401ks or (Cash or Deferred Arrangements)
MR. WATSON: Let's talk about a 401K plan.
STUDENT: 401(k) I believe is a participatory type of deal. The employee puts in so much, and the company may or may not match it up to a particular percentage.
MR. WATSON: Very good. I made $50,000 last year. I put $5,000 into the 401(k), which allowed me to reduce my taxable income. So, I only pay taxes on $45,000, You agree?
STUDENT: Yes.
MR. WATSON: I put five grand in, and my employer matched it 100 percent. The employer doesn't have to match it 100 percent, but he can. You understand?
STUDENTS: Yes.
MR. WATSON: That's the gist of it. There are limits or maximum amount of contributions for retirement plans. You can't just throw any amount into these. Does that make sense?
STUDENTS: Yes.
MR. WATSON: When are you vested in your contribution?
STUDENTS: Now. Immediately.
STUDENT: When's the earliest you can take it out?
MR. WATSON: There is a 10% penalty if the money is taken before 59 1/2. You always pay income taxes on the money you take out. You put money in, typically 401(k)s include matching employer contributions. You got to tax-deduct your portion and the employer got to tax-deduct his portion. It’s been invested and it’s been growing and none of the interest has been taxed. So later, the IRS will force you to take it out. And when they do, ALL of the money you receive is taxable earned income. But if you take the money before 59 1/2 then you’ll have an additional 10% penalty on the total amount you took.
MR. WATSON: You can't take the money out until after 59-1/2, with a few exceptions. There are income taxes plus a 10% penalty if the money is taken before 59 1/2. The exceptions are:
- retirement, after age 59 1/2, (Taxes, but no 10% penalty)
- death, (Taxes, but no 10% penalty)
- disability, (Taxes, but no 10% penalty)
- qualifying medical expenses, (Taxes, but no 10% penalty)
- higher education, (Taxes, but no 10% penalty)
- separation from service (meaning you left your job and rolled your 401k into the 401k offered by the new employer).
MR. WATSON: You leave your company, you can rollover or transfer the 401(k), but you can't take the money out without penalty. You roll it over into another 401k. You understand? Cool. As long as you understand that.
Tax-Sheltered Annuities 403(b) Plans, (covered in annuity chapter 11)
MR. WATSON: Who is the 403(b) for?
STUDENTS: Teachers, preachers, and nonprofits. Contributions ARE tax deductible.
MR. WATSON: This was covered in the annuity chapter, Chapter 11.
SECTION 457 Deferred Compensation Plans
MR. WATSON: SECTION 457 Deferred Compensation Plans. These are qualified deferred compensation plans for state & local government employees and non-profit organizations. Amounts deferred are NOT included in their income. You can also include life insurance in these types of plans.
Qualified Plans for the Small Employer
Keogh Plans****
MR. WATSON: Good. Keogh plans . These are for unincorporated businesses. That's what you need to know.
A couple of other points:
- they are subject to the same maximum contribution limits and benefit limits as qualified corporate plans
- they must comply with the same participation and coverage requirements as qualified corporate plans
- they are subject to the same nondiscrimination rules as qualified corporate plans. You can't discriminate!
Simplified Employee Pension (SEP)
MR. WATSON: Basically a Simplified Employee Pension (SEP) is an arrangement whereby employees establish and maintain individual retirement accounts (IRA) through which who contributes? The Employers. Does that make sense? These are easier to set up than the defined benefit and defined contribution plans. Cheaper too.
MR. WATSON: The primary difference between SEPs and IRA's is that you can contribute a lot more money into an SEP. Up to 25% of compensation. WOW! The max is around $60,000 in 2023, but that number goes up every year. The dollar amount doesn’t matter, but you definitely need to know that with a SEP you can contribute and tax-deduct up to 25% of earnings. Guys, you, the employees, set up individual retirement accounts. Does that make sense? I, the employer, put the money in on your behalf.
SIMPLE Plans
MR. WATSON: SIMPLE Plans (Savings Incentive Match Plan for Employees) This is for small businesses, including tax-exempt and government entities. These are available to businesses with no more than 100 employees who received at least $5,000 in compensation the previous year. Employees can elect to defer up to a specified amount each year and the employer then makes a matching dollar for dollar contribution up to an amount equal to 3% of the employee's compensation. The employee is immediately and fully vested. The employer can not have any other qualified plan in place.