Retirement Plans

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Simplified Employee Pension (SEP) Plans

Simplified employee pension (SEP) plans are designed for small businesses and the self-employed. They predate SIMPLE plans. SEP plans utilize individual retirement accounts, but allow for higher contribution limits. However, contributions to SEP plans are not mandatory, and if an employer has a bad year, contributions may not be made at all. As with any type of IRA, an employee can specify the type of IRA investment that they want, such as mutual funds, stocks, bonds, or certificates of deposit. Employees are fully vested immediately in these plans.

SEPs require little record-keeping and minimal administration. For this reason, SEP IRAs have appeal. Another retirement plan for the self-employed are known as Keoghs, for the New York legislator who sponsored the Self-Employed Individuals Tax Retirement Act of 1962. Keoghs offer many tax advantages as do SEPs but require more administration to meet government requirements. However, more money can be set aside and sheltered from taxes with a Keogh.

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Individual Retirement Plans

Many individuals do not work for an organization that offers a retirement plan, and many other individuals seek to supplement their retirement income by opening their own retirement accounts. These are known as individual plans, and they represent a part of the third leg of the “tripod of economic security.” There are two main types of individual plans: individual retirement accounts (IRAs) and Roth IRAs. In addition, there are a variety of life insurance products, such as annuities, that enable individuals to save for their retirement.

Beginning in 1975, employees without a retirement plan were able to contribute up to $2,000 into an IRA account on a before-tax basis. Similar to tax qualified plans, this contribution grew tax-free and was not subject to taxation until distributed at retirement. Subsequent legislation provided that IRAs could be started by anyone with earned income.

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The Tax Reform Act of 1986, however, restricted the advantage of before-tax contributions to IRAs to those taxpayers and their spouses who were not covered by an employer-sponsored retirement plan. For those who already participated in an employer-sponsored retirement plan, the advantage of before-tax contributions was not available with an IRA unless income fell below a certain level. Workers covered by a retirement plan could continue to contribute to an IRA but only on an after-tax basis—that is, taxes are paid on contributions at the time they are made.

The Taxpayer Relief Act of 1997 created another type of IRA known as a Roth IRA, for Senator William Roth who sponsored the act. Under a Roth IRA, contributions are taxed at the time they are made, but contributions are withdrawn tax-free provided certain conditions are met. Investment earnings also accumulate tax-free. Under new rules established for the Federal Deposit Insurance Corporation (FDIC) in April 2006, both traditional and Roth IRAs are insured up to $250,000 at FDIC-insured banks, savings associations, and credit unions.

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Other Ways to Save for Retirement

In addition to the various formal retirement savings programs, individuals can use a variety of financial products in the marketplace to save for retirement. Although not offering the same tax incentives, individuals can save for retirement using bank savings accounts, mutual funds, and life insurance products. Life insurance products, particularly annuities, are commonly used for retirement saving purposes. Insurance products permit the tax-deferred growth of investment income similar to a retirement plan. Some insurance products are designed with a savings component and a death benefit.

Annuity contracts guarantee a stream of income as long as an individual lives, based on the value that has accumulated in the contract. Because an individual cannot outlive the stream of income from an annuity, these products have historically been used to fund various types of retirement savings plans.

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Legislative Trends

Since the passage of ERISA in 1974, many laws have been enacted to regulate retirement plans. Much of this legislation occurs because of the tax-favored status enjoyed by retirement plans. Since large federal deficits are a national concern, Congress and the executive branch continually reexamine programs receiving tax-favored treatment. Most legislation concerning retirement plans has followed these principles: Tax benefits should not be provided unless the retirement plan benefits a broad cross section of employees, retirement plan rules should be kept as simple as possible, and special rules applying to various types of retirement plans should be made more consistent.

Recent legislation affecting retirement plans includes the Economic Growth and Tax Relief Reconciliation Act of 2001. This legislation was noteworthy for increasing maximum contribution levels to various retirement plans, for enabling people aged 50 and older to exceed these maximum contribution levels as they near retirement, for extending the tax-free withdrawal characteristic of Roth IRAs to 401(k) and 403(b) plans by creating Roth 401(k)s and 403(b)s beginning in 2006, and for providing retirement tax credits for people in low-income brackets. A specific purpose of the law was to address the problem of “late starters”—people who did not begin saving for retirement until later in life. Beginning in 2002, people aged 50 or older were allowed to contribute more to IRAs and 401(k)s than the maximum contributions allowed others as a way of helping late starters catch up.

The Pension Protection Act of 2006 was primarily meant to address underfunding and other serious weaknesses in some of the pension plans U.S. businesses have provided their employees. The legislation required most pension plans to become fully funded over a seven-year period beginning in 2008. The funding would need to meet strict guidelines. Companies would be allowed to deduct the cost of making additional contributions to fund their pensions but they would also be subject to a 10 percent excise tax if they failed to correct funding shortfalls. Other parts of the legislation made changes to 401(k)s and IRAs. Catch-up contributions by individuals 50 and older were extended and increased. Military personnel called to active duty are now able to make penalty-free withdrawals from their 401k or IRA between designated dates. Automatic enrollment of employees in a 401(k) plan offered by an employer would be permitted, with employees required to opt-out of the plan. IRA contribution amounts were raised. Non-spouse beneficiaries such as domestic partners are now allowed to roll over assets inherited from a qualified retirement plan into an IRA.

Due to continual changes such as these, Americans should carefully monitor their retirement plans and consult with experts on tax law and financial planning to ensure their financial security during their retirement years.