One of the tax questions I get most often is about retirement plans. Our expectations to what retirement will look like varies from person-to-person, but overall most expect to lead an active life for 20-30 years in retirement, which requires a significant amount of savings.
During my 23 years in practice, I have seen fewer pension plans every year. Employers have moved from defined benefit plans (pensions) to defined contribution plans (employee contributes and employer will often match), which many of us recognize as a 401k or an equivalent plan.
Retirement in the 21st Century
The new reality is that we can no longer expect our employer to automatically reward us for years of service by taking care of us in our golden years. Nor will Social Security provide our dream retirement lifestyle. This requires a change in mindset for many, particularly for baby boomers, whose parents lived off their pension and social security in retirement and may have expected to do the same.
Bottom Line: We are now responsible for saving for our own retirement.
The good news is we have more control than ever over on how we spend our retirement years and when we can retire too. The bad news is that too few of us are saving at the rate we need to fund even a bare bones retirement, much less our dream retirement.
Bottom Line: People will need to work longer than expected (or desired) because they cannot afford to quit.
Social Security Fun Fact
In their most recent survey of consumer finances, the Fed noted the average balance in a retirement account for people ages 55-65 is $120k. This is a low number when you consider current life expectancies. I still use Social Security in my planning for clients, but it is not THE plan. The additional income helps but likely will still be inadequate for most.
Social Security Tax Fun Fact
Did you know that more money is going in than coming out? An average “high income’ American couple (defined as having a joint income of at least $125,000) planning to retire in five years in 2020 will pay $909,000 in lifetime Social Security taxes but only receive $756,000 in Social Security benefits. In other words, for every $1 paid they paid in taxes, the couple will receive $0.83 in benefits (source: Urban Institute).
I will be dedicating another series to Retirement Planning, but I want to start by first outlining the different types of retirement plans and their tax benefits.
What Are Qualified Retirement Plans?
Qualified Retirement Plans (pre-tax money) are usually made available to employees by an employer. They are typically a 403 (b), 401k, 457, SAR-SEP, Simple IRA or Simple 401k.
- Each allow an annual pre-tax contribution based on your age.
- Maximum employee deferral for 2015 is $18,000 for 401k, 457, 403(b)/TSA and SAR-SEP plans. Those age 50 or older can contribute an additional $6,000 due to the catch-up provision.
- The employee contribution max is 12,500 for 2015 and the catch up over 50 is $3000 for those with a Simple IRA or a Simple 401k.
Tax Benefits of Qualified Retirement Plans
This money comes out of your compensation pre-tax, which lowers your taxable income for that year. It also allows the entire dollar (because it hasn’t been taxed yet) to go to work for your retirement. The taxes are deferred until you use the money or turn 70 1/2.
What Are Required Minimum Distributions
The 70 1/2 Required Minimum Distributions, often called RMDs, are required annually. They are calculated based on the balance of all your Qualified Accounts (tax deferred) on December 31st of the previous year. Then the IRS calculates how much you need to withdraw based on a uniform life expectancy table.
For example, you have $300k in qualified plans and are 70 1/2 this year. You would use the current tables, which states that you would use 27.4 years in your calculation.
$300,000 / 27.4 = $10,948.91
To calculate: Divide $300k by 27.4 which equals $10,948.91. This is the amount you need to withdraw by December 31st this year or face a 50% penalty or $5474.45. You then need to report this number on your taxes.
Safety Tip: It gets tricky when you have several accounts in different places to make sure you are taking your RMD correctly. You may want your financial advisor and/or CPA to assist you with this to avoid any penalties.
Retirement Plans for Small Business Owners
For the small business owner not all retirement plans are created equal, and each plan has a different set of rules around what you can contribute. For many of the plans, if you have employees, you will need to contribute for them as well. I would highly recommend that you consider sitting down with your financial advisor to make sure you are taking full advantage of the tax deferral and savings plans available to you as a business owner. It’s been my experience that most small business owners are so busy creating successful businesses that they miss huge opportunities to save money for their future.
What Are IRAs?
IRA stands for Individual Retirement Account, which you typically set-up yourself, rather than an employer-based program. They offer tax benefits and are commonly used to supplement a Qualified Retirement Plan.
- An individual can contribute $5,500 to a Traditional or a Roth IRA in 2015.
- There is also a catch-up provision of $1k for those 50 or older.
- There are eligibility restrictions based on your income for Roth IRAs.
- You may face penalties if you withdraw money before the designated retirement age.
Work with your CPA or financial to determine if you are eligible to deduct your contribution as there phase out ranges for the deductibility of contributions. A non-active participant (someone who is not earning money) can contribute and deduct an IRA if they have an active participant they file taxes with. Again, there are phase out ranges.
Did You Know: If your children earn any money, they are also eligible to contribute to an IRA. Starting their retirement savings at such a young age, gives their money plenty of time to grow and a real advantage over their peers.
Retirement Savings and You
This is a broad topic in taxes and each of your situations is unique to your family. Retirement savings, if done correctly, can save a substantial amount of taxes during your working years, while allowing you to use the whole dollar to save. The best part is you can’t miss what you don’t see (most set-up automatic contributions to Qualified Retirement Plans and IRAs), so it’s easy, painless savings that has a significant impact on achieving your retirement goals.
One important note on Qualified plans and taxes: Don’t just consider the tax impact/benefit today but also in retirement. More to come on this topic!
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