match up to 3% of its
employees’ contributions
• All full-time employees must generally be eligible to participate and
vesting of employer contributions must be full and immediate
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Keogh Plans
• Designed for persons with self-employment income
• Frequently people with “side jobs” shelter part of their
earnings in these plans
• The tax-sheltered contributions and accumulating
investment returns are not subject to current income
taxation
• The annual amounts that can be contributed and
deducted from taxes are based on a person’s income
from self-employment
– With the specific limits dependent on the type of Keogh plan
established
• Keogh plans can also be deferred profit-sharing plans or
defined benefit pension plans
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Section 403(b) plans
• Also called a tax-sheltered annuity, a tax-deferred
annuity or a section 501(c)(3) annuity
• Specifically designed for certain types of nonprofit
institutions
– In general, employees of public schools, universities, hospitals,
and nonprofit organizations operated exclusively for religious,
scientific, charitable, literary, educational, cruelly prevention, or
public safety testing purposes are eligible
– Because such organizations are usually exempt from income
taxes and often lack the financial resources necessary to fund
adequate retirement incomes for their employees
• Special rules exist to assist employees of such organizations in
saving for retirement on their own
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Section 403(b) Plans
• In setting up a plan, an employee typically
enters into a contract with the employer to
reduce his or her contractual salary by the
amount the employee wishes to save
– The amounted contributed can be deducted
from the employee’s current taxable income
– Investment income on the contributions
accumulates tax-free until distribution
• The maximum annual contributions are the
same as for 401(k) plans
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