Back in the early part of the year, we alerted you to the basic changes in the tax laws. Bottom line – Taxpayer friendly! This month, we’re going to expand on one small part of the tax package – retirement savings. Get on your headgear; this can get a little complicated.

So what’s new?

Unlike people, not all retirement plans are created equal. This was true before the new law and it’s still true. The amount of income you’re able to defer under the new plan depends on the type of plan you have. In general, here’s what you can expect.

Contribution Limitations

Individual Retirement Accounts – You may deduct up to $3,000 in IRA contributions for the years 2002 – 2004, $4,000 for the years 2005 – 2007 and $5,000 for 2008. After 2008, the $5,000 deduction will be increased by a Cost of Living Adjustment (COLA) in $500 increments, rounded to the next lowest $500. These increased amounts apply to both deductible and nondeductible IRA (including Roth) contributions.

401(k), 403(b), Section 457 and SEP Plans – You may defer the following for 401(k), 403(b), Section 457 (governmental) and SEP Plans:

• $11,000 for 2002


• $12,000 for 2003


• $13,000 for 2004


• $14,000 for 2005


• $15,000 for 2006 or thereafter

Additionally, the maximum deduction in 2006 will be indexed for COLAs beginning in 2007 and thereafter in increments of $500, rounded to the next lowest $500.

SIMPLE Plans – You may defer the following for SIMPLE plans:

• $7,000 for 2002


• $8,000 for 2003


• $9,000 for 2004


• $10,000 for 2005 or thereafter

Additionally, the maximum deduction in 2005 will be indexed for COLAs beginning in 2006 and thereafter in increments of $500, rounded to the next lowest $500.

Catch-up Contributions

Recognizing that older Americans have less time in which to save for retirement, the new law allows for catch-up contributions as follows:

Individual Retirement Accounts - You may deduct up to an additional $500 per year for 2002 – 2005 if you’re 50-years-old or older by the end of the year. This is increased to $1,000 per year for 2006 and thereafter.

401(k), 403(b), Section 457 and SEP Plans – If you’re 50-years-old or older by the end of the tax year, you may defer the following for 401(k), 403(b), Section 457 (governmental) and SEP Plans:

• $1,000 for 2002


• $2,000 for 2003


• $3,000 for 2004


• $4,000 for 2005


• $5,000 for 2006 and thereafter

These amounts will be adjusted for COLAs after 2006 in the same manner as other contributions, rounded to the lowest $500. An added plus to these catch-up contributions is that they are available regardless of other limitations. Thus, if you’re limited by the terms of your employer’s plan to $8,000 in 2006, but you are 50-years-old by year end, you will be able to contribute up to an additional $5,000. One caveat – make sure your employer’s plan allows for the catch-up contribution.

SIMPLE 401(k) and SIMPLE IRA Plans – The additional contribution you can make into SIMPLE plans is ½ of the amount allowed for 401(k), 403(b), Section 457 and SEP Plans. These amounts will also be subject to increase for COLAs after 2006, rounded to the lowest $500.

Credit for Contributions to Qualified Plans

One major barrier for lower income individuals to making contributions to qualified retirement plans has been a lack of available cash. Sure, $2,000 may not sound like much to a person who makes $100,000 a year, but it’s a large chunk of money to someone who makes only $30,000 a year.

As an added incentive, Congress created a tax credit to help these folks make retirement contributions. For the years 2002 – 2006, a credit of up to $1,000 will be allowed for contributions to qualified plans, subject to certain income limitations as follows:

• Joint filers will receive a credit of 50% of eligible contributions up to
  $2,000 ($1,000 per person multiplied by 2 eligible persons) if their joint
  income is $30,000 or less. The percentage drops to 20% for those with joint
  income over $30,000 but equal to or less than $32,500 and 10% for those with
  joint income greater than $32,500 and equal to or less than $50,000.


• Head of Household filers will receive a credit of 50% of eligible contributions
  up to $1,000 if their income is equal to or less than $22,500. The credit
  drops to 20% for those with income greater than $22,500 but less than or equal
  to $24,375 and 10% for those with income greater than $24,375 and less than
  or equal to $37,500.


• Those filing Singly or Married Filing Separately will be eligible for a
  credit of 50% of eligible contributions up to $1,000 if their income is equal
  to or less than $15,000. The credit drops to 20% for those with income greater
  than $15,000 but less than or equal to $16,250 and 10% for those with income
  greater than $16,250 and less than or equal to $25,000.
  

Eligible persons are those 18 years of age or older and who are not claimed as a dependent on another person’s tax return and who are not full-time students. Eligible contributions include contributions made to qualified retirement plans including 401(k), 403(b). 457, SEP and Simple plans along with contributions to traditional or Roth IRAs. Voluntary after-tax contributions to a qualified plan also count as eligible contributions. There are other distributions, which will also reduce the amount eligible for credit, but we thought we’d try to keep this article under 15 pages in length.

Employer Deductions for Certain Plans

Prior to the new law, employers were eligible for a deduction of up to 15% of compensation paid to all employees participating in a profit sharing or stock bonus plan (the term compensation refers, roughly - as we'll see later - to wages, income from self-employment, etc.). This decreased the potential benefit available to employees. This percentage will increase to 25% for profit sharing and stock bonus plans and 100% for tax-qualified defined contribution plans, 403(b) annuities and 457 government plans after 2001.

Additionally, the amount of compensation that could be used to calculate the employer’s deduction was $170,000 but will increase to $200,000 in 2002. However, the total deduction can not exceed $40,000. Both the $200,000 and $40,000 amounts will be indexed for inflation in increments of $5,000, rounded to the next lowest $5,000.

Compensation Defined

Prior to the new law, your employer had to reduce compensation for making sure their contribution didn’t exceed deductible limits. This made compensation pretty tricky to define. Thus, even though you thought you made $100,000, after deducting the $10,000 you deferred and the cafeteria plan withholdings of $10,000, the amount your employer took into account to determine deductibility, i.e. your compensation, was only $80,000.

While you may think this is only a good thing for your employer, remember your employer tends to look at the deductibility of business expenses, no matter how nice they are. Employers are much more willing to make a contribution to a retirement plan for an employee if they can deduct the payment. In the preceding example, the extra $20,000 would mean an extra $5,000 contribution to your plan if your employer looks strictly at deductibility.

Coupled with an increase in the deductibility percentage from 15% to 25% for profit-sharing stock bonus plans, Congress greatly increased the employees’ potential retirement savings provided by their employers.

So, what do you do with all of this new information?

We could try to be funny and tell you the best thing you can do with this new information is use it, but that would be obvious. We do suggest you do a few things, though.
First, if you’re an employer, review all of the plans you and determine if changes need to be made. Does your plan limit compensation to a dollar amount of, say, $170,000? If so, amend it to track with the new compensation definitions. If you and your key employees make more than the $170,000, this simple change will add to the amount you can sock away for retirement while still being deductible.

Then find out if your plan allow for additional catch-up contributions. If not, amend it. The change won’t cost you much and you ‘ll be able to sock more away for retirement if you’re older than age 50. Even if you, as the employer, can’t use the catch-up provisions now, bringing those benefits to your employees won’t cost you anything except a little paper work: A small price to pay for helping others.

Conclusion

The 2001 tax law provided some powerful new incentives for you and your employees to get into the retirement saving mode. These incentives will make it easier to accumulate needed retirement assets. However, as with all things in life, you must base your choices not only on your future desires, but also on your current needs. For that, you need a comprehensive financial planning road map. That’s what we’re here for. Give us a call and we can discuss where you are and where you need to go next.

Happy holidays and Happy New Year!