By Stephen J. Dunn
You cannot rely upon Congress to provide for the long-term solvency of the Social Security trust fund. You need to provide for your own retirement. Your first obligation is to yourself, as I often advise clients.
You need a qualified retirement plan. By “qualified retirement plan,” I mean a defined contribution retirement plan or a defined benefit pension plan. A defined contribution plan establishes an employee contribution account for each participant and, if the plan provides for employer matching contributions, an employer matching account. Contributions are made to the accounts, the accounts earn income, and, hopefully, the assets in the accounts appreciate. When the participant reaches retirement age, she may begin receiving distributions from the accounts.
A defined benefit pension plan is a homogeneous pool of assets. When a participant reaches retirement age, he begins receiving distributions from the plan based upon a formula, such as a percentage of his final five years’ average compensation. Employer contributions to the plan are based upon periodic actuarial valuations, taking into account participants’ ages, expected attrition, and mortality, and the plan benefit formula. Very expensive to administer, defined benefit pension plans are not commonly found today.
There are many other reasons why you need a qualified retirement plan.
Shelter income from current tax. For 2013, the annual limit for an employee contribution to a defined contribution retirement plan is $17,500, or $23,000 for an employee who has reached age 50. The annual employee-employer combined limit for contributions to a defined contribution plan is $51,000.
Assume, for example, that you are 51 years of age and that your business has a defined contribution retirement plan. For 2013, the maximum amount of your compensation which you can defer into your plan account without incurring current income tax on it is $23,000. The maximum contribution that your company can make to your plan account for 2013 and deduct on its tax return is $28,000. These contributions may be made to your plan account only to the extent they are allowed by the plan’s governing document.
Larger amounts can be contributed to a defined benefit pension plan by an employer with respect to an employee.
An individual who does not participate in a defined contribution retirement plan or a defined benefit pension plan may make $5,500 in tax-deductible contributions to an individual retirement account for 2013 ($6,500 for an individual who has attained 50 years of age).
Assets in defined contribution retirement plans, defined benefit pension plans, or individual retirement accounts will eventually be subject to income tax, when they are withdrawn from the qualified plan—unless the beneficiary is an entity exempt from income tax.
Protect assets from creditors. Qualified retirement plans are immune from creditors’ claims. For this reason qualified retirement plans are popular among persons vulnerable to creditors’ claims—such as physicians. The immunity from creditors’ claims applies to defined contribution retirement plans and defined benefit pension plans, but not unfunded plans maintained by an employer for a select group of highly-compensated employees (so-called “top hat” plans), or individual retirements accounts.
A qualified retirement plan interest or an individual retirement account is, however, an asset subject to equitable division upon the participant’s divorce.
Provide a benefit for employees. A qualified retirement plan is an attractive benefit for employees. This is especially true if the plan provides for employer matching contributions.
Resolve a tax collection matter more favorably. If you owe tax which you cannot currently pay, your current income will determine the amount you will have to pay each month under an installment agreement with the IRS. By establishing a qualified retirement plan, and making a monthly contribution to it, you will reduce the amount of your monthly income, and thus the amount you will have to pay the IRS each month under the installment agreement. In effect you will be paying yourself rather than the IRS.