IRS Rule Changes on 403(b) Plans

Last week, I discussed the lack of the level of uniformity in the set-up and administration of 403(b) plans as compared to their 401(k) counterparts.  Specifically such areas as lack of employer involvement, lack of fiduciary responsibility, and lack of employee education has effected a recent change in IRS regulations.  It's important to note that many employers do take the administration of their 403(b) plans very seriously and are on an “even keel” with their 401(k) counterparts. 

However because of the lack of uniformity of 403(b) plans, the IRS issued new regulations on July 26, 2007.  The purpose of the regulations was to bring 403(b) plans more in line with 401(k) plans in terms of formalizing procedures. 

Here are the key provisions of the new regulations:
1)   Plan terms and conditions must be in writing - All plans must have a written plan document that satisfies section 403(b) (of the tax code).  Specifically the document must contain terms and conditions for eligibility, limitations, and benefits under the plan.  The goal of this rule is to have one set of plan provisions that apply to all investment issuers.
2)  Contributions Limits must be spelled out - Generally this means the same contribution limits as 401(k) counterparts.  However, there's a special provision for employees who have worked for the same employer for at least 15 years and whose average contributions their plan have not exceeded $5,000 annually.  These employees can contribute an additional $3,000 above the elective deferral limit of $15,500.  Participants over 50 years of age can contribute an additional $5,000.
3)  Employers will need to oversee whether vendors are fulfilling their administrative obligations - This basically places the responsibility on the employer instead of the employee.
4)  Plan Terminations now allowed - Before this law change, there were no provisions for terminating a 403(b) plan.  Plans could be “frozen” but not terminated.  Employers may now terminate their 403(b) plans and assets may be distributed to participants who may (if they wish) roll them into their own IRA accounts.
5)  Certain types of employees can no longer be excluded from the plan - Before this law became effective, certain employees could be barred from plan participation.  This was typically union employees or visiting professors.  Now, if one employee is allowed to make elective deferrals, all must be allowed to do so.  The only exceptions are nonresident aliens, employees eligible for 457(b) deferrals (known as deferred compensation plans), students, and employees who normally work fewer than 20 hours per week.
6)  Roth accounts are now permissible - The new regulations allow designated Roth contributions under 403(b) plans.  However this does not mean that your 403(b) plan allows for it.  The employer must make the decision on whether or not to include the Roth provision.  
7)  Life Insurance is no longer allowed - Separate contracts of incidental life insurance will no longer be allowed with 403(b) plans.  However a grace period allows contracts issued up to 60 days after publication of the regulations to be grandfathered.

All 403(b) plans must comply with the newly passed provisions for tax years starting after December 31, 2008.

The Defined Benefit Plan for the Small Business Owner     Back to top

Last week, I began a series devoted to retirement planning for the small business owner.  I started off by explaining the overall differences between the two main types of plans:  Defined Benefit (DB) and Defined Contribution (DC).  This week I will go into more detail on the Defined Benefit Plan for the small business owner and how this can help him reach his goal of a more secure retirement.

As stated last week, a defined benefit plan might be the single most effective way for certain business owners to “sock away” as much money as possible into a plan.  Although contribution limits are certainly more liberal than in the past, defined contribution plans are still quite limited for those with the ability and the need to invest significant retirement dollars.

The DB plan would be well-suited for the business owner with the following characteristics:
Middle-Aged - Generally Mid-40's and up.
Owns a business with few (if any) employees.
Is in a position to significantly fund relatively large retirement contributions.  (i.e. nets over $75,000 or more per year).
Is committed to yearly contributions for a period of at least 3 years.

This type of plan is generally well-suited for a successful business owner who does not have any significant retirement assets.  This person usually has focused on their children and their business and perhaps was not in a position in their younger years to fund retirement plans under the more conventional methods.  Now they might be in a position where the children are grown, their debt is paid off, and their business is successful.  Their yearly income is high enough where they can “kill 2 birds with one stone”.  This would be funding their retirement AND at the same time, significantly reducing their federal tax liability.

These plans are popular with service-oriented business professionals (Doctors, Lawyers, etc.).  Businesses such as these are often dependent upon the skills and expertise of the one owner.  They might not have significant tangible business assets like some other businesses.  Since in many cases the owner IS the business, it's important to have enough retirement assets upon disposition of the business.  A defined benefit plan can provide this.  Even for those businesses with significant tangible business assets, owners might want to consider diversifying in a retirement plan.  After all, it's quite risky, especially with technology and general changes in any business environment, to assume that selling your business in the future will provide you with all your retirement needs.

Contributions - Amounts you can contribute each year depend on many factors and assumptions.  You, as the business owner decide how much you want your benefit to be (this is why the plan is called a defined benefit plan because YOU are defining the benefit you will receive in retirement).  Once the benefit is defined, the next step is to determine how much you will need to “put away” each year to reach that goal.  This of course depends upon your age, your compensation, assumed rate of return on investments, actuarial assumptions, when you plan on retiring, and current tax law.  It is not unusual for business owners to contribute over $100,000 in a given year to their defined benefit plan.  This is one of the major advantages of a DB plan over other types of retirement plans.

The DB plan is flexible regarding some of the above assumptions.  For example if the benefit originally defined is not realistic, it can generally be changed within certain plan guidelines.

Next week, I'll discuss some of the more conventional plans that fall under the Defined Contribution category.

Roth 401(k) Plan - Available for 2006!      Back to top

Beginning in 2006, traditional 401(k) plans have the option of having a Roth feature!

This means you can designate some or all of your salary deferrals (contributions) as “Roth” contributions.

With any qualified retirement plan, there are 4 components that you must understand
1)  Employee Contributions - This is the amount deducted from your own paycheck and contributed into your retirement plan
2)  Employer Contributions - This is the amount your employer may contribute towards your retirement.  This is often based on a percentage of your income.
3)  Earnings on amounts contributed - This represents the growth of your contributions throughout the years
4)  Distributions - These are amounts you take out in your retirement years (after age 59½).

Under the traditional set up, contributions are not taxed, earnings grow tax-deferred, and ALL distributions are taxed as they are taken out years later.   This is under the “traditional” thinking that it is wiser to take a tax break on your contributions now because you are making more money in your earnings years and are in a higher tax bracket than you will be at retirement.  You then defer paying taxes on any growth in your investments as they increase in value over the years.  Finally all distributions will be taxed as you take money out of your retirement plan.  These distributions will be taxed at the tax rates in effect at the time you take your money out.

In contrast under the Roth, contributions ARE taxed, earnings are NOT subject to taxes as they grow, AND distributions are NOT taxed when you take them out.  In essence, the only thing ever taxed was the amounts you contributed into the plan.  This is a very big deal, especially for people with longer time horizons until retirement and for those of us who think we will be in a higher tax brackets in the future.  With the strains on our health care system, social security, and the aging population, it is difficult (especially for younger people) to believe that tax rates will remain the same or go lower in the future.

Here are some key points of the Roth 401(k) feature:
1)  Your employer would have to adopt it - In order for you to take advantage of this feature your employer would have to adopt it.  This is an optional feature to existing and future 401(k) plans.  You can not take advantage of the Roth 401(k) feature unless it is adopted by your employer.
2)  Unlike a Roth IRA, there are no income limits.  Individuals with high incomes can obtain the benefits of a Roth if their employer adopts the Roth 401(k) feature.  Under a Roth IRA, there are income limitations.
3) Contributions would be available for participant loans.
4) Roth 401(k) contributions may be matched (employer matching).  However, matching contributions and earnings are taxable upon distribution.
5) Like a traditional 401(k), a terminated employee would have the option of rolling over their Roth 401(k) account to a Roth IRA or another plan with a Roth 401(k) feature.

Employers should consider allowing this feature into their retirement programs.  It simply offers more flexibility for you and your employees.  One drawback is that it would require a bit more record keeping.  This is because the Roth 401(k) contributions would have to be accounted for separately.  You would have to make sure that your staff or payroll service would be able to handle this additional task.

The SIMPLE IRA      Back to top

Continuing on with my series of retirement plans for small businesses and small business owners, I will go over another common plan; the SIMPLE IRA.  This plan generally is considered for those smaller businesses who want to contribute something for their employees as well as saving for their own retirement.  It also gives the employees the option to make their own contributions into the plan, just like a 401(k) plan.

SIMPLE stands for Savings Match Plan for Employees.  The SIMPLE IRA has some large differences over the SEP plan that I discussed last week.  Here are the major ones:

1.   Employee contributions allowed - Under a SIMPLE Plan, employee contributions are allowed.  This means that the employee can have wages deducted (on a pre-tax basis) from his paycheck, in the same way as a 401(k) plan.  In fact, the SIMPLE plan is often thought of as a “mini” 401(k) plan because it is fairly easy (simple) and not costly to administer.
2.  Eligible Employee - For purposes of a SIMPLE Plan, an eligible employee is one who has earned $5,000 during any two preceding years and who is expected to earn $5,000 in the current year.
3.  Employer contributions are mandatory - Unlike a SEP plan, the employer has less leeway regarding contributions make to his employees.  The employer has two choices regarding contributions he makes to his employees. 
a. Dollar for Dollar match of up to 3% of pay or
b. 2% of gross pay for ALL eligible employees who earn at least $5,000 during the year.

The dollar for dollar match option is only for those employees who are making employee contributions to their plan.  So if you have employees who are not deducting money from their pay into the SIMPLE plan, an employer contribution would NOT be required.  Under this option, the employer can reduce the match to as low as 1% for two years out of a five year period.  This is designed to help the employer if he has a difficult year financially.

The second option is an across the board 2% contribution for all eligible employees, even the ones who do not contribute to the plan.

4.  Contribution Limits - Under a SIMPLE plan, the combined maximum contribution (both employer and employee) cannot exceed $23,000 ($28,000 for those over 50).  Maximum contributions are split evenly between employer and employee.
5.  Number of participants - SIMPLE plans are only for that business with no more than 100 employees.  This is why you will not see large businesses with SIMPLE plans.  They would most likely offer the 401(k).
6.  Timing of plan establishment - A SIMPLE plan can only be established for the current year between January 1 and October 31.  This is unlike the SEP plan which can be established all the way up until tax filing deadline (including extensions).

The SIMPLE plan is an efficient and effective way for small businesses (with no more than 100 employees) to establish a retirement plan without the added costs and complexities that some other plans carry.

403(b) plans (Tax Sheltered Annuities)     Back to top

Most people are familiar with the term 401(k).  However several people who are employees of colleges, school districts, and nonprofit organizations use 403(b) plans to supplement their retirement.  This week, I will provide some history and information about 403(b) plans and next week, I will go into some detail about changes that were recently signed into law for these plans.

403(b) plans are similar to the 401(k) in the sense that employees can set aside a portion of their pretax salary in a tax-deferred account.  The major difference between the two types of plans has been the employer's lack of involvement in the case of 403(b) plans. 

Many 403(b) plans are not endorsed by the employer at all but exist as loosely defined alliances between individual participants and product sponsors.  In fact, it's not uncommon for some employers to maintain “lists” of different advisors/product sponsors that employees can use for their 403(b) plan.  Sometimes employers are very flexible in allowing their employees to choose anyone they wish to set up individual 403(b) plans.  The bottom line here is that has not been a level of uniformity in the set-up and administration of 403(b) plans.  Some employers take a very active role while others do not.  Likewise, some employers place stringent restrictions on their plans while others do not.

Regarding participant education, the same applies.  Some employers play a very limited role (if at all) in educating participants about investment choices while others view this as an important responsibility.  In any case, employers of 403(b) plans (unlike 401(k) plans) are currently NOT subject to fiduciary responsibility. 

This might be due to the fact that since 403(b) plans were established by the tax code in 1958, they were required to be invested in annuities.  The vast majority of these were fixed (i.e. low risk and less volatile annuities).  This is where the term “Tax Sheltered Annuities” (TSAs) came from. 

In 1974 the law was changed so that investments in 403(b) plans did not have to be wrapped in the “annuity” shell.  This allowed for regular mutual fund investments for example to be inside employees 403(b) plans without also being inside an annuity.  The TSA term is often used interchangeably with 403(b) even though some 403(b) plans are not annuities.

The vast majority of 403(b) plans however are in fact still in annuities, although now many more are in “variable” annuities as opposed to the fixed annuities. 

From the IRS's standpoint, the concern is that no one is helping to ensure that these accounts comply with distribution and reporting requirements that govern all qualified plans.  Next week I'll go into some detail on recent tax laws that were passed.  The overall goals of the changes were to put 403(b) plans on a more even level with their 401(k) counterparts.

Defining “Defined Benefit” and “Defined Contribution” Retirement Plans      Back to top

In the past, I've discussed the difference between the two main types of employer retirement plans; defined benefit (pension) plans and the defined contribution plans.
This information bears repeating as it will help people understand why the traditional pension plan continues to decline.  Lets' discuss the two basic types of employer retirement plans:  “Defined Benefit” (DB) vs. “Defined Contribution” (DC).

Defined Benefit - This plan is the “traditional” type of plan that was more common in years past (although these plans continue mainly in governmental jobs).  A defined benefit does just that; define the benefit that employees will have upon retirement.  Benefits payable are usually determined by such factors as length of employment and the amount of wages you earn.  An example of a benefit is often determined as a percentage of your average income over the last 5 years worked.  You would then receive this benefit upon retirement.  The responsibility to fund the obligation is essentially upon the employer and amounts needed to provide future benefits are determined using complex actuarial assumptions based on an assumed rate of return.  This calculation is performed each year and determines the additional amounts needed to fund the plan.

A defined benefit plan is much more expensive to administer for the employer than its defined contribution counterpart.  This is particularly true in the cases of a mature work force.  Quite simply, older people are closer to retirement and the amount of money needed to fund the retirement benefit will be much greater than the amount needed to fund a younger employee who is just starting out with the company. 

Because of the higher costs, defined benefit plans have fallen out of favor in recent years with many employers.  In many cases (even when the employer may like to provide such a plan), it has simply become nearly impossible to do so if he wants to remain competitive.  There are still several of these plans still in existence today.  In fact many large corporations and government entities use the defined benefit plan.  Many of these same employers use a combination of DB and DC plans.

Defined Contribution - A DC plan is pretty much the opposite of the defined befit plan because it is the contribution that is defined, not the benefit.  Most people are covered under 401(k), 403(b), or a deferred compensation plan.  These can also be referred to as “pension plans” or a TSA plan (tax sheltered annuity).  This often confuses people as it can give the impression that it is more like a DB plan.  With DC plans, the employer (if he decides to match at all) can contribute a percentage of the employee's salary.  That ends the employer's obligation.  Generally under a DC plan, the responsibility of how funds are invested lie with the employee, not the employer.  The benefit that the employee receives is a function of how well he/she invests the funds that are contributed by the employer (if any) and the amount of funds deducted from his/her paycheck through the working years.

This week I am continuing on with my series of retirement plans geared towards the small business owner.  Last week, I discussed the defined benefit plan and how it can significantly help those business owners who are in a position to invest large sums to reach their retirement goals.

This week, I will go over to the defined contribution (DC) side and discuss a popular choice of many self-employed individuals, the SEP-IRA plan.

By definition, the SEP IRA stands for Simplified Employee Pension Individual Retirement Account.  I prefer however to think of the SEP as standing for (Self Employed Person's IRA.  This is because many people who use SEP plans are individual business owners with no employees.  The SEP IRA is one way for employers to provide their employees with retirement benefits.

Under a SEP IRA, the employer makes tax deductible contributions for their employees.  Unlike a 401(k) plan, no employee contributions are allowed in a SEP. (i.e. the employee can not contribute to the SEP with money deducted from their paycheck).

SEP plans have minimum guidelines regarding which employees must be covered.  For example any employee who has worked for three out of the past five years and is age 21 or older must be covered.  The employer at his discretion, can make employee eligibility rules for his employees more liberal but he cannot make them stricter.

For the 2009 year, employers are limited to a contribution of 25% of the employees pay or $49,000 (whichever is less).  Employees are not eligible to make contributions into a SEP Plan.

It should be noted however that SEP contributions are NOT mandatory for the employer.  This can provide him with much needed flexibility for years that are not as profitable.  As you will see in future articles, there are some plans that require the employer to make employee contributions regardless of the business's profitability.  The defined benefit plan that I wrote about last week is one such plan.

Under a SEP plan employees are 100% vested immediately.  Vesting percentages refer to the percentage of employer contributions they are entitled to.  Many plans out there require that the employee be employed for a minimum number of years (i.e. 5 years) in order for him to be eligible to receive 100% of employer contributions.

The business owner of course under a SEP IRA can make his own contribution.  Unlike a traditional IRA for example, where he could only deduct the maximum of $4,000 ($5,000 If he's over 50 tears old), under a SEP, he would be able to deduct potentially much more.

SEP IRA plans are in a nutshell uncomplicated.  These plans are generally very low cost, require minimal tax filing, flexible, and do not require the employer to make contributions.  These are the main reasons why SEP IRA plans are a popular choice for the small business owner.

Next week, I'll discuss the SIMPLE IRA and how it differs from the SEP Plan and other defined contribution plans.

Retirement and the Small Business Owner -      Back to top
By Robert L. Tackabury, CPA

Many small business owners who start or purchase a business do so for a number of reasons, both emotional and financial.  Social status, the freedom to be your own boss and the potential for a high income are a few of the reasons commonly cited.

For some, business ownership is also seen as a primary way to pay for retirement.  If everything goes as planned, the business owner works hard and, over time, the business grows and becomes more valuable.  When the owner reaches a certain age, the business is sold and proceeds from the sale can fund the retirement years.

Using the business as the sole means of achieving financial independence amounts to placing a bet that the owner will be able to sell at the right time, the right price, and under the right terms.  There are several reasons why this may not happen:

Business Failure - Despite good intentions and hard work, businesses do fail.  In 2000, for example, there were 574,300 new small businesses (less than 500 employees) started in the United States.  In the same year 542,831 small businesses closed their doors.
Timing of the sale - Selling a business is a complex, often time-consuming procedure.  The actual process of finding a buyer, negotiating the deal, arranging financing and finally closing the sale may extend over months or even years.
Proceeds - Depending on market conditions, the amount realized may not be enough to pay for retirement.  Income taxes will inevitably consume some of the proceeds.  The owner may have to accept installment payments, rather than a lump sum.
“I am the business” - The value of a business may depend largely on the skills and/or customer relationships of a particular owner.
Changes in the business environment - As we all know things change.  What currently may be a very profitable business may not be so in the future due to technology and other factors.  Although the business may still be going, it won't enjoy the prosperity that it once had.

A business owner who seeks to reduce risk will view his or her business as one asset among many.  In addition to the business a diversified portfolio could include the following:

Qualified retirement plans - Business income is used to fund employer-sponsored qualified plans with a current deduction for contributions and tax-deferred growth.  There are now several options available to small businesses due to recent legislation.
Nonqualified plans - Nonqualified deferred compensation plans are often used to reward selected employees and serve to supplement qualified retirement plans.
General investment portfolio - A business owner can develop a general investment portfolio, outside the framework of the business.

Entrepreneurs should always try to make balanced financial decisions in order to benefit their business and their future.  If you have questions or would like to start up a retirement plan for your small business, please call me at 315-825-0255.

Profit Sharing & Money Purchase Plans     Back to top

This week, I will continue my series of retirement plans for small businesses by discussing two other common types of Defined Contribution plans:  the Profit Sharing Plan and the Money Purchase Plan.

These two plans have many things in common:

Employee Eligibility:  The minimum requirement for both plans would be any employee with 1,000 hours of service within one year and who is age 21 or older.  The employer can make eligibility less restrictive if he chooses.

The maximum contribution that the employer may deduct per employee (including himself) is 25% of each employee's eligible payroll.  (Eligible payroll is capped at a limit of $245,000 per employee).

The employer can however allocate as much as 100% of each employee's pay or $49,000 (whichever is less).

Example:  An employee earns $50,000 per year.  In this case, the employer can deduct a contribution of $12,500 (25% of $50,000).  But he can if he wishes, contribute as much as $49,000.

Unlike a SIMPLE IRA, employee contributions are not allowed under the Profit Sharing and Money Purchase Plans.  Also, you must set up a plan by the end of the employer's calendar year (or fiscal year).

Both profit sharing and money purchase plans allow for participant loans in much the same way as 401(k) plans.  This feature is not allowed on the SEP and SIMPLE plans that I discussed in a few weeks ago.

Finally both plans allow for employee vesting.  This means that you can require your employee to stay with your company for a particular amount of time in order to receive all contributions.  If the employee does not meet this requirement the contributions are considered “forfeited” and will be allocated amongst remaining employees.  Vesting is usually accomplished through a schedule.  A common one might be a 20% per year vesting until the employee is 100% vested after 5 years.

The major difference between a Profit Sharing Plan and the Money Purchase Plan is in regards to Employer contribution flexibility.  Under a profit sharing plan, any contribution is at the complete discretion of the employer.  There is no requirement as in some other plans.  This can be a very attractive feature for those employers who wish to maintain flexibility.

Under a Money Purchase Plan there IS a required minimum employer contribution.  Generally, the employer must contribute the percentage of each employee's income as stated in the original plan document (the document that the employer signs when he sets up the plan for the business).

A profit sharing plan is also allowed to purchase life insurance.  This cannot be done in most other plans and can be very beneficial for some more affluent clients.  I will write on this in a future article.
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Bob Tackabury is owner of Robert L. Tackabury, CPA 2556 Rt. 12B, Hamilton, NY 315-825-0255 and is an Investment Registered Representative.  Securities offered through IBN Financial Services, Inc., 404 Old Liverpool Rd.Liverpool, NY 13088.  315-652-4426. 
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