Save on Taxes When You Save for Retirement
Employer-Sponsored Retirement Plans
© by Lita Epstein
Employers sponsor two different types of retirement plans. A defined-benefit plan is the traditional retirement plan funded completely by your employer. Your pension benefit is usually based on the number of years you worked and your salary. Some companies are converting these to cash-balance plans, also fully funded by your employer, but your funds build in an account that you take out as a lump sum when you leave the company. Some companies do offer an annuity based on the cash balance that will give you a set amount for life, for your life and the life of your spouse, or for a set number of years.
The second type of plan at work, which is more common today, is the defined contribution plan. In most companies both you and your employer add funds to the account in your name. Your contributions are taken out of your salary before taxes, so the funds go into the account tax-deferred. You can defer as much as $12,000 in 2003 and that amount will increased by $1,000 a year until it tops out at $15,000 in 2006. After that the maximum allowed will be indexed to inflation. People 50 and older can put in additional catch-up contributions, which are $2,000 in 2003 for a total of $14,000. These catch also increase by $1,000 until they top off at $5,000 in 2006 and then will be indexed for inflation.
There are many different types of defined contribution plans. The 401(k) is used by for-profit companies. Non-profits use the 403(b), Tax-Sheltered Annuities (TSAs), or Tax-Deferred Annuities (TDAs). State and local government employees have Section 457 accounts.
As I mentioned earlier, most of these defined-contribution are partially funded by you and your employer. Usually the employer matches your contribution. For example, a common match is 50 cents on every dollar up to 5 percent of your salary. The amount to be matched is not set by law, but instead set up as part of your employer's document when establishing the plan. Some non-profits will put in a certain even if you don't contribute and then add to that percentage if you do.
If you don't contribute to your employer-sponsored to at least get the company match, it's like giving back benefits to your company, so always be sure to at least put in the minimum required to get the full company match. Employees of non-profits and state governments are fully vested when the enter the plan, but some may need to wait as long as two years before they become eligible to enter the retirement program. The company sets waiting time for eligibility. Fully vested means when you leave the job you get to take 100% of the money with you by lump sum or by rollover into another retirement plan. You can roll it over into an IRA or into your new company plan. People working at for-profit companies are not fully vested immediately. They can lose a portion of the company match until they have been with the company a certain number of years.
The 2001 tax law required companies to vest employee interest in the employer's matching funds more quickly. Employers can chose to fully vesting employees after three years of service (down from five), or grant employees gradual vesting rights of 20 percent each year, beginning after two years of service and resulting in full vesting after six years. (The old schedule went from three to seven years.) The new vesting schedule is for employer matches in plan years starting after 2001, except for plans covered under a collective bargaining agreement. Employers do have the option to vest employees even more quickly than this, but few do.
As money is withdrawn it is taxed at your current income levels provided you wait until you are at least 59½. Otherwise you will pay penalties and taxes. If you lose your job at age 55 or older or if you become disabled, there are ways to avoid the penalties when you begin withdrawing funds. Check with your tax advisor to find out what the best alternative is for you.
A new kind of 401(k) is set to be introduced in 2005, which tentatively has been dubbed the Roth 401(k). With this type of plan your contribution will not be tax-deferred instead both your contributions and the gains on them will be withdrawn tax-free in retirement just like with the Roth IRA. In all the other types of employer-sponsored plans mentioned here your funds are taxed as income at your current income tax rate when you withdraw them in retirement. You can take the money in a lump sum, as an annuity or as a rollover to an individual IRA.
A lump sum is not recommended because your money will be taxed fully in the first year. If you then put the lump sum into taxable investments, the gains will be taxed yearly as well. If you roll the money into a tax-deferred IRA, you can delay paying taxes and the gains can continue to grow tax-deferred.
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Copyright 2003, by Lita Epstein.
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