A 403(b) plan is a special tax-deferred retirement savings plan that is often referred to as a tax-sheltered annuity, a tax-deferred annuity, or a 403(b) annuity. It is similar to a 401(k), but only the employees of public school systems and 501(c)(3) organizations are eligible to participate in 403(b) plans.
Employees can fund their accounts with pre-tax contributions, and employers can also make contributions to employee accounts. Employer contributions can be fixed or discretionary. Eligible employees may elect to defer up to 100% of their salaries, as long as the amount does not exceed $18,000 (in 2016, unchanged from 2015). A special “catch-up” contribution provision enables those who are 50 and older to save an additional $6,000. Total combined employer and employee contributions cannot exceed $53,000 (in 2016, unchanged from 2015). Contribution limits are indexed annually for inflation.
Employees have the option of choosing the types of investments utilized in their funds. A 403(b) can be an annuity contract, a custodial account, or a retirement income account. It is a good idea to do a little research before selecting how you would like to invest your funds. Your employer can provide you with a list of the investments that are available.
Distributions from 403(b) plans are taxed as ordinary income. Withdrawals made before age 59½ may be subject to a 10% federal income tax penalty unless a qualifying event occurs, such as death or disability.
Generally, once you reach age 70½, you must begin taking annual required minimum distributions. You can receive regular periodic distributions on a schedule that is calculated based on your life expectancy, or you can collect your entire investment as a lump sum.
Participating in a 403(b) plan may be a good way to save for retirement. Contact your employer to find out what type of plan is offered and how you can take advantage of this retirement funding vehicle.
A money purchase plan is a type of defined-contribution plan that is similar to a profit-sharing plan, except that the contribution amounts are fixed rather than variable. Thus, employers are required to make annual contributions to each employee’s account regardless of the company’s profitability for the year. These plans can be used in conjunction with profit-sharing plans to achieve the maximum contribution levels allowed each year.
Employers that set up money purchase plans must declare a set contribution level each year in the plan document, based on employees’ salaries. Companies can contribute up to 25% of the total annual compensation of all plan participants, up to 100% of each participant’s salary or $53,000 (in 2016, unchanged from 2015), whichever is less.
Employer contributions are tax deferred as long as the amounts are within annual limits. As with other defined-contribution plans, employee funds accumulate tax deferred until withdrawn. It’s important to note that employees are not given the option of contributing additional money to their own accounts. However, they are often allowed to choose which investments will be included in their accounts.
It is common for employers to set up vesting schedules that dictate when an employee can claim the funds from his or her plan. When employees are fully vested, they are able to begin taking withdrawals upon reaching age 59½ without incurring a tax penalty. Employees may also borrow from their plans before they reach age 59½ if a circumstance occurs that can be identified as a “qualifying event,” as defined in the plan document.
Withdrawals are taxed as ordinary income and must begin after the account holder reaches the age of 70½; withdrawals can be taken as a lump sum or in minimum annual installments based on life expectancy.
If you are a business owner and desire to attract employees from larger corporations that offer a wide range of retirement plans, then a money purchase pension plan may be an option for you. It allows you to contribute high amounts on your employees’ behalf while providing you with the added benefit of tax deductions.
David Wray, the president of the Plan Sponsor Council of America, once said that the purpose of profit-sharing plans is “to generate goodwill and a feeling of partnership” between employer and employee. Profit-sharing plans give employees a share in the profits of a company each year and can help fund their retirements.
All the money contributed to a profit-sharing plan accumulates tax deferred, as it does with other defined-contribution retirement plans, but employer contributions are tax deductible only if the plan is defined as an elective deferral plan, which means that instead of accepting their profit shares as cash, employees defer the assets into retirement funds.
Profit sharing is attractive to business owners because of its flexibility. Employers can choose how much to allot to employees each year based on the amount of revenue taken in. There is no required minimum. If the company has a bad year, the employer has the option of giving very little or nothing at all to employee accounts.
Employees are usually enrolled automatically in profit sharing once they become eligible. Companies can choose eligibility requirements based on age and length of service. A company is allowed to contribute up to 25% of an employee’s salary or $53,000 (whichever is less) in 2016 (unchanged from 2015). This amount is indexed annually for inflation.
Typically, companies set up vesting schedules that dictate how long workers must be employed in order to claim profit-sharing contributions when they move to another job or retire. Once employees are fully vested, they can take the entire amount contributed on their behalf and roll it over to an IRA or to a new employer’s qualified retirement plan.
If you participate in a profit-sharing plan, you may begin withdrawing funds after age 59½ without incurring a 10% income tax penalty. Withdrawals are taxed as ordinary income. Some plans may allow early withdrawals. Profit-sharing providers have greater flexibility when it comes to deciding the terms of early withdrawal than do administrators of other plans, such as 401(k)s. However, the trend has been to permit no early withdrawals.
Generally, you must begin taking required minimum distributions after reaching age 70½. You can elect to withdraw the assets as a lump sum and be taxed on the entire value of the fund or you can set up a minimum distribution schedule based on your life expectancy.
Some companies offer a combination arrangement with both a profit-sharing plan and a 401(k). A conjoined plan allows employers to contribute as much or as little as they would like each year, while giving employees a way to supplement their retirement funds.
If you are a business owner, profit sharing may be a way to attract high-caliber employees. It provides retirement funds for your employees yet still gives you the freedom to choose how much you wish to contribute each year.
The arena of employer-sponsored retirement plans has been dominated by 401(k) plans that are funded with pre-tax contributions, which effectively defers taxes until distributions begin. However, the recently created Roth 401(k) is funded with after-tax money just like a Roth IRA, allowing retirees to enjoy qualified tax-free distributions once they reach age 59½ and have met the five-year holding requirement.
It might be smart to invest in a Roth 401(k) if you believe that you will be in a higher tax bracket during retirement. This is always a possibility, especially if you end up with fewer tax deductions during your post-working years. On the other hand, if you expect to be in a lower tax bracket during retirement, then deferring taxes by investing in a traditional 401(k) may be the answer for you. If you have not been able to contribute to a Roth IRA because of the income restrictions, you will be happy to know that there are no income limits with a Roth 401(k).
Employers may match employee contributions to a Roth 401(k) plan, but any matching contributions must go into a traditional 401(k) account. Therefore, employers must have both types of plans in place if they want to offer their workers a Roth 401(k).
If an employer offers a Roth 401(k) plan, the employees will usually have the option of contributing to either the regular or the Roth 401(k), or even both at the same time. If you do not know which type of account would be better for your financial situation, you might want to split your contributions between the two types of plans. It’s important to note that your combined annual contributions to a 401(k) plan cannot exceed $18,000 if you are under age 50, or $24,000 if you are 50 or older (in 2016, unchanged from 2015). These amounts are indexed annually for inflation.
If your employer offers a Roth 401(k) plan and it allows in-plan Roth conversions, you can make transfers to a Roth 401(k) account at any time. Conversion is a taxable event. Funds converted are taxed as ordinary income.
Upon separation of service, workers can roll over their Roth 401(k) assets to another Roth 401(k), a Roth 403(b), or a Roth IRA. Assets cannot be rolled over to a traditional 401(k) plan. If you transition from an employer that offers a Roth 401(k) plan to an employer that does not, your only option would be to roll the assets directly to a Roth IRA or to leave your money in your former employer’s plan (if allowed).
The required minimum distribution guidelines of a Roth 401(k) work like those of traditional 401(k) plans. You must begin taking distributions after reaching age 70½, either as a lump sum or on a required minimum distribution schedule based on your life expectancy. However, unlike a traditional 401(k), Roth distributions would be free of federal income taxes.
If you see the advantages of having tax-free income in retirement, then you might want to consider a Roth 401(k). It allows you to contribute more annually than you could to an IRA, and the tax-free distributions won’t add to your income tax liability. Of course, before taking any specific action, you might want to consult with your tax professional.
If you leave a job or retire, you might want to transfer the money you’ve invested in one or more employer-sponsored retirement plans to an individual retirement account (IRA). An IRA rollover is an effective way to keep your money accumulating tax deferred.
Using an IRA rollover, you transfer your retirement savings to an account at a private institution of your choice, and you choose how you will invest the funds. To preserve the tax-deferred status of retirement savings, the funds must be deposited in the IRA within 60 days of withdrawal from an employer’s plan. To avoid potential penalties and a 20% federal income tax withholding from your former employer, you should arrange for a direct, institution-to-institution transfer.
You are able to roll over assets from an employer-sponsored plan to a traditional IRA or a Roth IRA. Because there are no longer any income limits on Roth IRA conversions, everyone is eligible for a Roth IRA conversion; however, eligibility to contribute to a Roth IRA phases out at higher modified gross income levels. Keep in mind that ordinary income taxes are owed (in the year of the conversion) on all tax-deferred assets converted to a Roth IRA.
An IRA can be tailored to your particular needs and goals and can incorporate a variety of investment vehicles, as opposed to the limited number of options available in many employer-sponsored retirement plans. In addition, tax-deferred retirement savings from multiple employers can later be consolidated.
Over time, IRA rollovers may make it easier to manage your retirement savings by consolidating your holdings in one place. This can help cut down on paperwork and give you greater control over the management of your retirement assets.
Keep in mind that you may be able to leave your funds in your previous employer plan, if it is allowed by the plan. You may be able to transfer the funds from your previous employer plan to a new employer plan (if it accepts rollover funds).
Distributions from traditional IRAs are taxed as ordinary income and may be subject to a 10% federal income tax penalty if taken prior to reaching age 59½. Just as with employer-sponsored retirement plans, you must begin taking required minimum distributions from a traditional IRA each year after you turn age 70½.
Qualified distributions from a Roth IRA are free of federal income tax (under current tax laws) but may be subject to state, local, and alternative minimum taxes. To qualify for a tax-free and penalty-free withdrawal of earnings, a Roth IRA must meet the five-year holding requirement and the distribution must take place after age 59½ or due to death, disability, or a first-time home purchase ($10,000 lifetime maximum). The mandatory distribution rules that apply to traditional IRAs do not apply to original Roth IRA owners; however, Roth IRA beneficiaries must take mandatory distributions.
Finding a method to leave a lasting legacy to your loved ones without increasing their tax burdens can be difficult and complicated. A “stretch” IRA may be a useful approach that can benefit your heirs for generations to come.
A stretch IRA is not a special type of IRA but rather a term frequently used to describe this IRA strategy, also known as a “multigenerational” IRA, that can be used to extend the tax-deferred savings on inherited IRA assets for one or more generations to benefit future beneficiaries.
Here’s how it works. You let the funds accumulate in the IRA for as long as possible. You name as beneficiary someone younger, perhaps a son or daughter. When you have to start taking required minimum distributions (RMDs) from your traditional IRA after turning age 70½, you take only theminimum annual amount required by the IRS each year. (If you fail to take a minimum distribution, you could be subject to a 50% income tax penalty on the amount that should have been withdrawn.)
When your beneficiary inherits your IRA, he or she might also have the ability to take required minimum distributions (RMDs) based on his or her life expectancy. (RMDs are calculated each year and must begin no later than December 31 of the year following your death.) In this way, your beneficiary would have the potential to stretch the distributions over his or her own lifetime, which enables the funds to continue compounding tax deferred for a longer period and avoids a large initial tax bill. Your beneficiary can also name a beneficiary, who can potentially stretch the distributions even longer.
There is a limit to how long you can “stretch” an IRA. The IRS doesn’t want to postpone taxes indefinitely. The distribution period cannot extend beyond the first-generation beneficiary’s life expectancy. For example, if you designated your son to be the sole beneficiary of your IRA and he was 40 when you died (and you hadn’t yet reached the age for taking RMDs), he could take RMDs based on his 37.6-year life expectancy, starting the year after you died. If he died 20 years later, his designated beneficiary could continue taking minimum distributions based on what would have been your son’s remaining life expectancy (20.8 years).
Of course, nonspouse beneficiaries of IRAs face some hurdles. There are different sets of rules to determine the RMDs that a nonspouse beneficiary must receive. They depend on whether the original account owner died before, on, or after reaching the required beginning date for RMDs. Not only are these rules complex, but they can have far-reaching implications. Spousal beneficiaries of IRAs have more options than nonspouse beneficiaries.
If you have a desire to extend your financial legacy over future generations and don’t need the IRA assets for income during your lifetime, then this strategy may be appropriate for you. Because many tax and distribution rules must be followed, make sure to seek legal or tax counsel before making any final decisions.
Note: Make sure the provisions in your IRA allow beneficiaries to take distributions over their lifetimes and to name second-generation beneficiaries. Distributions from traditional IRAs are taxed as ordinary income. Distributions prior to age 59½ are subject to a 10% federal income tax penalty (this rule does not apply to IRA beneficiaries, who must begin taking minimum distributions no later than December 31 of the year following the original owner’s death). Beneficiaries also have the flexibility to take out more than the minimum distribution at any time.
There are many types of employer-sponsored retirement plans. One that may appeal to small businesses and to self-employed individuals is the savings incentive match plan for employees of small employers (SIMPLE) because, as the name implies, it is easy to set up and administer, and employers are allowed to take a tax deduction for the contributions that are made.
SIMPLEs can be established by small businesses that have 100 or fewer employees (who were paid at least $5,000 or more in compensation during the previous year) and do not maintain other retirement plans. They can be structured as an IRA for each eligible individual or as part of a qualified cash or deferred arrangement such as a 401(k) plan. Typically, they are structured as SIMPLE IRAs.
Eligible employees (those who earned at least $5,000 in the preceding year) can make pre-tax contributions to their plans each year. Participants may contribute 100% of their salaries up to $12,500 in 2016 (unchanged from 2015). Those who are 50 or older during the year can elect to make $3,000 catch-up contributions. These amounts are indexed annually for inflation.
Administrators of SIMPLE IRAs are required to make either matching contributions equal to employee contributions (up to 3% of employee salaries) or nonelective contributions, which set a flat 2% contribution rate for all eligible employees. Employees are immediately 100% vested in contributions made by the employer, and they direct their own investments.
Distribution rules are similar to most IRA plans. Withdrawals are taxed as ordinary income and are also subject to a 10% federal income tax penalty if withdrawn prior age 59½, unless there are extenuating circumstances as outlined by the IRS. Required minimum distributions also must begin after the participant reaches age 70½.
An additional rule for SIMPLE plans is that there is a two-year waiting period after the date when an employee enrolls in the plan to transfer contributions to another IRA on a tax-deferred basis. Any withdrawals taken during the first two years of an employee’s participation in the plan are subject to a 25% tax penalty in addition to ordinary income taxes. After the first two years, early withdrawals are generally subject to the 10% early-withdrawal penalty prior to age 59½. Of course, the IRS sometimes allows exceptions under special circumstances.
SIMPLE IRAs may be a good choice for small-business owners because the responsibility for funding the plan is shared between the employer and the employee. The start-up and maintenance costs also may be lower than for other qualified plans. If you are considering whether to establish a retirement plan for your business, you may want to make it SIMPLE.
A simplified employee pension plan (SEP) is a deferred-compensation arrangement that is similar to a profit-sharing plan. It can be set up by employers and self-employed individuals, as well as sole proprietorships and partnerships. Employers receive tax deductions for plan contributions made to employees’ accounts, and employees do not pay taxes on SEP contributions until they begin taking distributions (generally, in retirement). Thus, SEPs can be attractive to both the employer and the employee.
Companies that institute SEPs agree to contribute on a nondiscriminatory basis to IRAs maintained by employees. Employers are required to provide benefits to all employees who are eligible. Employees are eligible if they are at least 21 years old, earn at least $600 each year (indexed for inflation), and have been employed by the company for three out of the five years prior to the year for which the contribution is being made. Employers also have the option of selecting eligibility requirements that are less restrictive, but they must be applied to every employee.
Employer contributions are limited to the lesser of $53,000 or 25% of an employee’s compensation (in 2016, unchanged from 2015). Contributions are made on a discretionary basis, which means that the employer can decide each year whether or not to contribute, as well as how much to contribute.
SEP contributions are made to separate IRAs for eligible employees. Employees are responsible for setting up their own traditional IRAs to receive employer contributions, which are immediately 100% vested, and employees direct their own account investments.
When participants start taking distributions from a SEP IRA, the rules are essentially the same as those for a traditional IRA. Distributions are taxed as ordinary income and cannot be taken before the age of 59½ without incurring a 10% federal income tax penalty, except in the case of extenuating circumstances. [For example, penalty-free distributions may be allowed if an individual is unemployed, buying a first-time home ($10,000 lifetime max), or cannot pay medical expenses.] SEP IRA account owners must begin taking minimum distributions after reaching age 70½.
If you are a small-business owner or are self-employed, a SEP IRA may be a good option for you, because contributions may be tax deductible and this type of plan is easy to establish and administer. If you are an employee of a company that offers a SEP IRA, you can benefit from the potential to receive employer-paid contributions. If you are a business owner, always make sure to discuss your retirement plan options with a financial professional before deciding on a method.
The history of estate taxes in America has been a long and winding road. Careful estate planning is still one of the most important ways to manage and protect your assets for your heirs.
The Stamp Act of 1797 was the first federal estate tax in the United States and was passed to help fund an undeclared war with France; it was repealed in 1802. The Revenue Act of 1862 reinstated the estate tax in order to fund the Civil War; it was abolished in 1870. To finance the Spanish American War, the War Revenue Act of 1898 was passed, and subsequently abolished in 1902. Due to the costs of World War I, the Revenue Act of 1916 reinstated an estate tax that, in some form or other, has been in effect ever since.
The Economic Growth and Tax Relief Reconciliation Act of 2001 gradually increased the federal estate tax exemption, until finally repealing the federal estate tax altogether for the 2010 tax year only. The Tax Relief Act of 2010 reinstated the federal estate tax with a $5 million exemption, indexing the exemption for inflation after 2011. The provisions of the Tax Relief Act of 2010 expired on December 31, 2012.
The American Taxpayer Relief Act of 2012 increased the federal estate tax rate from 35 percent to 40 percent, but left in place the higher exemption level ($5.45 million in 2016 up from $5.43 million in 2015); both provisions are now permanent. It also left in place the “portability” of any unused exemption between spouses.
What Is the Best Form of Property Ownership for Me?
In planning your estate, it is customary to consider wills and trusts (as well as intestacy) as a means of property distribution. As a matter of fact, the manner in which you hold title to your assets may supersede provisions contained in other transfer documents. Likewise, significant tax benefits can be gained (or lost) depending on the characterization of your property.
Let’s take a look at the general classifications of ownership.
Sole Ownership
Sole ownership occurs when one owns a complete interest in property. Ownership is passed by the typical transfer documents, or by the laws of intestate succession. The complete interest is included in the estate of the decedent. Because of this, the beneficiary receives a full step-up in basis. This, in essence, brings up the original purchase price to the fair market value, thereby eliminating a capital gain.
Joint Tenancy
Joint tenancy exists when two or more persons share equal, undivided interests in property. Joint tenancy is not limited to spouses. Anyone can share joint interests, but there are tax benefits when this arrangement is shared only between husband and wife (qualified joint tenancy).
A joint property interest cannot be passed through traditional documents, such as a trust or a will. Ownership of a joint interest passes by “operation of law” to the surviving joint owner(s). Further, property held in joint tenancy will not be subject to probate.
Under qualified joint tenancy, half of the property is included in the first decedent’s estate. Because of this, the surviving spouse obtains a stepped-up basis only on the first decedent’s half of the property.
If any nonspouses participate in joint ownership, the entire value of the property is includable in the decedent’s estate, reduced to the extent that the estate can prove that the surviving tenant(s) contributed to the cost of the property.
Another form of joint ownership — tenancy by the entirety — is similar to joint tenancy, but it can only be created between husband and wife. Unlike joint tenancy, an interest cannot be transferred without the consent of the spouse. Tenancy by entirety is only recognized in certain states.
Tenancy in Common
Tenancy in common provides an undivided interest in property between two or more people. Unlike other forms of joint ownership, however, these interests can be owned in different percentages.
A tenant in common can utilize the traditional transfer documents, but interest cannot be passed by operation of law.
Community Property
Under community property statutes, all property earned or acquired by either spouse is owned in equal shares by each spouse. The essential principle of community property is that the earnings of either husband or wife and the revenue from their property belong not to the producer but to the community of the husband and wife.
For estate conservation purposes, there are no restrictions on how each spouse can give away his or her half of the community property. There is no law requiring one person to leave his or her half to the surviving spouse, although, of course, many do.
Currently, nine states have community property laws: Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, and Wisconsin.
The amount includable in the estate of a decedent is based on his or her percentage of ownership. The beneficiary of the property interest receives a stepped-up basis on that portion of the property. It is important to remember that the beneficiary can be chosen by the decedent. This is in contrast to joint tenancy, under which the surviving joint tenant(s) automatically inherit the interest of the decedent.
