11 b Retirement Planning

Types of Retirement Plans

• Tax advantaged in some way to provide an incentive to save.

• Qualified vs. Tax-Advantaged vs. Non-qualified (won’t cover NQ)

1974 - ERISA

• (Employee Retirement Income Security Act) enacted to protect retirement and pension benefits – basis for qualified plans today (creditor protection/non-discrimination rules).

Qualified Plans

• Governed by ERISA. Plan qualifies by meeting ERISA standards therefore offering benefits to both the employer and the employee

  • employer-sponsored retirement plan that qualifies for special tax treatment under Section 401(a) of the Internal Revenue Code.

Basic Characteristics of Qualified Retirement Plans

• Creditor protection (under ERISA)

  • Differs for tax advantaged vs. qualified plans

• Deferral of federal/state income tax payments (until withdraw)

  • For Roth – no federal/state income tax payment upon withdrawal.

  • FICA tax not deferred (must pay within current year on contribution dollars)

• Typically offered as part of a compensation package

  • Employer match and/or profit sharing contributions are common.

  • Employee doesn’t pay tax or FICA on match/PSP contributions

Pension vs Profit Plan

• Pension Plan

  • employer promised to contribute

  • funding is mandatory

  • cant invest in more than 10% of employer’s stock

  • employer bears risk

• Profit Sharing Plan

  • employer no promise to contribute

  • funding is discretionary - employer can choose whether to contribute

  • can invest up to 100% of employers stock

  • employee bears the risk

Pension vs Profit Types

• Pension

  • Defined Benefit

    • becoming rare, expensive for employers

• Profit

  • Defined contribution

    • employer-fund

      • SEP - IRA

    • employee-fund

      • 401(k), 403(b), 457, SIMPLE-IRA

        • only 401(k) is qualified plan, the others are tax advantage

Defined Benefit v Defined Contribution

• Defined Benefit

  • specific retirement benefits (2k per month/for life - annuity)

  • employer has investment risk

  • no separate accounts

  • less portable

• Defined Contribution

  • specific contributions (% of salary have lump sum of $ when you retire)

  • employee has investment risk

  • separate investment accounts

  • more portable

SEP IRA

• EMPLOYER ONLY CONTRIBUTIONS!!!!

• Like a pension plan for small business - cheap and uncomplicated

• CANT have a SIMPLE & a SEP in the same business

SIMPLE IRA

• For small businesses → set up for each employee

• Employer must match 3% of employees participation and 2% of employee’s contribution

• EMPLOYEE CONTRIBUTIONS

  • lesser of 100% of their income or $15,500

  • $3,500 catch-up (of over 50)

• Employees are 100% vested immediately

  • 25% penalty for withdrawing <2 yrs

401(k)

• You determine your periodic contribution

  • Usually a % of salary or stated $ amount

  • Can stop/change your contribution

• EMPLOYEE CONTRIBUTIONS before taxes

  • This lowers your income taxes this year

  • Still subject to FICA and FUTA

What are 401(k), 403(b), and 457 plans

• EMPLOYEE CONTRIBUTIONS

• 401(k) profit

• 403(b) non-profit/schools

• 457 govt/ non-profit

• deferrals

  • $22,500/year with $7,500 > age 50

  • pre-tax, not in taxable income

  • FICA & FUTA

• withdraws

  • free after 59 ½

    • except 457 can withdraw before, taxes apply

  • taxed ordinary

  • RMD’s 73

Disadvantage of Qualified retirement plans

• cost to qualify, fund and administer the plan

• annual compensation limit

• eligibility requirement

• coverage of employees

• vesting requirements

• top-heavy plans

• disclosure requirements

• annual testing

Vesting Requirements

• 3 year cliff vesting

  • 0% ownership of employer contributions if you leave before 3 years of service.

  • At 3 years, you become 100% vested all at once.

• 2-6 graduated vesting

  • partially vested starting at year 2 and more each year until 100% vested

Capital Needs Analysis

• calculating the amount of investment capital needed at retirement to maintain the pre-retirement lifestyle and mitigate the impact of inflation during the retirement years

• three methods to for analyzing

  • basic annuity method

  • capital preservation model

  • purchasing power preservation model

Basic Annuity Method

simplest way to determine retirement needs

• calculate WRR

• gross dollar needs

• net dollar needs

• inflated pre-retirement dollar needs

• capital needed at retirement age

Decreasing Income Needs

• reduced social security

• reduced need to save

• reduce work-related expenses

• house mortgage might be paid odd

• auto insurance may be reduced

• possible lifestyle adjustments

Increasing Income Needs

• rising cost of health care and increased medical expenses

• increasing expenditures/gifts to relatives

• rising property taxes (due to inflation)

• more travel, second home, hobbies, activities

WRR (wage replacement ratios)

• is an estimate of the percent of annual income during retirement compared to income earned prior to retirement

• most clients need around 70-80% of their pre-retirement current income to retire and maintain their pre-retirement lifestyle

• Top - down

  • used with younger clients where income and expenditure patterns are unlikely to remain constant

• Bottom - up

  • also called budgeting approach and is used with older clients

  • determines wage replacement ratio with greater precision than top-down

Capital Preservation Model (CP)

• assumes that at death, the client has exactly the same account balance as he started with at retirement

• no calculation - conceptual

Purchasing Power Preservation Model (PPP)

• assumes that the client will have a capital balance of equal purchasing power at death as he did at retirement

• no calculation - conceptual

Range Estimates

• project what outcome will occur if we use a range of assumptions (e.g., 2.5% to 3.5% inflation) instead of a single expectation (3%)

Sensitivity Analysis

rotating each variable assumption toward the undesirable side of the risk

small deviations can impact the whole plan

Monte Carlo Analysis

helps planner understand the possibilities and probabilities

Managing Retirement Distribution

reduce the risks of outliving the retirement accumulation

4% rule (Bill Bengen)

• limit withdraws from the capital accumulation to 4% each year