Year-end tax guide: Retirement savings

2015 Year-end tax guideRetirement planning is tricky for managers, executives and business owners. Your business’s retirement benefits can be costly, but are among the most important benefits for attracting and retaining employees. Plus, you’ve got your own retirement to worry about. Fortunately, lawmakers have loaded the tax code with valuable incentives, and with careful planning, these incentives offer you some of the best tax savings in the code.

As fewer employers offer defined benefit pension plans, most businesses and individuals are focused on defined contribution plans. They come in employer-sponsored versions like 401(k)s, 403(b)s, 457s, SIMPLE IRAs and SEP IRAs, or in nonemployment versions like individual retirement accounts (IRAs). All of these accounts have contribution limits and different rules and benefits, and some allow extra catch-up contributions if you’re 50 or older.

Comparison of tax-preferred retirement savings vehicles (click to view chart)

Q: What happens if I withdraw from my account before age 59½?
You are generally subject to a 10% penalty, plus normal tax, unless you qualify under narrow exceptions. Many 401(k) plans let you borrow against your account without tax consequences; there are also hardship waivers that can allow you to escape the 10% penalty (but not normal tax).

Q: Do I have to include my employees in my retirement plan?
Yes, the price for the tax advantages offered is that employees are generally required to be covered, and plans have nondiscrimination rules.

Q: When should I take money out of my account after I retire?
Generally, if your account is appreciating and you don’t need the money immediately, you should wait to make withdrawals until you’re required to do so. Your assets will continue to grow on a tax-deferred basis.

Unfortunately, you must begin making annual minimum withdrawals from most retirement plans at age 70½. These required minimum distributions (RMDs) are calculated using your account balance and a life-expectancy table. They must be made each year by Dec. 31 or you are subject to a 50% penalty on the amount you should have withdrawn (although your initial RMD when you turn age 70½ can be deferred until April 1 of the following year). You may not be required to make distributions if you’re still working for the employer who sponsors your plan.

Employer accounts
Employer-sponsored defined contribution accounts have several advantages over IRAs, which are generally maintained by an individual. For one, many employers offer matching contributions, and there are no income limits for contributing.

Because of the tax advantages, contributing the maximum amount allowed is usually a smart move. The tax benefits of these accounts (in the traditional versions) are twofold: Usually contributions are pretax, so they reduce your current taxable income, and assets in the accounts grow tax-deferred — meaning you will pay no income tax until you receive distributions.

Business perspective: Managing your 401(k) plan
Qualified plans such as a 401(k) or a 403(b) remain among the most popular retirement plans for employers. But they can be costly and complex to administer. Unless you operate your 401(k) plan under a safe harbor, you must perform nondiscrimination testing annually to make sure the plan’s benefits don’t favor highly compensated employees over other employees.

The safe harbors require employer contributions. If you operate under a safe harbor but need to conserve cash and cut costs by ceasing 401(k) contributions, you must amend the plan and give employees advance notice. Employees must have the option of changing their contributions during this advance notice window, and the nondiscrimination test must be performed for the entire year.

Despite the challenges of a qualified plan such as a 401(k), it is still an attractive option for many reasons:

  • A qualified plan has significant design flexibility to allow sponsors to provide value to their top executives.
  • Nonqualified plans aren’t as tax-effective for plan sponsors as qualified plans, because the employer doesn’t receive a current tax deduction for contributions to a nonqualified plan.
  • Employer contributions to a qualified plan are never subject to Federal Insurance Contributions Act (FICA) or other payroll taxes.
  • Distributions can be rolled over on a tax-free basis, so an employee’s taxable event is delayed until the actual payout from a tax-qualified retirement vehicle such as an IRA.
  • The use of qualified retirement plans avoids Section 409A penalty risks.

If you don’t already do so, consider offering employees a Roth version within your qualified plan. These are popular with employees, and it’s now easier for employees to roll over their traditional account into a Roth version within the employer plan.

Individual accounts
Individual IRAs come with some limits that can make them harder for successful taxpayers to use. Contributions to traditional IRAs aren’t deductible above certain income thresholds if you’re offered a retirement plan through your employer. For 2015, the deductibility of IRA contributions phases out between an adjusted gross income (AGI) of $98,000 and $108,000 for joint filers and between $61,000 and $71,000 for single filers.

Still, IRAs have advantages. You have more flexibility over how you invest, and you can even self-direct an IRA. An IRA can be an important supplement to employer-sponsored plans, and many higher-income taxpayers maintain IRAs that were opened when they were earning less or consist of rollovers from employer-sponsored plans. If you’re above the deductibility threshold, you can also consider making nondeductible contributions because the tax-free growth of the account still provides a benefit. Be aware, however, that your distributions will be ordinary income rather than capital gain. You can roll over nondeductible contributions into a Roth version without paying tax, but it may be easier to contribute directly to a Roth account if you haven’t exceeded the Roth IRA income limit.

Tax law change alert: IRS limits indirect IRA rollovers
The IRS issued new rules this year limiting taxpayers to a single indirect IRA rollover in any 12-month period beginning after the end of 2015. You make an indirect rollover when you withdraw money from an IRA and contribute it to another IRA within 60 days. This is typically a tax-free transaction if done properly. Under the new rule, if you make two indirect rollovers within 12 months of each other, the second is disallowed. The withdrawal will be included in gross income and could be subject to a 10% early withdrawal tax, while the contribution to the other IRA could be treated as an excess contribution subject to a 6% tax. The good news is that you can still make as many direct rollovers as you want. A direct rollover occurs when you instruct your IRA trustee to distribute your money directly into another IRA.

When to choose a Roth version
Four of the defined contribution plans — 401(k)s, 403(b)s, governmental 457(b)s and IRAs — offer Roth versions. The tax benefits of Roth accounts differ slightly from those of traditional accounts. Roth accounts allow for tax-free growth and tax-free distributions, but contributions are neither pretax nor deductible.

The difference is in when you pay the tax. With a traditional retirement account, you get a tax break on the contributions — you pay taxes only on the back end when you withdraw your money. For a Roth account, you get no tax break on the contributions up front, but you never pay tax again if distributions are made properly. See our planning tip for which account makes the most sense for you.

Unfortunately, there is an income phaseout for contributions to a Roth IRA. For 2015, the ability to make Roth IRA contributions begins to phase out at an AGI of $183,000 for joint filers and $116,000 for single filers. However, if you participate in an employer-sponsored 401(k), 403(b) or 457(b) plan that allows Roth contributions, these income limits don’t apply for contributing to the plan.

Planning tip: Boost tax-protected savings with a Roth rollover
Rollovers into Roth accounts have become very popular even though they go against the traditional strategy of deferring tax. To convert into a Roth account, you must pay tax on the rollover immediately in exchange for no taxes at withdrawal. So why pay tax now instead of later?

  • You must pay the tax on your rollover from money outside the account. This has a silver lining. It reduces the cash outside the account, but your full account balance after the rollover becomes tax-free, effectively increasing the proportion of your total wealth in a tax-preferred investment.
  • There are no RMDs for a Roth IRA, so you can let your money appreciate  tax-free as long as you want — or grow tax-free until death (unfortunately, this is not the case with a Roth 401(k) within an employer plan). After your death, the tax-free distributions to your heirs can be made over several years. What’s more, by prepaying the income tax on the account during the conversion, you’ve effectively removed that amount from your estate for estate tax purposes.

But there are many reasons to be cautious:

  • The time value of money still makes deferral of taxes a powerful strategy.
  • A large conversion can generate a lot of income, which could affect other tax items tied to AGI (including how much of your Social Security benefits are taxed).
  • Paying tax now may not make sense if you’ll be in a lower tax bracket during retirement.
  • Paying tax now may not make sense if you plan on moving to a lower-tax state to retire.

If you’re uncertain about a Roth conversion, remember that you can reverse it by “recharacterizing” the rollover as a contribution to a traditional IRA. (This option is not available for rolling over into a Roth 401(k) within an employer plan.) This makes it a fairly safe tax play. You have until your extended filing deadline to recharacterize contributions, so you can make a conversion and then reverse it if the value of the assets declines.

Example: (click to view chart)          

Business perspective: When to choose a SEP or a SIMPLE for your small business
Because 401(k) plans can be so difficult and costly to administer, lawmakers have given small businesses simplified ways to offer themselves and their employees the tax benefits of retirement accounts.

So which is a better fit for your business, a simplified employee pension (SEP) or a savings incentive match plan for employees (SIMPLE)?

A SIMPLE is limited to businesses with 100 or fewer employees, while a SEP is more broadly available. You adopt a SEP agreement and make contributions directly to traditional IRAs for you and each of your eligible employees. SEPs do not let employees make contributions themselves, but have a high limit on employer contributions. The maximum 2015 contribution is the lesser of $53,000 or 25% of your eligible compensation (net of the deduction for the contributions). Your employees are always 100% vested.

SIMPLE plans come in two types: the SIMPLE IRA and the SIMPLE 401(k). Unlike a SEP, a SIMPLE plan allows employees to contribute to their SIMPLE accounts, but only up to $12,500 for 2015. Like a SEP, a SIMPLE plan requires employers to contribute and provides that employee contributions are immediately 100% vested. Employers are required to contribute either of the following:

  • Dollar-for-dollar matching contributions up to 3% of an employee’s compensation
  • Fixed contributions of 2% of compensation

Eddie Adkins
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