Distribution options for defined-contribution plans: this two-part article examines issues and strategies to enhance the value of defined-contribution-plan distributions. Part 1 describes the common types of plans and applicable restrictions.

• Author: Maloney, David M.
• Position: Part 1

EXECUTIVE SUMMARY

* A plethora of account-balance-type retirement plans is available under the tax law.

* Withdrawals are generally taxable, except for those from Roth and nondeductible traditional IRAs.

* Early distributions may be subject to penalty; however, there are numerous narrow exceptions.

A common message from financial planners, to young and old alike, is that to achieve a financially comfortable retirement, one must systematically save and invest throughout one's career by taking full advantage of available defined-contribution qualified retirement plans. Investing through such plans is important today, because relatively few workers can rely on receiving benefits from a traditional defined-benefit pension plan on reaching retirement. In addition, no one should rely on Social Security as the sole means of providing a financially secure retirement.

Part I of this two-part article, below, identifies the various types of defined-contribution qualified retirement plans commonly used by employers and self-employed individuals and the withdrawal restrictions that apply. Part II, in the June 2007 issue, will identify issues and strategies that may help enhance the value of distributions to account owners.

Commonly Used Plans

A plethora of account-balance-type retirement plans is available under the tax law. These plans can be used to accumulate retirement assets to provide beneficial tax treatment for individuals. Potential tax benefits include:

1. Exclusion by the employee of employer contributions to the plan.

2. Deduction or deferral treatment for employee contributions. (1)

3. Tax deferral or tax-free treatment of plan earnings.

   Participation in multiple types of retirement plans can maximize accumulated wealth. For example, a college professor who also operates a consulting practice may be able to participate in a defined-benefit plan of the employer, a Sec. 403(b) or 457 plan, a Keogh plan and/or a traditional IRA.

   A financially astute taxpayer will likely also save a portion of his or her disposable income in taxable investments outside of qualified retirement plans. These funds can be accessed without the restrictions that apply to most such plans; many taxable investments are eligible for the favorable rates on capital gains and qualified dividends.

   Employee Plans

   These plans are commonly available to employees and self-employed individuals. (2)

   Money-purchase plan: One type of defined-contribution plan, sometimes referred to as a money-purchase plan, allows for regular contributions (flat-dollar or formula-based) (3) to an account maintained for the participant. Contributions may be made by the employer and/or employee.

   Pension, profit-sharing and cash-match plans under Sec. 401(a): These plans provide for contribution of a stated or formula-based amount to an account for the employee's benefit. Contributions may be made by the employer, the employee or both. Employee contributions may be voluntary or mandatory. Distributions must begin by the later of age 70 1/2 or retirement, except in the case of certain business owners. "Late" distributions are those that begin (1) after the time required by statute or (2) on a timely basis, but the amount distributed is less than the amount required by statute. (In this article, "later of age 70 1/2 or retirement" means the Sec. 401(a)(9)(C)(i) requirement that the distribution begin by April 1 of the calendar year following the later of the calendar year in which the employee (1) attains age 70 1/2 or (2) retires.)

   Sec. 401(k) plan: This is a plan (sometimes referred to as a cash or deferred arrangement) in which employees of private employers have the option to set aside a portion of current compensation in a qualified retirement plan. (4) Neither the portion of the salary deposited in the Sec. 401(k) plan, nor the earnings generated on the deposits, is taxed to the employee until withdrawn. In many Sec. 401(k) plans, the employer will "match" the employee's contributions up to a certain percentage of salary. Like other retirement plans, access to the accumulated balance is restricted during the account owner's career; required minimum distributions (RMDs) generally must begin by the later of age 70 1/2 or retirement, under Sec. 401(a)(9)(C)(i).

   Because of the RMD rule, the retirement assets in employer plans, such as a Sec. 401(k), should not be rolled over into a traditional IRA if the taxpayer plans to work past age 70 1/2. RMDs must be made from a traditional IRA beginning at age 70 1/2, even if the taxpayer is still working. By keeping the assets in the employer plan, the assets can continue to grow on a tax-deferred basis.

   Sec. 403(b) plan: A Sec. 403 (b) plan is a tax-sheltered annuity plan offered to an employee of a nonprofit or Sec. 501(c)(3) tax-exempt organization (e.g., church, college or university) or a public school. Under Sec. 402(g)(1), the 2007 contribution limit is $15,500 for a taxpayer under age 50 and $20,500 for a taxpayer age 50 or older. Distributions must begin by the later of age 70 1/2 or retirement.

   Sec. 457 plan: This is a deferred-compensation plan established for the benefit of government employees. Such plans are maintained by a state, a political subdivision of a state, or an agency or instrumentality of a state. Sec. 457 plans are also available to employees of certain nongovernmental organizations exempt from tax under Sec. 501 (e.g., trade associations, private hospitals, labor unions). (5) Under Sec. 402(g)(1), the 2007 contribution limit is the same as that for Sec. 403(b) plans. Distributions must begin by the later of age 70 1/2 or retirement.

   Self-Employed Hans

   The plans discussed below are commonly available to individuals with self-employment (SE) income.

   Keogh plan: Such plans are commonly used by sole proprietors and partners to defer current taxation of income from their wade or business activities and by employees who also generate earned income from SE activities (e.g., a member of a corporate board of directors). Under Sec. 415(c)(1) and (d), the contribution limit for 2007 is the smaller of SE income or $45,000. Distributions must begin by the later of age 70 1/2 or retirement, except in certain cases of benefits held for owners.

   A cash-method taxpayer who receives compensation as a member of a board of directors may elect to defer it until retirement by making deductible contributions to a Keogh plan. Contributions can continue as long as the taxpayer is earning SE income, although distributions must begin by April 1 of the year following the year the individual turns 70 1/2.

   The annual deadline for making contributions to a Keogh plan is the tax return filing date, including extensions (i.e., April 15th for a calendar-year taxpayer).The plan must be established by the end of the tax year. However, making contributions as early as is economically feasible, rather than waiting until the deadline, lengthens the period of tax-deferred growth.

   SEP plan: A simplified employee pension (SEP) is a type of IRA used by small businesses (sometimes referred to as a SEP/IRA).These accounts are similar to Keogh plans in that they accept retirement savings from nonemployee income, but generally are not subject to as many restrictions and offer greater flexibility. (6) The maximum 2007 employer contribution for an employee is the lesser of $45,000 or 25% of the employee's earned income. (7) Elective deferrals by an employee are limited to the lesser of earned income or $15,500 for 2007. However, under Sec. 408(k) (6), starting in 1997, elective deferrals by an employee are permitted only if the employer plan was established before that year. Distributions must begin by the later of age...