Prudential Financial

Tax Strategies: Other Retirement Plans

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Simplified Employee Pension Plans (SEPs)
SEPs are attractive to small businesses because they have less cumbersome reporting rules and lower administrative expenses than maintaining a qualified plan. Employer-funded SEPs allow the employer to make tax-deductible contributions into each eligible employee's SEP IRA. For 2009, the maximum contribution cannot exceed 25% of compensation (up to a maximum of $245,000 for 2009) or $49,000, whichever is less. This plan must be established and funded prior to your company's tax-filing deadline, including extensions. You may also contribute (within the annual limit) to a traditional and/or Roth IRA.

Salary Reduction Simplified Employee Pension (SARSEP)
SARSEPs allow employees to contribute up to $16,500 in 2009 (adjusted for inflation). This contribution reduces the employee's salary and is not subject to federal income taxation until distributed. Overall, employer and employee contributions may not exceed 25% of the employee's compensation. New SARSEPs can no longer be established. However, contributions to existing SARSEPs can continue and new employees can participate. You may also be eligible to contribute (within the annual limit) to a traditional and/or Roth IRA.

Savings Incentive Match Plan for Employees (SIMPLE)
A SIMPLE plan is a retirement plan arrangement for employers with 100 or fewer eligible employees and who do not maintain any other tax-favored retirement plan. A SIMPLE plan can either be structured as an IRA-based plan or a 401(k) plan. For the 2009 tax year, the maximum contribution that an employee can make to a SIMPLE plan is $11,500 (adjusted annually for inflation) based on a percentage of compensation. This contribution reduces the employee's salary and is not subject to federal income taxation until distributed.  If you are age 50 or older, you may make an additional "catch-up" contribution of $2,500. You may make this "catch-up" contribution even if you didn't contribute to a SIMPLE or contributed the maximum in previous years.

Employers make tax-deductible contributions by either matching participating employee elective contributions on a dollar-for-dollar basis, up to 3% of the employee's compensation, or by making a nonelective contribution of 2% to all eligible employees.

A special rule applies to SIMPLE IRA plans, which allows employers to elect to contribute a lower percentage for two out of five years. For SIMPLE 401(k) plans, the maximum deduction an employer can take for its contributions equals either the total of required contributions (including both employer and employee pre-tax contributions) or 25% of total compensation paid under the plan, whichever is greater.

SIMPLE Distributions
IRA-based SIMPLE plans and 401(k)-based SIMPLE plans have different tax consequences.
  • SIMPLE IRA plan: Distributions from a SIMPLE IRA plan are taxed according to the rules governing IRAs. Distributions are included in your income. Tax-free transfers can also be made from one SIMPLE IRA plan account to another. After you have participated in a SIMPLE IRA plan for two years, it can be rolled over into a traditional IRA or other employer qualified plan tax-free. SIMPLE IRAs that are rolled over into a Roth IRA will result in a taxable transfer not subject to the 10% penalty. Distributions are generally subject to the 10% penalty if you take them before you reach age 59½. This penalty is increased to 25% for withdrawals made within the first two years of participation.

  • SIMPLE 401(k) plan: Distributions from a SIMPLE 401(k) plan are taxed according to the same rules that govern 401(k)s. Distributions are included in your income. Distributions are generally subject to the 10% penalty before you reach age 59½. Tax-free rollovers can also be made from one SIMPLE 401(k) plan to another SIMPLE 401(k) plan during the first two years of participation or a traditional IRA or other employer plan after two years of participation in the SIMPLE plan.
Employer-Sponsored Qualified Plans
There are two basic types of qualified plans: defined contribution and defined benefit. Contributions made to these plans by a company on behalf of its employees are tax-deductible to the employer. Income generated from contributions to a plan is generally not taxed to the employee until distributed. Contribution limitations are based on the type of plan chosen.
  • A defined contribution plan does not guarantee any specific dollar benefit to a participant at retirement. Benefits received are based on the amount contributed (as a percentage of compensation), income, expenses, gains and losses, and forfeitures from the accounts of former plan participants. Money purchase pension plans and profit-sharing plans are two examples of defined contribution plans.

    Annual contributions to money purchase plans are determined by a fixed formula and must be made each year, regardless of the company's profit or loss. The employer's maximum tax-deductible contribution is the lesser of $49,000 or 25% of the compensation (indexed at $245,000 for 2009) of eligible employees. Annual contributions to profit-sharing plans are at the employer's discretion. This funding flexibility is especially attractive to employers, because contributions are determined on an annual basis and are not mandatory. For 2008, the maximum tax-deductible contribution that can be made by an employer to a profit-sharing plan is $46,000 or 25% of compensation, whichever is less.

    If you have a profit-sharing plan and a money purchase pension plan, the annual combined contributions and additions (i.e., forfeitures) to a participant's account cannot exceed $49,000 or 25% of compensation, whichever is less for 2009.
  • A defined benefit plan specifies the benefit an employee will receive at retirement. This annual retirement payment cannot exceed $195,000 in 2009 (adjusted for inflation annually) or 100% of the participant's average compensation for the three consecutive years of highest compensation, whichever is less. Contributions are based on the amount necessary to fund the benefits provided. These contributions must be determined by an actuary.
Both types of qualified plans have the following characteristics in common:
  • A plan must provide benefits or contributions to eligible employees in a nondiscriminatory manner.

  • Active participation in a retirement plan may reduce or eliminate deductible IRA contributions. However, a nondeductible IRA contribution can always be made for any individual under age 70½ with earned income. For individuals who exceed traditional deductible IRA AGI limits, nondeductible contributions may be made to a Roth IRA, regardless of age (subject to AGI limits).

  • To take advantage of the benefits of a retirement plan for the current year, the plan must be established by the end of the employer's tax year (whether calendar or fiscal). Contributions to an existing plan are deductible on the company's tax return if they are made prior to the due date of the return, including extensions.
Distributions from Qualified Plans
You can delay taking required minimum distributions from qualified plans until April 1 of the calendar year following either the year you reach age 70½ or the year you retire, whichever is later. If you are at least a 5% owner of a business, you are required to begin withdrawals by April 1 of the year following the year you reach age 70½.

Lump Sum Distributions
A lump sum distribution occurs when you receive your entire interest in a qualified plan within a single tax year. The distribution must be payable on account of the participant's death or disability, upon attaining age 59½, or upon separation from service of the employer. If you take a lump sum distribution after attaining the age of 55 and you receive the distribution on account of separation from service of an employer, you will not be subject to a 10% penalty. For certain public safety employees, it's age 50 and separation from service. 

Generally, the entire amount of the lump sum distribution will be subject to ordinary income tax and mandatory 20% federal income tax withholding. However, you may prevent current taxation and withholding by making a direct transfer rollover into an eligible retirement plan or IRA.

You can roll over a lump sum distribution to an eligible retirement plan or IRA by either directly transferring the funds or by directly taking the distribution and transferring it to an eligible retirement plan within 60 days.

In a direct transfer, the trustee of the distributing plan pays the distribution directly to the trustee of the recipient plan. This method avoids current income taxation and withholding entirely.

If you take a direct distribution, you will receive only 80% of the distribution, because 20% of the distribution is required to be withheld for taxes. If you roll over the amount actually received (i.e., 80% of the distribution), you will be taxed on the 20% of the distribution that was withheld. In order to avoid taxation, you are permitted to add additional funds to your new plan to make up the 20% withheld.

A projection of tax liability should be done to determine whether income averaging or rollover treatment is best for you. Speak with your tax advisor for more information.