The United States Supreme Court will hear an appeal on a case involving the protection from bankruptcy for inherited IRAs. Inherited IRAs are those you receive as a beneficiary of the person who set up the IRA and who then died before it was all paid out. The question before the Court of Appeals for the 7th Circuit was whether an individual who inherited an IRA can protect it from creditors if the beneficiary files for bankruptcy. That court said there was no protection, because once the beneficiary inherited them, they were no longer retirement funds. This is contrary to the rulings of other courts, so the Supreme Court has decided to settle the dispute among the courts. It’s an important issue because so many spouses, children and others inherit IRAs, and protecting those IRAs from creditors in bankruptcy would be a valuable form of asset protection.
A recent study by Bernstein Investments makes some good points about financial planning for retirement. Some of these statements seem obvious once we’ve heard them, but we don’t always act on them without being reminded. Think about these concepts:
*Because of improvements in health and medicine, we’ll need money to spend for more years.
*You need to figure out the core amount you need to live on, based on age and spending habits.
*Diversify investments to lower volatility.
*Defer taxes whenever possible.
*Spend from after-tax accounts before retirement accounts.
*Spend at a rate that is sustainable over a long period of time.
*Work longer and
I recently attended my homecoming at the University of Pennsylvania, and as part of the day’s events there was a program on estate planning for pets. Many people are concerned about what happens to their pets after they are gone, some more concerned than they are about their children. An interesting idea that came out of the seminar was having a card to carry around, giving information about pets and who should be contacted about their care. Planning of this type isn’t just for eccentric (i.e., crazy) millionaires who want to leave huge sums to their pets, but more often about people of ordinary means who want to make some arrangements for the care of their faithful companions. It can involve an allocation of, for example, $1,000 to help someone who has agreed to take the pets. Our pets give us so much joy (especially my dogs Lucy and Georgia) that we should take the time to think about their care if we are not here to give it to them.
When 2012 passed into 2013, many federal tax laws simply disappeared, and tax laws in effect from 13 years earlier were to be resurrected. But in the early days of 2013, with the wind shear from the drop off the fiscal cliff picking up force, Congress and the President undid their version of Back to the Tax Future by enacting a “permanent” change to the tax laws.
As part of the new 2013 tax law, monumental changes were made to the estate tax laws. In the words of many practitioners, these changes are a game changer. The permanent federal estate tax rate is now 40%. Much better than the pre-2001 rate of 55%. The exemption amount is now set at $5 million and indexed for inflation (the 2013 exemption is $5.25 million per person and the 2014 exemption will be $5.34 million per person). Much better than the pre-2001 exemption of $1 million per person with no inflation adjustment. The exemption is now “portable” between spouses: when the first spouse dies, unused exemption can be ”inherited” by the surviving spouse and added to the surviving spouse’s own exemtpion. Much better than the ”use it or lose it” exemption, which had been the case since 1916.
All these changes intersect at the planning stage. They will now often make the decision about how to structure a client’s planning very different from planning in prior years, not to mention much more difficult and much more time consuming. The new law introduces opportunities that must be carefully considered. It is not always easy.
When the exemption was “use it or lose it,” it generally made eminent sense to shelter assets through a trust created for the surviving spouse’s benefit. Doing so would avoid estate tax at the survivor’s death, often at rates as high as 55% of the value of the assets, as explained above. Sheltering assets in trust for the surviving sposue also helps protect the children’s inheritance from a second spouse who marries the survivor, protects the assets from criminals who prey upon vulnerable adults, and allows a trustee such as a child or professional advisor to more closely monitor the survivor’s financial well-being. But trusts comes with tradeoffs, such as separate record keeping and tax returns and the legal questions of access to funds, roles and responsibilities. Another tradeoff: assets in a trust that avoid estate tax at the survivor’s death likely triggers a higher capital gains tax if sold after the survivor dies.
In years past, it was much less burdensome to accept this higher capital gains tax than the confiscatory federal estate tax. Now, however, the tradeoff for using a trust is much more pronounced. This is because if the surviving spouse receives the inheritance directly, and not in trust, the inheritance will be included in the survivor’s estate. Even though these assets would be subject to estate tax, they nevertheless have the benefit of wiping clean the capital gains slate. Except with respect to certain assets such as IRAs and annuities, all appreciation of assets that are in the survivor’s estate goes away at the survivor’s death.
In the next installment of this article, I will review how this plays out in the planning stage.
Despite efforts by the Social Security Administration to make the system user-friendly, it remains a complicated system. Here are two planning techniques, one of which I’ve used myself. To be sure I’ve explained them correctly, I’m going to paraphrase a recent article on the subject by Jane Bryant Quinn, a well-known writer on financial topics.
First, one spouse begins taking her benefits, in a reduced amount, at age 62. When the other spouse reaches age 66, that spouse files for benefits based on the other spouse’s account. The 66 year old spouse begins receiving a benefit equal to one-half what the other spouse is receiving. Then, four years later, at age 70, the spouse switches to his or her own benefit, which has grown by 8% per year between 66 and 70. The spouse is not penalized in the amount received because he or she received the half benefit for four years. When I applied for this benefit, the Social Security people referred to it as the spouse’s benefit.
The second technique is a little different. One spouse files to receive his or her own benefits at age 66, but asks that payment be suspended. In that way, the benefit continues to grow at 8% per year until age 70. But the other spouse then applies for the spouse’s benefit, and gets one half of the first spouse’s benefit amount, calculated at age 66.
Here’s one more wrinkle. If both spouses are high earners, the older spouse could apply and suspend at age 66. The younger spouse could apply for the spouse’s benefit at age 66. Then, both can wait to get the enhanced benefits at age 70.
A couple of recent articles from online sources highlight dramatic changes in the prospects for the retirement years, changes which occurred over time but have now come directly to the attention of the many baby boomers approaching retirement. One article asked people throughout the world if they thought they would outlive their retirement savings, a question I don’t recall having been asked ten or fifteen years ago. This is just people’s opinions, not a measure of what they have and need. The article revealed that one third of those in the U.S. believe they will outlive their retirement income (63% in the U.K.!). Although the article didn’t say so, this information is only of use if people act upon and change their behavior to save enough for retirement. It does, however, highlight the attention being paid to this problem. The other article reminds us of how retirement has changed from a financial standpoint. In an earlier generation, pensions were more prevalent, and the recipient had few decisions to make about them. Now, with most people relying on 401(k) plans, it’s necessary to think about investments and withdrawal rates long after retirement has begun. In addition, many people benefited from retiree health plans in past years, but most of these are gone, and retirees must plan for their health coverage from the combination of Medicare and supplemental health care coverage. The point of that article is that retirees have to be more involved in planning their retirements, and continue planning and revising plans long after they retire.
The U.S. Treasury Department and the Internal Revenue Service announced, on August 29, 2013, that same sex couples who are legally married in jurisdictions that recognize their marriages will be treated as married for federal tax purposes. Note that this announcement does not apply to civil unions that are permitted in some states, and note as well that it applies to couples legally married who now reside in a jurisdiction that does not permit same sex marriage. For example, if a couple was legally married in New York, but now lives in Pennsylvania, they are considered as married for federal tax purposes. The announcement is a reaction to the U.S. Supreme Court’s decision striking down provisions of the so-called Defense of Marriage Act.
What is the effect of this ruling? The ruling applies in all income tax situations in which marital status is a factor, such as filing status, personal and dependency exemptions,contributing to an IRA, employee benefits, the earned income credit and the child care credit. Same sex couples who are legally married may file joint federal income tax returns and may file for income tax refunds where their status as married would have resulted in a smaller income tax liability in past years (subject to the statute of limitations for filing refunds, three years from the date the return was filed or, if later, two years from when the tax was paid). The announcement also applies to federal estate and gift tax provisions. Another significant change is that employees who purchased same sex spouse health insurance coverage from their employers on an after-tax basis may now obtain that coverage on a pre-tax basis, a valuable tax benefit.
Important decisions in planning retirement income and expenses can be made at seven ages, and the decisions made at those ages can have a substantial effect on the quality of retirement.
Needless to say, perhaps, the age to start saving for retirement is as soon as you have an income. One of the best and earliest techniques for retirement saving occurs when young people have summer jobs. They are likely to have no significant tax liability from those jobs, so it is an ideal occasion to open a Roth IRA. There is no income tax deduction for contributions to a Roth IRA, so a year when an individual has little or no taxable income is an ideal time to make such contributions. The other side of the Roth IRA bargain is that, provided you wait a while to take distributions, the amounts withdrawn are free of federal income tax, and there is no date by which distributions from the Roth IRA must be made to the person who set it up. This is in contrast to the rule for traditional IRAs and qualified plans, requiring that distributions begin shortly after age 70½ and continue each year thereafter. The ability to postpone distributions from Roth IRAs for a indefinite period is a valuable attribute. In general, as soon as there is a vehicle available for retirement saving, make use of it.
Age 50: Catch-Up
The first age for retirement decisions is 50. At age 50, it is possible to make catch-up contributions to IRAs and qualified plans. The premise of permitting such contributions is that contributions might not have been made in earlier years; but the ability to make catch-up contributions is not dependent upon having failed to make contributions earlier. This provision, Internal Revenue Code Section 402(g)(1)(c), was added to the law in 2001, and offers an opportunity to make additional contributions at an age when an individual might begin to think more carefully about accumulating assets for retirement. The catch-up contribution provision will occur in the IRA documents received from the provider (bank, mutual fund company, insurance company), but for those who are participating in qualified plans, the plan must provide for catch-up contributions, and most plans do. This is a good point to emphasize that participants in qualified plans should have an understanding of how they work, and what options are available in them. Review of the plan’s summary plan description, which most people ignore, is a worthwhile effort in planning retirement saving.
Retirement saving also occurs outside of retirement plans. It is possible to save money and invest it in conventional ways, outside of the IRA and qualified plan venues. Careful planners will know that a comfortable retirement probably requires even more than the maximum that can be accumulated through the tax saving techniques. But this much seems clear: if you are not deferring the maximum under IRAs and qualified plans, you are probably not saving anything outside of them. Some people use the premise, or excuse, that they need not save as much because of the growth in value of their homes. Apart from the debunking of that theory in the recent fall in housing values, the technique of living in retirement from the sale of a residence and downsizing to a smaller one was never valid. Those who downsized, as it happened, usually paid as much for a smaller home, in purchase price and upgrades. While it might be helpful to think about accumulating assets in other ways, saving as much as possible in IRAs and qualified plans should be the first step, and age 50 offers an opportunity to increase the rate of accumulation.
Age 59½: Penalty Ends
A second age point in the retirement process arrives at age 59½. This is the age established in the Internal Revenue Code (Section 72(t)), when distributions may be made from IRAs and qualified plans without a penalty. Prior to that age, withdrawals may be subject to a 10% penalty, in addition to income tax imposed on a distribution. There are some exceptions to the penalty, such as for death or disability, but generally 59½ is a tollgate, after which withdrawals can be made more easily. This will always be possible in an IRA, but a qualified plan must affirmatively permit such withdrawals.
The ability to withdraw from retirement accounts at age 59½ can be a problem. Most people have not retired by age 59½, but if amounts can be withdrawn without penalty (other than paying income taxes), there will be a temptation to take distributions for non-retirement reasons. These might be worthwhile, such as paying college expenses for children, but there is a downside to reducing funds available for retirement at this point in life: not only will you lose the amount withdrawn, but also the future appreciation. Consequently, age 59½ can be a dangerous point in planning for retirement. It is advisable to resist the temptation to withdraw funds at that point. If funds are needed for an important reason, it might be a better course to borrow them from a qualified plan (you cannot borrow from an IRA), because that imposes a discipline to pay back the funds into the plan, together with the interest on the loan that will be added to your account balance.
Age 62: To Collect or Not
At age 62, it is possible to retire and begin collecting Social Security benefits. That age is not considered full retirement age, so a person who begins receiving benefits at 62 will receive a reduced amount. Why would some make this choice? One reason is that the individual might believe that the system is shaky, and wish to get something out of it. Another reason might be that one spouse will retire and the other continue to work, and the retiring spouse might believe that he or she could invest the payments received and earn a better rate of return than is implicit in the larger amount that would be received at full retirement (66 for many people). There is no single correct answer. If you continue working at age 62 and earn more than a modest amount, you will receive little or no benefits. But retirement at age 62 offers an option to begin receiving Social Security benefits that can be considered as part of a plan for retirement. As long as the individual knows what is given up by taking benefits at that early date, the decision to take early retirement can be an appropriate one.
Age 65: Medicare
Individuals may sign up for Medicare at age 65. Medicare, it is generally agreed, is a very complicated program, and a full discussion of the options when signing up would be a very long article by itself. Deciding whether to sign up for the various parts of Medicare or retain private insurance is a complicated decision that probably requires expert assistance. The website www.medicare.gov is helpful, but even that information isn’t enough to know that one has made the right choices. Of all of the areas of decision-making that must be faced by those approaching retirement, Medicare and health insurance issues are surely the least understood.
Age 66: Social Security Retirement
For many people, age 66 is the time when full retirement benefits can be received from Social Security. (For younger people, the age stretches out to 67; look for further increases in the future.) The amount of retirement benefits can be estimated online, from the website www.ssa.gov, which will show the amounts received at various retirement ages. At age 66, benefits can be received even if an individual is still working, no matter what level of income is being received.
So why not start receiving benefits at that age? A delay in the receipt of benefits beyond age 66 will increase the amount received on eventual retirement. From age 66 to 70, the increase is substantial. After 70, the increases are much less. Again, whether to take benefits at age 66 or wait until a later age is a personal one: does the individual want to apply at age 66 and begin taking benefits, or can he or she live on other income and assets and afford to wait until 70? What is the individual’s life expectancy? A comparison of the benefits payable at the various retirement ages, available on the website cited above, will help with the decision, although it might be advisable to have a financial advisor help with the process.
Age 70: Retirement
There is little incentive to delay receiving Social Security benefits beyond age 70. If an individual has postponed their receipt, age 70 is the time to begin receiving benefits. Benefits continue for life, and if the individual is survived by a spouse, there are additional benefits payable. There is not much to decide at this point.
Age 70½: IRA and Plan Benefits Must Begin
Pursuant to Internal Revenue Code Sections 401(a)(9) and 408(a)(6), required minimum distributions must begin by April 1 of the year following the year in which an individual reaches age 70½. (Similar rules apply to Section 403(b) tax-sheltered annuities, but they are limited to educational and nonprofit organizations.) That first sentence is subject to so many conditions and exceptions, and opportunities for planning, that one author has written a book of over 500 pages explaining the Code Sections. Here is one important point: if an individual continues to work beyond age 70½ and does not own as much as 5% of the employer, the payment of benefits can be postponed until actual retirement. This could be of interest to lawyers in law firms where they do not own 5% of the firm. By continuing to work, benefits in qualified plans may remain in that plan, and continue to grow on a tax-deferred basis. This option is not available for IRA accounts, and this might affect an individual’s decision to transfer assets from the law firm’s qualified plan to an IRA. And, it might affect the law firm’s decision as to how benefits may be distributed. An individual might be encouraged to leave funds in the law firm’s plan if distribution options extended beyond a lump sum distribution to annual or quarterly payments. In that way, participants in the plan could take some distributions without being required to take the full minimum required distribution. But this presents another question: what does it mean to continue working? There appear to be no minimum requirements for hours or presence in the office.
The stages of retirement are times when decisions may or must be made regarding the accumulation of retirement income and its distribution. By understanding the options and the applicable law, and having assistance as needed, the retirement process can be used to the most satisfying advantage.
(This article previously appeared in the Legal Intelligencer.)
Over the past 30 years, a dramatic change has taken place in the use of retirement plans to help people save for their later years. In an earlier era, many people were covered by defined benefit pension plans, which promise a fixed benefit at retirement, often based on years of service and compensation levels. In recent years, 401(k) plans have become the dominant form of plan for accumulating retirement funds. This article looks at the plusses and minuses of each.
Defined benefit plans are generally a promise made by the employer, private or public, to provide a benefit at retirement. The employee may be called upon to contribute toward the benefit, but the responsibility is on the employer to make sure the funds are there at retirement. For many years, until the enactment of the Employee Retirement Income Security Act of 1974, ERISA, funding of defined benefit plans by employers was required at only a modest level. And many of them were poorly funded. The best-known example was the retirement plan for Studebaker, which made cars, in Indiana and elsewhere, for many years. When Studebaker went out of business, there was not enough in its retirement plan to fund all of the promised benefits. Employees who got less than they had expected had little or no recourse. ERISA changed that, requiring that plans be funded on a regular schedule. Contributions to such plans are deductible by private employers, which is a tax benefit, but they also reduce the bottom line and require the transfer of cash to the plan each year. Private employers have some funding leeway, but eventually have to fulfill their obligations to the plans. Or, they could terminate the plans, and move to another type of plan, which is what most employers did.
The upside of defined benefit pension plans, then, is that they offer a benefit that can be calculated well in advance, and aid in planning for retirement. The funds in the plan are invested by advisors chosen by the employer, who, presumably, are skilled in doing so. The downside is that the employer is responsible for the liability for such plans and must have a plan for defraying it. That liability would be reflected in financial statements, which could result in a drag on the employer’s value. And if investments of the retirement funds do not do well, the employer has to put in more money to make up for the losses. And that responsibility placed on the employer, and the use of expert investment counsel, is the upside of such plans for those participating in them.
Governmental plans are not subject to ERISA, so they have more leeway when they fund retirement plans. The result in that situation has been that governments postponed payments into public plans, resulting in the very serious problems we find today throughout the country: public pension funds are woefully underfunded. How underfunded they are is a matter of statistical analysis, and seems to vary depending on whether a writer is a supporter or opponent of such plans. But the ability of governments to postpone funding retirement plans until a sunny day arrives is a serious defect of such plans.
The replacement for many private plans has been the 401(k) plan, a reference to the Internal Revenue Code section authorizing them. In this type of plan, the employee reduces his or her income, and the amount of the reduction is placed in the retirement plan. It is a voluntary decision on the part of the employee, who could contribute the full amount permitted by law, or a lesser amount. (The maximum annual contribution for 2013 is $17,500, plus an additional $5,500 for those have reached age 50). The employer could add to the plan, such as through a matching contribution, but matching rates, if there were any, could vary.
Once the funds are contributed to the plan, in almost every case the employee decides how to invest them. The plan administrator or an advisor to the plan offers a selection of investment vehicles, usually a range of mutual funds, and it was up to the employee to decide among those funds. At retirement, the employee receives the amount to which the investments had grown by that time. If the employee is skillful, and defers the maximum each year, it could be a very large amount. Both the benefit and risk of investments is shifted to the employee. In recent years, governments have also begun considering these types of plans as replacements for defined benefit plans. Proponents of defined benefit plans have suggested that there are constitutional limits on the ability to make such a change, at least for current employees. This process, and the questions it raises, are ongoing.
The upside of these plans is that they are usually less expensive for the employers. They rely on the forbearance and wisdom of the employee in selecting investments. The right decisions can be very beneficial to the employee. The idea of such a plan is to place the responsibility on the employee to create his or her own future, a sort of consumer-driven retirement planning.
The downside of these types of plans is easy to see. If the employee doesn’t make the decision to defer income, there is nothing to invest. In addition, the idea that employees could choose their own investments from a menu of mutual fund choices and make the right decisions is, generally, false. Many studies have shown that if employees make their own investment decisions, they don’t do well, because they are not experts at investing money. In recent years, many plans have offered more sources of investment advice through plans, which can be helpful. In some plans, employees can use their own outside advisors, so called individually directed accounts.
But a more fundamental problem is this: for many people in higher income levels, a 401(k) plan does not permit large enough contributions that, with investment gains, can produce an adequate investment fund at retirement. A substantial level of employer matching contributions can help, but experts in pension policy have concluded that the 401(k) structure is not designed or adequate for providing the needed amount of retirement income for higher income people. In an earlier era, people thought of retirement funding as a three-legged stool: Social Security, a defined benefit pension, and personal savings. For higher income individuals, replacing the defined benefit plan with a 401(k) plan means the stool has one short leg, with the expected result.
It’s unlikely that employers will go back to the days of widespread defined benefit plans, but it is important to understand that the 401(k) structure, with too much employee discretion to make decisions for which they are not trained and for which they often make the wrong choices, is not the solution. There are other types of plan, combining both the 401(k) voluntary aspect and some level of formula employer contribution, that might offer a solution. But the first step for employers is to understand the benefits and the drawbacks of the types of plan available, and decide what they want to achieve with retirement plans. This is especially true for law firms, where the provision of an adequate retirement account can be a useful part of the transition process for lawyers, and avoid the dangers inherent in providing unfunded promises of retirement income to retiring lawyers.
(This article previously appeared in the Legal Intelligencer.)
Despite the extensive information available from many sources about retirement planning, many people remain puzzled and disconnected from that type of planning. As mentioned in a previous article, there is an abundance of advice being offered by investment professionals, but not as much assistance on getting into and through the process of planning for retirement. And, not surprisingly, the advice being sought is by older people, often within a few years of retirement, when there are fewer planning options. There are some centers or think tanks observing and reporting on the retirement process, notably the Center for Retirement Research at Boston College. And as baby boomers move further toward and into retirement, the topic will be discussed even more. But all this is to say that help of some kinds is available, not that people are taking advantage of it when and to the extent they should. And some good advice and guidance is sandwiched between offers and advice that are too general to be helpful. Psychologists would describe the delay in planning for life after a long career, despite the abundance of help available, with the term avoidance.
At the Saul Ewing firm, we began several years ago to offer programs and advice on retirement planning. Clearly, retirement is not the same for everyone. At one of our recent programs, retired partners spoke on their retirement “lifestyles”. One retired partner, who had worked on corporate transactions for more than forty years, described daily life on the golf course. Another talked about retaining a few clients in the nonprofit sector and working just enough to remain involved and up-to-date on the development of the law. A third focused on family and political interests. Attitudes toward retirement are influenced by attitudes toward work. While nearly all lawyers will say that they are very busy and want to remain so until physically unable to continue, many would benefit from a change or reduction in pace. Many more will find that they are unable to continue working because of family commitments or changes in the economics of legal practice, and some will be asked to make way for younger lawyers. It’s this lack of a definite endpoint for practice that seems to make planning more difficult, and easier to put off.
The process of understanding retirement planning starts with the basic idea that you have to save for a period of time when you will no longer be working, and that you will undoubtedly have such a period of time, when you can’t or don’t want to work, full-time or part-time. Our Social Security system was created to provide a base level of income for those who reached a specified retirement age, and we have been forced to save, over our working lives, to provide those benefits. And once politicians start doing the jobs they were elected to do, the problems (not a crisis) facing Social Security will be resolved. For many people, that will be their only source of retirement income- a very modest form of retirement, but, as we used to say in math class, a non-zero amount. The purpose of this article is to begin the process of understanding issues we will all face in retirement, with some basic rules of retirement income. Having a source of income in retirement isn’t the entire answer to this puzzle; maintaining good health and positive personal relationships are also vital; but having an adequate stream of income is very important.
The Social Security Administration has made an effort to simplify the description of benefits and the application process. Despite these efforts, Social Security is a complex subject. Perhaps the most basic question is, when should I begin receiving benefits? Some people have elected to begin benefit payments at age 62, even with the reduction in benefits resulting from early commencement, on the theory that benefits are less likely to be reduced in future years for those already in pay status. It’s not an argument based in law or regulations, but on a political hunch. More people will wait to receive benefits until the normal retirement age, which for many baby boomers will be age 66. By waiting a few more years, until age 70, benefits are significantly increased. The unanswerable question is, which method works out best for the recipient. Of course, it depends on how long you live. But if you are planning to work until age 66 or thereabouts, and you have enough other income or savings such that you will not need Social Security payments until later years, there is a good rate of return in waiting until age 70. Waiting past age 70 isn’t of much value, though, as the increase in benefits for waiting past that age is far less attractive.
Despite the amount of information available on line and in newspapers and magazine articles, it is probably advisable to obtain personalized advice on this subject. Representatives of the Social Security Administration will meet with you to discuss your options, and you may also use the services of a financial planner, provided he or she has expertise in Social Security. There are some wrinkles to Social Security that repay careful study of the system, such as: if one spouse has retired, but the other continues to work, the working spouse may begin receiving a benefit at that person’s normal retirement age, based on the retired spouse’s benefit amount, without affecting the benefits payable to the working spouse at age 70.
Qualified Retirement Benefits
The term qualified refers to the fact that the retirement plan has satisfied the requirements of the Internal Revenue Code that permit contributions to the plan to be deducted for federal income tax purposes and the buildup of income within the plan to remain untaxed until distributed, which is a valuable wealth-building benefit. In an earlier era, defined benefit pension plans were the dominant retirement planning technique. A benefit was promised, which could be determined under a formula using compensation and years of service as factors. It was then the employer’s responsibility to see that the sum promised was there at retirement. Defined benefit pension plans have disappeared from most law firms and large corporations, and are most frequently observed in governmental employment and union-represented work forces.
Most employers who sponsor retirement plans now use a defined contribution plan. Amounts are contributed by the employer or the employee, or both, and then invested. At retirement, the employee receives whatever amount the contributions have grown to over the years. The risk of failure and the benefits of success are on the employee, not the employer. Within the overall category of defined contribution plans are included 401(k) plans, probably the most popular form of qualified retirement plan today.
The deferred taxation of the buildup of assets within qualified retirement plans is a valuable benefit or, to look at it from the other side of the looking glass, a substantial drain on income tax receipts. The Internal Revenue Code has “hemmed in” the benefit of qualified retirement plans by imposing penalties when those plans are not used as intended. As they are retirement plans, says the Internal Revenue Code, benefits should be paid out at or near retirement. Section 72(t) of the Code imposes a 10% penalty on distributions made before the attainment of age 59 ½. There are exceptions to that rule, such as for distributions after death or disability, or at the termination of employment after age 55. This is a complicated provision, which supports the policy of paying retirement benefits at retirement and not before.
When amounts are paid from a qualified plan, they will be considered ordinary taxable income in most cases. If there are after-tax contributions, they will be received free of tax under a statutory formula. A provision allowing some benefits to be received on a capital gains taxation basis is fading away as more time passes since the enactment of the Employee Retirement Income Security Act in 1974.
At the other end of the spectrum, the authors of the Internal Revenue Code do not want benefits to remain in qualified plans indefinitely. Instead, they should be distributed and taxed during retirement years. If benefits do not begin to be withdrawn by age 70 ½, a 50% penalty may be applied to the “under-withdrawal.” More specifically, benefit payments must begin by April 1 of the year following the year the plan participant reaches 70 ½. After that, benefit payments must continue on a specified basis, tied to life expectancies of real and imaginary persons. (A grandfather provision under the Tax Equity and Fiscal Responsibility Act permits avoidance of these rules, but under rarely achieved circumstances.) From this fairly complex statutory provision have flowed hundreds of pages of regulations, rulings and commentary. Like other provisions of the Internal Revenue Code, a sensible policy has generated an industry of interpretation and planning.
Beginning from rudimentary beginnings as promises to pay retirement benefits out of current income and assets (still the method in a dwindling number of law firms and other businesses), the provision of retirement benefits, whether through Social Security or qualified retirement plans, has become a complex system of laws and regulations, one that rewards careful planning and penalizes the lack of it, either through actual penalties or the loss of tax-saving and deferral opportunities. Navigating and planning for the retirement process includes understanding the ways and times in and at which benefits may be paid, and matching up retirement living decisions to the statutory requirements.
(This article previously appeared in the Legal Intelligencer.)