Tax-deferred savings plans.

AuthorGahin, Fikry S.

Most taxpayers view tax-deferred savings (TDS) plans as desirable vehicles for reducing current income taxes and accumulating greater funds for retirement. Over the years, legislation has provided taxpayers with substantial tax incentives to save for their particular retirement needs, thereby boosting personal savings and economic growth in general.

All such tax laws share the same general principles: (1) annual contributions (savings) under tax-deferred plans are not subject to current taxation, (2) contributions by employers are currently deductible, (3) investment income is not subject to annual income taxes and (4) both contributions and investment income are taxed only when received by the individual on retirement in excess of the individual's tax basis. However, Congress has also passed a variety of penalty taxes constraining these plans.

Contrary to what many practitioners and their clients have been led to believe, TDS plans may not always be desirable. Depending on the rates of return on savings dollars and the tax rates before and after retirement, the spendable dollars at retirement under TDS could be greater or less than the spendable dollars under taxable saving plans with alternative comparable investments (ACIs). One should not set up a TDS plan to avoid a current income tax rate of, say, 15% and then end up paying 35% tax later on when retirement income is received. The tax deferral advantage of greater fund accumulation under TDS could be more than offset by a steep rise in the tax rate after retirement, or by a much higher rate of return under ACI. However, there could be substantial differences in the rates of return for different plans within either TDS or ACI.

A TDS plan has a definite net economic advantage (greater fund accumulation after tax) over ACI when the investor's marginal tax rate after retirement is lower than that before retirement, and the rate of return under TDS is greater than that under ACI. Even if one of these two conditions is not satisfied, the investor might still find TDS a viable investment if the tax disadvantage of TDS is more than offset by a TDS rate of return advantage over ACI, which is highly unlikely in an efficient financial market.(1)

This article will compare and analyze two distinct situations: in one, TDS is desirable; in the other, the individual is better off under alternative savings plans.

TDS Plans

The major individual plans are briefly described below. Table 1, on page 43, summarizes the major differences among these plans.

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* Individual retirement accounts (IRAs): IRAs must meet the requirements of Sec. 408(a). They provide the broadest eligibility provisions, allowing all persons under the age of 70 1/2 to set up an IRA. The annual deduction for contributions is limited to the lesser of 100% of taxable compensation or $2,000 (plus an additional $250 for a spousal account). The deduction is phased out for participants (or spouses) covered in an employer retirement plan as their adjusted gross income (AGI) exceeds certain levels (see footnote a to Table 1).

* Simplified employee pension (SEP) plans: When SEP plans meet the five requirements of Sec. 408(k), an employer can make annual contributions to an employee's IRA in an amount up to the lesser of 15% of compensation or $30,000. A main advantage of a SEP is that it eases the compliance and reporting obligations of the Employee Retirement Income Security Act of 1974 (ERISA) regarding vesting, funding and participation requirements. In addition, an employee may also make an annual contribution of up to $2,000 under the basic IRA provisions and limitations. A SEP plan is also subject to the minimum contribution rules on top-heavy plans.

* Keoghs: Self-employed individuals are subject to special retirement plan rules--called Keogh or H.R. 10 plans--under Sec. 401(c). A Keogh plan can be set up to benefit both the self-employed individual and his employees. A person who is both an employee covered under another pension plan and a self-employed person may still establish a Keogh plan for his income from self-employment activities. For a Keogh based on a defined contribution plan, a self-employed person can generally contribute the lesser of $30,000 or 25% of earned income from self-employment activities. Keogh plans are subject to top-heavy rules regarding coverage of key employees.

* Cash or deferred arrangements (CODAs): CODAs are governed by Sec. 401(k). CODAs allow eligible employees the flexibility to elect to receive a benefit directly as cash (taxable) or have the benefit contributed to a qualified retirement trust for their benefit (and not be currently taxed). Employees eligible to benefit must satisfy the coverage requirements of Sec. 410(b)(1), the most substantive requirement being that the plan must benefit at least 70% of employees who are not highly compensated employees. Employees' elective contributions vest immediately. The maximum annual deferral to a CODA changes annually with indexing (the amount as of Jan. 1, 1993 is...

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