At what age should you start to save for retirement? For most of us, we would say the answer would be next year, as soon as the kids are out of diapers, as soon as they are in school, as soon as they are out of college, as soon as they are married, as soon as the house is paid off, as soon as (insert your reason).
I have come to the conclusion there is no easy time to save for retirement; there is always a perceived better time in the future. The best time to save for retirement is now, whether you are 20 or 60.
No time like the present; the sooner the better. There are many tax-favored ways to save. There are very simple employer plans to very complex plans – each one fills a purpose.
The following is a discussion of some of the advantages and disadvantages of each type of plan. In most cases the plan that is the simplest, and accomplishes the employer’s and employee’s needs, is the best one to adopt.
Let’s start with the simplest and progress to the most complicated, which is usually the most expensive to administer. With this being said, even the most expensive to administer might have the lowest overall cost to the employer when considering the amount of employer contribution going to the targeted group of employees.
If an employer is interested in helping its employees (including the owners) save for retirement, a plan that fits most of the employer’s needs can probably be found and adopted.
To encourage employers to adopt retirement plans, the federal government has provided a startup tax credit of $500 a year for the first three years of a new plan for eligible small businesses to help cover the costs of plan adoption and administration.
All limits have been updated to 2012 amounts as announced on October 20, 2011, by the IRS.
Payroll deduction IRA (traditional tax-deferred and/or Roth contributions)
• Advantages: Easy to set up and maintain with no annual plan accounting or tax filing required.
• Disadvantages: All IRA limits and rules apply.
• Other provisions: All contributions are from employee deferrals, which are 100 percent vested at all times, with a maximum annual contribution limit of $5,000 for participants under 50 years old and $6,000 if 50 or older. Employees can withdraw their contributions and earnings at any time; however, withdrawals are subject to taxes and, if the employee is under 59½ years old, a 10 percent penalty may apply.
SEP IRA (traditional tax-deferred contributions)
• Advantages: Easy to set up and maintain with no annual plan accounting or tax filing required and can be set up and funded after the end of the year.
• Disadvantages: No employee-deferral contributions are allowed. All contributions come from the employer.
• Other provision: Employer contributions are limited to the lesser of 25 percent of compensation or $50,000 per participant. Employer annual contributions can be anything from 0 to 25 percent of qualified compensation and can change each and every year. However, all eligible employees must receive the same contribution percentage each year.
All contributions are 100 percent vested at all times. Employees can withdraw employer contributions and earnings at any time; however, withdrawals are subject to taxes and, if the employee is under 59½ years old, a 10 percent penalty may apply.
Simple IRA (traditional tax-deferred contributions)
• Advantages: Easy to set up and maintain with no annual plan accounting or tax filing required.
• Disadvantages: Annual employer contribution may be required even in loss years.
• Other provision: Employee and employer contributions are allowed. Annual employee contributions are limited to $11,500 if under 50 years old and $14,000 if 50 or older.
Annual employee contributions are matched dollar for dollar up to 3 percent of employee’s compensation if matching contributions are elected – if matching contributions are not elected, then a 2 percent employer contribution to all eligible employees is required.
All contributions are 100 percent vested at all times. Employees can withdraw all contributions and earnings at any time; however, withdrawals are subject to taxes and, if the employee is under 59½ years old, either a 10 or 25 percent penalty may apply.
Defined contribution profit sharing plan (traditional tax-deferred contributions)
• Advantages: Permits large employer contributions up to $50,000 per employee limited to 25 percent of total qualified compensation, employer contributions can be disproportionately allocated to employees based on age, position, integrated with social security, length of service or some other acceptable allocation method.
• Disadvantages: Employees only receive a benefit if the employer makes a contribution to the plan. The company is required to do annual plan accounting and to file a 5500 tax return with the Department of Labor. Annual plan testing is also required.
• Other provision: Employer annual contributions can be anything from 0 to 25 percent of qualified compensation and can change each and every year. A vesting schedule can be selected for all employer contributions requiring several years of service to become fully vested.
Distributions are generally available only upon termination or retirement and are subject to a 10 percent penalty if withdrawn before age 59½ unless an exception applies. The plan must be adopted before the business’ tax year end.
Defined contribution 401(k) (traditional tax-deferred and/or Roth contributions)
• Advantages: Permits large employer contributions up to $50,000 per employee limited to 25 percent of total qualified compensation, employer contributions can be disproportionately allocated to employees. Employees can fund up to $17,000 of the $50,000 per employee limit. If an employee is 50 or older an additional $5,500 can be contributed by the employee.
• Disadvantages: The employer is required to do annual plan accounting and to file a 5500 tax return with the Department of Labor. Annual nondiscrimination testing is also required which might restrict employee deferral contributions by highly paid employees.
• Other provision: Employer annual contributions can be anything from 0 to 25 percent of qualified compensation and can change each and every year. Employee contributions are 100 percent vested at all times, whereas employer contributions can use a vesting schedule requiring several years of service to become fully vested.
Distributions are generally available only upon termination or retirement and are subject to a 10 percent penalty if withdrawn before age 59½ unless an exception applies. The plan must be adopted before the business’ tax year end.
Defined contribution safe harbor 401(k) (traditional tax-deferred and/or Roth contributions)
• Advantages: Permits large employer contributions up to $50,000 per employee limited to 25 percent of total qualified compensation; some of the employer contributions can be disproportionately allocated to employees. Employees can fund up to $17,000 of the $50,000 per employee limit.
If an employee is 50 or older an additional $5,500 can be contributed by the employee. The annual nondiscrimination testing which can limit employee deferral contributions of highly compensated employees is not required.
• Disadvantages: Annual 3 to 4 percent safe harbor employer contributions are required. The employer is required to do annual plan accounting and to file a 5500 tax return with the Department of Labor.
• Other provision: Employer annual contributions can be anything from 3 to 25 percent of qualified compensation and can change each and every year. Employee and employer safe harbor contributions are 100 percent vested at all times, whereas employer non-safe harbor contributions can use a vesting schedule requiring several years of service to become fully vested.
Distributions are generally available only upon termination or retirement and are subject to a 10 percent penalty if withdrawn before age 59½ unless an exception applies. The plan must be adopted before the business’ tax year end.
Defined benefit plan (traditional tax-deferred contributions)
• Advantages: The plan provides for a predetermined retirement benefit for employees, usually based on compensation similar to social security benefits.
• Disadvantages: Expensive to maintain due to additional testing and actuarial calculations. All investment risks are borne by the employer. The employer is required to do annual plan accounting and to file a 5500 tax return with the Department of Labor.
• Other provision: Annual employer contributions can be anything from 0 to more than 100 percent of qualified compensation depending on promised retirement benefits and can change each and every year depending on investment performance. Contributions may be required regardless of current year profits.
Annual employer contributions are actuarially determined each year by an actuary. A vesting schedule can be selected for all employer contributions requiring several years of service to become fully vested. Employee contributions may be allowed or required depending on the plan provisions adopted.
Distributions are generally available only upon termination or retirement and are subject to a 10 percent penalty if withdrawn before age 59½ unless an exception applies. The plan must be adopted before the business’ tax year end.
There are a few other types of retirement plans available, but these are the ones most often used. One of the most important things regarding retirement saving and planning is to start today.
Each stage of life has its own financial challenges. Saving now for retirement will minimize the challenges you will encountered when the time to retire does finally arrive.
