Edward A. Lyon, JD
TaxTuneup.com, Inc.
3416 Shaw Ave #5
Cincinnati OH 45208
513.321.2821
elyon@taxtuneup.com
|
Qualified Corporate Dividend
"Qualified corporate dividends" include any
dividend issued by a C corporation that has already paid tax on that
income. tax on qualified corporate dividends is capped at 15%, even if
your regular bracket is higher.
Qualified Domestic Relations
Order
A qualified domestic relations order, or QDRO,
let divorcing spouses transfer part or all of their
Qualified Plan balance to your spouse in
a divorce without paying tax on the transfer. If the recipient rolls the
money into an IRA, there's no tax on the transfer; if they simply take the
money and run, then tax is due.
The QDRO itself is a judicial order
establishing the recipient's right to receive qualified plan benefits. It
has to specify four items:
- The name and last known mailing address of
the participant and alternate payee
- the amount or percentage of the account
payable to the alternate payee
- the number of payments to which the QDRO
applies
- the specific plan to which the order
applies.
The QDRO can't require the plan to provide
any benefit not otherwise provided under the plan; any increased benefit;
or payment of any benefit already claimed by a different alternate payee
under another QDRO.
You don't need a QDRO to divide
Individual
Retirement Account balances. But your property settlement has to require the transfer.
Otherwise, it will be treated as a taxable distribution, subject to
ordinary income tax plus a 10% penalty for withdrawals before age 59½. The
following language should protect you:
"Any division of property accomplished or
facilitated by any transfer of IRA or SEP account funds from one spouse or
ex-spouse to the other is deemed to be made pursuant to this divorce
settlement and is intended to be tax-free under Section 408(d)(6) of the
Internal Revenue Code."
For more information, see
IRS
Publication 504, "Divorced or Separated Individuals."
Qualified
Plans
Qualified plans are retirement savings plans
that qualify for special tax treatment. Contributions going into the plan
are tax deductible, and earnings grow tax-deferred until you
withdraw the funds. Plan balances are generally portable if you change
employers, which means you can roll them into a new employer's plan or your
own Individual Retirement Account.
This discussion focuses on plans you
establish for your own business. If you're looking for information on
contributions you make to your employer's plan, see
401(k) Plan Contributions,
403(b) Plan Contributions,
457 Plan Contributions,
or SIMPLE IRA Plan
Contributions.
There are two main categories of qualified
plans. "Defined benefit" plans are old-fashioned pension plans that
promise a specific benefit at retirement. These have become too costly for
most of the Fortune 500, but they can be powerful tax-cutting tools for
small businesses and professional practices. "Defined contribution" plans,
such as today's popular 401(k)s, focus on contributions going into the
plan. Your eventual benefit depends on how your plan investments fare.
If you own your own business, either as a
sole proprietor, partner, or owner of a corporation, establishing a
retirement plan can be your most powerful tax-cutting tool. Some plans let
you and your employees "defer" part of your salary, while others require
the business to fund contributions. Deferrals and contributions are based
on "covered compensation," or covered comp, which generally includes W-2
wages or self-employment income up to $230,000. Your most important
decisions are how much you want to contribute for yourself and how much
you want to contribute on behalf of your employees. Your answers to these
two questions will usually determine which type of plan is best for you:
- A "Savings Incentive Match Plan for
Employees," or SIMPLE plan, lets you and your employees defer up to
$10,500. Your business will be responsible for kicking in an additional 2%
of your employees' covered comp or matching their deferrals up to 3% of
covered comp.
- A "simplified employee pension," or SEP,
lets you contribute up to 25% of your covered comp for yourself and your
employees. This lets you contribute more then SIMPLE plans; however, your
employees' contributions come out of your own pocket.
- A "profit sharing" plan lets you make
discretionary contributions of up to 25% of net income (20% for sole
proprietors or partners) for yourself and your employees.
- A "money purchase" plan lets you make
fixed contributions of up to 25% of net income (20% of gross income for
sole proprietors and partners) for yourself and your employees.
- A "401(k)" plan is a profit-sharing
plan that lets you and your employees defer up to $15,500 of covered comp
to the plan. You can choose to match their contributions or make
discretionary profit sharing contributions. 401(k) plans are subject to
strict nondiscrimination rules designed to ensure that plan benefits don't
disproportionately benefit highly compensated employees. However, "SIMPLE"
401(k)" and "Safe Harbor" 401(k) plans are available to sidestep some of
those rules.
- A "defined benefit" plan lets you
contribute whatever amount necessary to fund a defined income of up to
$185,000 per year beginning at a defined retirement age. These plans are
more difficult and expensive to administer. But once you reach age 45 or
thereabouts, a defined benefit plan can give you a far bigger tax break
than the defined contribution alternatives.
- Finally, a "cross-tested" plan is a
creative hybrid of a profit sharing or money purchase plan that uses
defined benefit testing principles to contribute more on behalf of
yourself and your highly compensated employees.
Let's examine each of these plans in more
detail. For more information, see
IRS
Publication 560, "Retirement Plans for Small Business.
SIMPLE IRA
A SIMPLE IRA is a "super-IRA" that let you
squirrel away more than the usual $5,000 IRA contribution limit.
Technically, a SIMPLE IRA isn't a "qualified plan" because plan assets
aren't held in trust and subject to the Employee Retirement Income
Security Act of 1974, or ERISA. Here are the rules:
- You and your employees can contribute 100% of your earned
income up to $10,500 (2008). If you're age 50 or older, you can make an
additional $2,500 "catchup" contribution.
- Your business can choose to contribute of
2% of each employee's earnings, whether they participate or not, or 100%
of each participating employees' contribution up to 3% of their earnings.
If you choose the match, you can reduce it as low as 1% for 2 out of every
five years. Your match is due by the date for filing your business tax
return, including extensions.
- You have to include any employees earning
at least $5,000 in any two preceding years and reasonably expected to earn
$5,000 this year.
- You have to open the plan by October 1 of
the year you plan to start contributions.
SIMPLE IRAs are especially good if you own
an S Corporation and pay yourself a minimal salary to avoid
Self-Employment Tax. That's because there's no limit on the percentage of
income you can contribute, as there is with SEPs and qualified plans. You
can also employ your spouse, pay him or her a nominal salary, and
contribute it all to the plan. SIMPLE IRAs also give you great flexibility
to choose your investment provider.
If you participate in another employer's
401(k) or 403(b) plan, your total deferrals from the employer plan and
your own SIMPLE plan can't exceed the overall deferral limit ($15,500 for
2008). You may want to consider maximizing your employer match, then
contributing the rest to your own plan for more investment options than in
your employer's plan.
To establish a SIMPLE IRA, complete
Form
5304-SIMPLE (if you're willing to let your employees establish
accounts wherever they choose) or
Form 5305-SIMPLE
(to designate a particular financial institution to hold IRA assets).
Deduct contributions for yourself as a sole proprietor or partner as an Adjustment to Income on Page 1 of
Form 1040. Deduct contributions for
yourself as an employee and your own employees on
Schedule C,
Form 1065,
or your corporate return.
Simplified Employee Pension
Simplified Employee Pensions, or SEPs, are
also "super-IRAs" that let you squirrel away more than the usual $5,000 limit
for yourself and your employees. They resemble profit sharing plans,
except you make contributions to individual IRAs and not a qualified plan trust.
Here are the rules:
- If you're a sole proprietor or a partner
in a partnership, you can contribute up to 25% of your net income up to
the "covered compensation limit" ($230,000 for 2008), reduced by one-half
of your Self-Employment Tax and your SEP contribution. Essentially,
this means you
can contribute up to 20% of net income up to the covered comp limit.
- If you're an owner/employee of a
corporation, you can contribute up to 25% of your W-2 wages up to the
covered compensation limit.
- You have to include any employees age 21
and up who have worked 3 of the last 5 years and earn $500 or more.
- You generally have to contribute the same
percentage of compensation for your employees as you do for yourself.
However, you can choose an "integrated" plan that lets you contribute more
on behalf of higher-paid employees--presumably, yourself. Integrated plans
include a base contribution which is the same percentage for everyone,
plus an "integrated" contribution of up to 5.7% of covered compensation
above a certain income--usually the Social Security wage base ($102,000
for 2008). For example, your plan might contribute 10% of each employee's
covered compensation, plus 5.7% of covered compensation above $102,000.
This arrangement lets you contribute more on your own behalf without
boosting contributions for your employees.
You can establish the plan and make your
contribution as late as your due date for filing the business's tax
return, including extensions. File
Form 5305-SEP to establish the
plan. Deduct contributions for yourself as a sole proprietor or partner as
an Adjustment to Income on Page 1 of
Form 1040. Deduct contributions for
yourself as an employee and your own employees on
Schedule C,
Form 1065,
or your corporate return.
Profit Sharing Plan
A profit sharing plan lets you make
discretionary contributions of up to 25% of covered compensation or
$46,000, whichever is greater, on behalf of yourself and your employees
- You can vary plan contributions each year,
or even skip contributions. You can make contributions even if the
business has no profits for the year.
- Plan contributions have to be held in
trust. The plan trustee can direct plan investments, or you can establish
participant-directed accounts for each employee to manage their own
account.
- You can choose an integrated contribution
formula that lets you contribute a higher percentage of covered comp on
behalf of employees earning above a specified threshold--usually the
Social Security wage base ($102,000 for 2008).
- Profit sharing plans are true qualified
plans, subject to ERISA rules and Department of Labor regulations. You'll
need to establish a trust to hold plan assets, and you'll need to
designate at least one trustee, who has to be bonded.
- Most plan sponsors designate a third-party
administrator, or TPA, to handle administrative chores and annual filings.
Most banks, mutual fund families, and insurance companies that offer
profit sharing plans offer in-house TPAs for "bundled" plans at an
additional fee. Or you can choose an independent TPA that specializing in
just administering plans.
- Your trustee can direct plan investments,
or you can let each employee direct their own account. Most investment
providers offer a choice of Mutual
Funds or group variable Annuity subaccounts. You can offer self-directed brokerage accounts that let you
and your employees invest in individual stocks and bonds; however, these
accounts are more expensive and raise fiduciary risks for plan trustees.
Think hard before you day-trade in your retirement plan!
- You'll have to file
Form 5500, an
informational return disclosing plan contributions and asset balances,
each year. (One-person plans with less than $100,000 don't have to file.)
To establish a profit sharing plan, you'll
need to complete an adoption agreement by December 31 of the year for
which you want to begin contributions. Report plan contributions as
"Pension and profit-sharing plans" on
Schedule C,
Form 1065,
or your corporate return.
If you're self-employed or a member in a
Limited Liability
Company taxed as a partnership, report employee
contributions on
Schedule C,
Form 1065,
or your corporate return and contributions on your behalf
as an Adjustment to Income on
Form 1040.
Money Purchase Plan
A money purchase plan resembles a profit
sharing plan, except that it calls for fixed annual contributions
specified in the adoption agreement. Contributions can range up to 25% of
covered comp or $46,000, whichever is less. Otherwise, money purchase
plans operate the same as profit sharing plans.
Under previous law, profit sharing plans
could contribute no more than 15% of an employee's covered compensation.
Money purchase plans were useful because they upped that limit to 25% of
covered comp. But since the rules for profit sharing plans have been
amended to allow higher contributions, money purchase plans have become
obsolete.
401(k) Plan
A 401(k) plan is a profit sharing plan that
lets you and your employees defer your income into the plan and lets your
business match deferrals or make discretionary profit sharing
contributions. 401(k)s have become the Fortune 500's favorite retirement
plan because employees fund the bulk of their accounts through deferrals.
But 401(k)s can be appropriate for smaller businesses too, especially if
you have younger, educated employees willing to defer today's income for
tomorrow's retirement. Here's how they work:
- You and your employees can defer up to 100% of covered
comp or $15,500, whichever is less. Employees age 50 or older can make an
additional $5,000 "catchup" contribution.
- The business can match each employee's
contribution up to a percentage of covered comp. A typical formula might
have the business match 50% of each employee's contribution up to 6% of
covered comp. The business can also make discretionary profit sharing
contributions.
- The total amount of deferrals and
contributions for any one participant can't top 25% of covered comp or
$46,000, whichever is less.
- If you're a "highly compensated
employee" (you own more than 5% of the business or you make more than
$105,000 per year) your contribution may be limited by special
antidiscrimination rules.
401(k) plans sound like a no-brainer
because employees fund the bulk of their accounts through salary
deferrals. But 401(k)s are subject to complicated "nondiscrimination" and
"top-heavy" rules to ensure that they don't disproportionately benefit
company owners and highly compensated employees. Without going into
technical details, these rules ensure that if your employees don't
contribute, you can't either. So 401(k)s may not be appropriate for
companies with large numbers of low-paid employees, who often don't fund
their accounts. Fortunately, the law offers two variations for companies
facing this problem:
- A "SIMPLE" 401(k) lets you avoid
nondiscrimination and top-heavy rules in exchange for guaranteed
contributions for employees. You and your employees can defer 25% of
covered comp up to $10,500; while the business has to contribute 2% of
covered comp or match contributions up to 3% of covered comp. This plan is
an excellent choice if you want a true 401(k), but you're afraid your
employees won't defer enough to let you make meaningful deferrals. You can
also convert an existing 401(k) to a SIMPLE 401(k) if you find yourself
unable to defer because of low participation.
- A "safe harbor" 401(k) lets you avoid
nondiscrimination rules (but not top-heavy rules) in exchange for higher
guaranteed contributions for employees. You and your employees can defer
up to $15,500. You can structure employee contributions in two ways: 1)
contribute 3% of covered comp; or 2) match contributions dollar-for-dollar
up to 3% of covered comp and fifty-cents-on-the-dollar for contributions
between 3% and 5% of covered comp. (Whew!) You can make extra profit
sharing contributions up to 25% of covered comp or $46,000, whichever is
less. You can even make cross-tested profit sharing contributions for
ultimate flexibility.
To establish a 401(k) plan, you'll
need to complete an adoption agreement by December 31 of the year for
which you want to begin contributions. You'll deduct employee deferrals as
part of their wages and employer contributions as
"Pension and profit-sharing plans" on
Schedule C,
Form 1065,
or your corporate return.
If you're self-employed or a member in a
Limited Liability
Company taxed as a partnership, you'll report your own deferral contributions
as an Adjustment to Income on
Form 1040.
Cross-Tested Plan
A cross-tested plan is a profit sharing or
money purchase plan that uses defined benefit testing principles to
qualify contributions for tax breaks. These can be effective tools for
allocating a larger part of the company's contribution to older,
higher-paid employees--presumably including you. Without going into
technical details, which involve actuarial concepts such as "Equivalent
Benefit Accrual Rates" and "the General Test," there are three main
flavors of cross-tested plans. "Age-based" plans allocate more of the
company contribution to older employees, on the theory that they have less
time to build retirement savings. "Super-integrated" plans allocate more
to higher-paid employees, on the theory that they get no Social Security
benefits from income above the Social Security wage base. Finally, "rate
group" plans divide employees into different groups, such as salespeople,
management, and administrative staff, and make different contributions for
each.
Cross-tested plans aren't for
do-it-yourselfers. They're more expensive to establish than other defined
contribution plans, and they require more ongoing administration to make
sure that contribution formulas meet strict tests. But benefits for
business owners can easily outweigh these costs. For more information, see
your attorney, CPA, or benefits specialist.
Defined Benefit Plan
A defined benefit plan is a traditional
pension plan that pays a fixed income for life. These are generally the
most expensive plans to establish, administer and to fund. But if you're
age 45 or older and you'd like to deduct the largest plan contribution
possible, a defined benefit plan may be just the ticket.
- Your first choice will be how much income
you want to provide at retirement (up to $185,000 for 2008). You can choose
from various formulas that pay according to service, your final
compensation, or both.
- Next, you'll have to decide your
retirement age (generally 55 or older).
- Next, you'll need to hire an actuary to
determine how much you'll need to contribute each year in order to
generate a fund large enough to provide your desired benefit.
- Each year, your actuary will review your
account balance and actuarial assumptions to determine how much you need
to contribute in order to fund plan benefits. If plan investments perform
well, your required contributions will be smaller. Conversely, if the
market tanks, you can find yourself on the hook for some hefty
contributions.
- If your account balance grows too large--a
problem we'd all like to have--you'll face a special 50% excise tax on the
excess.
- You can deduct whatever amount is
necessary to fund your benefit.
To establish a defined benefit plan, you'll
need to complete an adoption agreement by the end of the year for which
you want to start contributions. You'll need to file
Form
5500 by July 1 of each year. Report plan contributions under
"Pension and profit-sharing plans" on
Schedule C,
Form 1065, or
your corporate return.
A 412(i) plan is a defined benefit pension
plan funded solely by Life Insurance
and/or Annuity contracts. Your insurer,
rather than an actuary, will calculate the annual insurance and/or annuity
premium you'll need to contribute each year to guarantee the benefit. The
insurance company has to guarantee the benefits to be paid under the plan.
You have to pay premiums in a timely manner; there's no flexibility to
modify or skip payments as there is with a profit sharing plan. You can't
subject any of your rights under the plan to a security interest, and you
can't borrow against the policy. So long as the plan meets these
conditions, you can deduct as much as you need to guarantee your chosen
pension benefit. And, because plan benefits are guaranteed by the insurer,
412(i) plans don't require the annual administration necessary with
regular defined benefit plans. But you'll have to entrust your entire plan
balance to your insurer's general account. You might do better over time
by investing in stocks. And there are only a handful of insurers that
offer 412(i) qualified life insurance and annuity contracts. You may have
to search for an agent who knows the plan and offers the appropriate
contracts.
Defined benefit plans are best for small
businesses and professional practices headed by older, higher-paid owners.
You can layer a defined benefit plan on top of an existing defined
contribution plan. You can even establish a defined benefit plan to
shelter income from a sideline business. For more information, see your
attorney, CPA, or benefits specialist.
Qualified Plan Withdrawals
Qualified plan withdrawals are taxed as ordinary income as you take them from the plan.
Withdrawals before age 59½ are subject to a 10% penalty; however, there are
several exceptions:
-
There's no penalty for
withdrawals due to death or disability.
-
There's no penalty to withdraw
money from a regular IRA (but not a Roth IRA) to pay for unreimbursed
Medical Expenses (up to
the amount allowed as a medical expense deduction).
-
There's no penalty for
withdrawals of up to $10,000 (lifetime maximum) used within 120 days of
the withdrawal for qualified acquisition costs of a "first-time
homebuyer." To qualify, neither you nor your spouse may have owned a
primary residence for two years before the withdrawal.
-
There's no penalty to withdraw
money for higher education expenses (including tuition, room and board,
fees, books, supplies, supplies, and required equipment).
-
There's no penalty to withdraw
money if you're retired and over age 55.
-
There's no penalty or tax to
transfer money to a divorcing spouse under a qualified domestic relation
order.
Generally, you have to leave your money in
the plan until you retire or separate from service. At that point, you can
roll your account balance into an IRA or begin withdrawals as you see fit.
However, some plans let you withdraw funds while you're still employed.
These "escape hatches" include loans, hardship withdrawals, and in-service
withdrawals:
- Plan loans lets you tap your money without
giving up tax-deferral. They also let you reach it before age 59½ without
paying a 10% early withdrawal penalty. You can generally borrow up to
$50,000 or 50% of your vested account balance, whichever is less. (If your
plan is particularly flexible, you can borrow up to 100% of your plan
balance by putting up extra security, such as your house.) You have to
repay your loan within five years (unless you use it to buy a primary
residence, in which case you can repay it over 20 years), with
substantially level installments paid at least quarterly. If you leave
your job and take your account balance before you repay the loan, you'll
owe tax on the unpaid balance unless you repay the remaining loan balance
with funds from another source. Plan loan interest isn't tax
deductible--you'll repay the loan with after-tax dollars, then pay tax
again when you withdraw your money from the plan. But plan loans are the
easiest way to access your money before retirement. For more information,
see your plan administrator.
- Some 401(k) and 403(b) plans let you take
a "hardship withdrawal" of your own contributions (but not employer
contributions or earnings) for an "immediate and heavy" financial need.
These include medical bills, a down payment on a house, college costs, and
payment of any amount needed to prevent eviction or foreclosure on your
primary residence. If your plan allows both loans and hardship
withdrawals, you have to borrow the maximum amount available before taking
a hardship withdrawal. If you do take a hardship withdrawal, you can't
contribute to the plan for the next year. For more information, see your
plan administrator.
- Finally, some profit sharing and 401(k)
plans let you make "in-service withdrawals" while you still work for the
company. You can take the withdrawal in cash (after you pay tax and a 10%
penalty, if applicable), or you can roll the withdrawal into an IRA. (You
can also use an in-service withdrawal to roll money into an IRA if you
don't like your plan's investment options.) Again, for more information,
see your plan administrator.
For more information see
IRS
Publication 575, "Pension and Annuity Income," and
IRS
Publication 939, "General Rules for Pensions and Annuities."
|
