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Whole Ball of Tax 2003

SO MANY RETIREMENT OPTIONS, SO FEW RETIREMENT DOLLARS

Deciding Among Retirement Choices, Making the Most of Saving Incentives …While They Last

(RIVERWOODS, ILL., January 2003) – Thanks to new and revised laws, there are now more retirement plan choices and more incentives to spur individuals to save a little extra for their golden years. However, trying to figure out which to use when you have more options than money can be mind-boggling, according to CCH INCORPORATED (CCH), a leading provider of tax and pension information.

The main options most individuals have are contributing to their employer-sponsored plans — such as 401(k) plans, funding a traditional IRA or funding a Roth IRA. Employees of small businesses also may be eligible to participate in simplified employee pension IRAs (SEP-IRAs) and saving incentive match plans (SIMPLE). Each of these choices comes with different options and restrictions and, at least for the next few years, each may be funded with the help of tax credits that allow lower-income individuals to put more into retirement accounts. Additional contributions may be made to IRAs, 401(k) plans and SIMPLE plans by older individuals.

"Retirement options have become a lot more complex compared to the basic employer-funded pension plans employees of previous generations relied on," said CCH Pension Analyst Nicholas Kaster, JD, author of Saving for the Future: Roth and Traditional IRAs.

"Employees now have to be much more active participants in planning for their retirement, understanding what their options are and taking the lead in making investment choices based on their particular circumstances," Kaster said.

Choosing Between a Traditional Deductible IRA and a Roth IRA

Since the introduction of Roth IRAs in 1998, there has been a continuing debate as to which type of IRA is best: the traditional deductible IRA funded through pre-tax dollars or the Roth IRA funded through after-tax dollars. For 2003, individuals can contribute up to $3,000 to either type of IRA, assuming they meet the eligibility requirements. Which makes more sense depends upon the individual, their income and their long-term plans for using their retirement funds.

The first threshold is income and participation in other plans. Individuals, regardless of their income level, can qualify for a deductible IRA as long as they do not participate in an employer-sponsored retirement plan, such as a 401(k). If they are in an employer plan, however, they can only qualify for a deductible IRA if their income falls on the lower end of the scale. For 2003, this is $40,000 phasing out completely at $50,000 for single filers and $60,000 phasing out at $70,000 for joint.

Individuals can fund a Roth IRA regardless of whether or not they’re in an employer-sponsored plan.

However, to fully qualify for Roth IRA contributions, a single person’s adjusted gross income (AGI) must be less than $95,000, with benefits phasing out completely at $110,000. For married people filing jointly, the comparable figures are $150,000 and $160,000.

Assuming the income criteria are met, investors have to decide whether to take a deduction now and pay ordinary income taxes later – in which case they’d opt for a traditional IRA; or forego deductions now in return for receiving tax-free distributions later – in which case they’d opt for the Roth IRA.

"It can be tough making the call between a Roth and traditional IRA. You have to be willing to make some assumptions. At the time you’re making the decision, you don’t know a lot about the issues that can have an impact, for example, how much money you’ll earn in the account or what the tax rates will be at the time you take distributions," said Kaster.

Another factor to consider is whether the investor wants to take distributions at all from the account. Unlike a traditional IRA, which requires individuals to begin taking distributions when they reach age 70½, Roth IRAs do not require any distributions be taken.

"Roth IRAs can be a powerful estate planning tool for individuals who don’t need the money in retirement and whose top priority is to extend tax deferral for as long as possible," said Kaster.

"A grandmother could leave a Roth IRA to her 12-year-old grandson. The child would be required to take distributions over his life, but because his life expectancy is quite long, the distributions would be small and the money within the Roth IRA would continue to grow tax-deferred."

In addition to passing a Roth IRA on as part of an estate, Roth IRAs also are attractive for those who want to help a child get a head start in saving for retirement.

"Your teenager may not be too keen on contributing to her retirement from income she earned from her after-school job," said Kaster. "But as long as she earned at least as much as you’re willing to contribute to her Roth IRA, you can gift that to her to fund the Roth, and she can continue to spend the money she’s earned from her job or save it for something she wants."

Choosing Between a Traditional Nondeductible IRA and a Roth IRA

While trying to choose between a traditional deductible IRA and a Roth IRA can be difficult, it’s almost always an easier choice to decide on funding a Roth IRA over a traditional nondeductible IRA, assuming you meet the income requirements for a Roth IRA.

From a tax-savings perspective, a Roth IRA is a better option than a traditional nondeductible IRA, according to Kaster.

"With both types of IRAs, individuals are investing after-tax dollars, so there’s no up-front tax benefit," said Kaster. "However, distributions from Roth IRAs can be taken entirely tax-free, whereas distributions from nondeductible IRAs consist partly of nontaxable contributions and partly of taxable earnings."

An example of what this can mean: Consider a 30-year-old who contributes $2,000 annually to a traditional nondeductible IRA for 30 years.

Assuming he earns a return of 10 percent annually, he accumulates $361,886, of which $60,000 is basis. If he is in the 15-percent tax bracket at retirement, his tax due on this withdrawal will be about $45,283 (15 percent of $301,886).

If, rather than contributing to a nondeductible IRA, he establishes a Roth IRA, he could withdraw the entire proceeds of the account tax-free.

Choosing Between Employer-sponsored Plans and IRAs

Another choice facing many employees is whether to invest their retirement dollars into employer-sponsored plans, such as 401(k) plans – or their counterpart 403(b) plans for employees of tax-exempt organizations and 457 programs for government workers – or into an IRA.

Under tax law restrictions, all except lower-income employees who participate in qualified plans are precluded from making deductible IRA contributions. However, Roth IRAs aren’t subject to these active participation rules. Therefore, an individual could decide to fund both a Roth IRA and a 401(k) plan. Those with limited funds need to decide which is best.

"401(k) plans have two major advantages: They permit larger contributions ($12,000 in 2003) and employers often match a portion of the investment, which means the employee is able to fund part of their retirement with employer-provided dollars that wouldn’t be available through a Roth IRA," said Glenn Sulzer, JD, a senior CCH pension law analyst specializing in 401(k) plans. "So, it’s generally a sound strategy to first contribute to a 401(k) plan, at least up to the highest amount that an employer will match, before making a contribution to a Roth IRA."

For 2003, employees can defer up to $12,000 in 401(k), 403(b) or 457 plans, with the maximum contribution amounts increasing $1,000 each year until 2006, after which contribution limits are subject to cost-of-living increases. In comparison, the maximum contribution that can be made to either a Roth or a traditional IRA remains $3,000 for 2003 and 2004. For 2005 to 2007 it climbs to $4,000, and to $5,000 in 2008, after which contributions are indexed to inflation.

Other advantages of 401(k) plans include the ability of employees to borrow from their accounts. Also, many employees find it easier to save under 401(k) plans because the money is taken out of their paychecks before they see it, Sulzer noted.

Although individuals can’t borrow from Roth IRAs, these IRAs can be used to help meet many non-retirement goals, including saving for first-time home purchases, college education or certain medical costs. For example, a distribution for a first-time home purchase can be taken tax-free if the funds have been held in the account for five years. In addition, Roth IRA distributions are deemed to come from contributions first so that, as long as the total amount of withdrawals do not exceed the holder’s basis, no taxable event is triggered.

Vesting schedules for employer-sponsored plans also have been revised under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), allowing plans to choose between two vesting schedules. Using the gradual vesting schedule, employees become entitled to 20 percent of the employer contributions after two years of service, 40 percent after three years, 60 percent after four years, 80 percent after five years and 100 percent after six years.

Under a "cliff" vesting schedule, participants become 100-percent vested after three years.

Retirement Options Comparison Chart

 

Traditional Deductible IRA

Traditional Nondeductible IRA

 

Roth IRA

 

401(k) Plan

What is the annual per-person contribution limit?

$3,000 for 2002-2004; increasing to $4,000 for 2005-2007; and to $5,000 thereafter

Same as for traditional IRAs

Same as for traditional IRAs

$11,000 for 2002, increasing $1,000 annually through 2006

Is limit indexed for inflation?

Not until after 2008

Not until after 2008

Not until after 2008

Yes, after 2005

Are employee contributions deductible?

Yes

No

No

No

Can withdrawals be made tax-free?

No. Distributions subject to tax when withdrawn

Yes, for amounts attributable to contributions; No, for amounts attributable to earnings

Yes, for amounts attributable to contributions and distributions that are: 1) held for 5 years and 2) made on or after age 59 ½; upon death; upon disability; or for first-time home purchase

No. Distributions subject to tax when withdrawn

Are loans permitted?

No

No

No

Yes, if plan permits

Are minimum lifetime distributions required?

Yes, after 70½

Yes, after 70½

No

Yes, after 70½ or in the calendar year after the employee retires

Rollover to Roth IRAs allowed?

Yes, with tax consequences

Yes, with tax consequences

Yes

No

Source: Saving for the Future: Roth and Traditional IRAs,
2002, CCH INCORPORATED

More Options for Small Business Employees and Self-Employed

In addition to traditional and Roth IRAs, employees of small businesses also may have other options they need to be aware of – both in terms of qualified employer plans and other IRA options.

New for 2003 is the Deemed IRA. Introduced as part of EGTRRA, employers now can set up Deemed IRAs, essentially traditional or Roth IRAs, on behalf of their employees without impacting any other qualified plans the employer offers. Under a Deemed IRA, the employer can withhold contributions from an employee’s paycheck, making it easier for the employee to save. While Deemed IRAs can be established by employers of any size, they’re particularly suited to small businesses.

"There’s a concern that employees of smaller companies are at particular risk when it comes to having adequate retirement coverage, so lawmakers are trying to make it as easy as possible to get people covered by some type of retirement plan," said Kaster.

Toward that end, small businesses with no more than 100 employees also can receive a tax credit to help defray the costs of starting retirement plans. The credit amount is limited to $500 (50 percent of the first $1,000 of qualified start-up costs) incurred in the first year of the plan and in each of the two following years. Employer plans eligible for the tax credit include new qualified defined benefit plans, defined contribution plans — including 401(k) plans, SIMPLE plans, or SEP plans. Small businesses that started a plan before 2002 are not eligible for the credit.

SEP-IRA and SIMPLE Plan Changes

While any employer – including a corporation, partnership or a one-person sole proprietorship – can establish a SEP-IRA, these plans are generally geared to small businesses or self-employed individuals. For 2002 and beyond, the contribution limits for SEP-IRAs have risen considerably. Employer contributions are now the lesser of 25 percent of the employee’s compensation (up to the compensation limit of $200,000) or $40,000.

Increased employee contributions also are available for SIMPLE plans. Under these plans, for employers with 100 or fewer employees, employees can make elective contributions of up to $8,000 in 2003. The contribution amount rises by $1,000 per year until it reaches $10,000 in 2005, after which it will be indexed for inflation. Under SIMPLE plans, employers generally must make either a matching contribution or a nonelective contribution on behalf of each eligible employee.

Individuals may contribute to a SEP-IRA or may make elective deferrals under a SIMPLE IRA and, assuming they’re eligible, still fund a traditional or Roth IRA.

"As with other employer-sponsored plans that offer matching funds, employees covered by SIMPLE plans should consider investing in the employer plan first – at least up to the maximum matching point – to accrue as much retirement funding as possible," said Kaster.

Taking Advantage of Extra Incentive Savings

Another outcome of EGTRRA was added incentives to help employees nearing retirement and those employees in lower income brackets to accelerate saving for retirement.

Individuals 50 years old and older are allowed to make "catch-up" contributions to employer-sponsored plans or to IRAs in addition to regular contributions. Those in 401(k), 403(b) and 457 plans can contribute up to $2,000 extra in 2003. Participants in SIMPLE plans can make up to $1,000 in catch-up contributions for 2003, while IRA participants can contribute an additional $500. All the plans increase catch-up contribution levels over the next several years.

Maximum Catch-Up Contributions by Plan Type

 

401(k), 403(b) and 457 plans

SIMPLE plans

IRAs

2002

$1,000

$500

$500

2003

$2,000

$1,000

$500

2004

$3,000

$1,500

$500

2005

$4,000

$2,000

$500

2006 and after

$5,000

$2,500

$1,000

While recent laws have attempted to make 401(k), 403(b) and 457 plans more comparable, one unique feature of 457 plans will be retained under the catch-up contributions. In the three years before retirement, participants in 457 plans will still have the opportunity to make the special, large catch-up contributions that have long been a feature of government plans. Participants in governmental 457 plans who have attained age 50, however, may make the catch-up contributions authorized by EGTRRA if those contributions would exceed the catch-up contribution permitted during that last three years of employment.

As with many other provisions in EGTRRA, the catch-up contributions are set to expire after 2010 unless extended by further legislation.

Also available for a limited time – through 2006 – are incentives for lower-income workers to start building up their retirement funds. Under this program, individuals will be eligible for a tax credit of up to 50 percent of the amount of their contributions to employer plans or IRAs, based on their income and filing status. The "saver’s" credit applies to the first $2,000 of contributions, so the maximum credit is $1,000.

Saver’s Credit

Maximum Credit

Max. AGI

for Joint Filers

Max. AGI for

Single Filers

50% of first $2,000

$30,000

$15,000

20% of first $2,000

$32,500

$16,250

10% of first $2,000

$50,000

$25,000

"The saver’s credit stems from the recognition by policymakers that while many individuals could benefit from the increased contribution limits for retirement plans there still were a significant number of individuals that weren’t even nearing the old limits and they needed an extra incentive to save," said Kaster.

One of the interesting outcomes of the saver’s credit is that it could essentially provide an up-front tax saving to the historically tax-deferred Roth IRA. For example, a married couple filing jointly with an AGI of $30,000 and with each spouse contributing $800, for a combined total of $1,600 to a Roth IRA could be eligible for a credit of $800, or 50 percent of their contribution.

There are several limitations to the credit, however. It’s not available to people under the age of 18 or those who are claimed on someone else’s return.

For example, a child funding a Roth IRA could not take advantage of the credit.

In addition, withdrawals from a qualified plan or an IRA made within a "testing period" count against the contributions that can be considered for the credit. The testing period for each year’s contributions includes the current tax year, the previous two tax years and the period in the following tax year up to the due date of the return, including any extensions.

Married taxpayers should further note that distributions received by a spouse will be considered to be distributions to the taxpayer, and thus, will reduce the contributions used in calculating the credit, if a joint return is filed for the tax year in which the spouse received the distribution.

Distributions from a Roth IRA that are not rolled over will reduce the amount of the saver’s credit, even if the distributions are not taxable. However, a distribution that represents a return of a contribution of a Roth IRA or traditional IRA for the tax year will not reduce the saver’s credit if: the distribution is made before the due date of the individual's tax return for that year, no deduction is taken for the contribution and the distribution includes income attributable to the contribution.

In addition, plan distributions that are not includible in income because of a trustee-to-trustee transfer, rollover distributions, and loans treated as distributions do not reduce the saver’s credit.

The effectiveness of the saver’s credit also is limited by the fact that it is nonrefundable and, while it can reduce a participant’s tax burden to zero, it can’t reduce it any lower. Thus, the credit does not entitle an employee to an income tax refund. Those who owe little tax – or who may even be eligible for refundable earned income or child credits – will receive little or no benefit from the credit. However, the saver’s credit will not reduce a taxpayer’s refundable tax credits, such as earned income credit or the refundable portion of the child tax credit.

About CCH INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, legal, securities, insurance, human resources, health care and small business markets. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH web site can be accessed at cch.com. The CCH human resources web site can be accessed at hr.cch.com. The CCH tax and accounting destination site can be accessed at tax.cchgroup.com.

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nb-03-22

   

 
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2003 Bush Tax Plan

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(847) 267-7153
 
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Neil Allen
(847) 267-2179
allenn@cch.com

   


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