WHAT... ME WORRY? RETIREMENT PLANNING IN THE 21ST CENTURY
By David N. Heap
The future of
Social Security and the design of private retirement plans have been much
in the news. As the baby-boom generation ages and begins to retire,
financial preparation for the "golden years" has become a more common
topic of conversation, interest, and even Congressional legislation.
Historically, private
retirement plans have been viewed as a cash cow by Congress. Tax-exempt
private retirement plans hold roughly $4.6 trillion in assets; the taxes
forgone by the Government with respect to qualified retirement plans
continue to be the largest single tax "expenditure." Until recently, many
or most retirement plan law changes were intended to raise revenues -- to
balance the budget -- by gradually (and sometimes not so gradually)
reducing the tax advantages of such plans.
Driven perhaps as
much by demographic shifts, as by increased tax revenues from a healthy
economy, the legal and regulatory climate has changed in the last few
years. The political parties now compete in introducing legislation to
ENCOURAGE formation of private retirement plans, to reduce regulatory
burdens, and to increase tax advantages.
Among such welcome
changes are : (1) the repeal of the so-called "success tax," the 15%
excise tax on "excess distributions" or "excess accumulations" in
retirement plans and IRAs; (2) the repeal of section 415(e), a stringent
combined limit that applied to contributions and benefits for people
covered by a defined contribution and a defined benefit plan; (3) the
development of "safe-harbor" 401(k) plans, SIMPLE 401(k) plans, and SIMPLE
IRAs, along with more rationalized regulatory testing standards; and (4)
the establishment of ROTH IRAs and other tax-favored savings
vehicles.
The most important
change in 2000, with respect to physicians and other professionals, is the
second item mentioned, the elimination of the combined limit when an
individual is covered by both a defined benefit and a defined contribution
plan.
A "defined benefit"
plan is a pension plan that defines the ultimate benefit to be paid; e.g.,
a lifetime benefit of $10,000 per month, beginning at age 65. An actuary
then determines the amount necessary to contribute annually to fund that
benefit. If earnings are less than anticipated, the required annual
contributions increase. If earnings are more, then the required annual
contributions decrease. For the year 2000, the maximum benefit, beginning
at a person's Social Security normal retirement age, that may be provided
by a defined benefit plan, is $135,000 per year (as long as this does not
exceed the participant's final average annual pay).
A "defined
contribution" plan defines the amount to be contributed--e.g., 5% of pay
each year. The benefit eventually paid will depend not only on the amounts
contributed, but on the plan's investment performance. A "profit sharing"
plan is a defined contribution plan that defines how the employer's
contribution, if any, will be divided among the participants, but the
employer has the discretion, within limits, to determine on a year-by-year
basis the amount of the overall contribution. 401(k) plans and 403(b) tax
sheltered annuity plans are types of defined contribution plans. The
annual limit on total annual contributions to defined contribution plans
for a participant (including 401(k) contributions), is 25% of pay or
$30,000, whichever is less.
In the past, if a
professional received the maximum contribution to a defined contribution
plan or plans, in most cases the professional could not earn any benefit
under a defined benefit plan, and vice versa. In some cases, a
professional who had been covered by a TERMINATED defined benefit plan
could not currently participate at all in a defined contribution plan.
With the repeal of
section 415(e), a participant may, theoretically, concurrently accrue a
maximum benefit under a defined benefit plan AND be allocated a maximum
contribution under a defined contribution plan. Of course, there are other
restraints that may as a technical or practical matter preclude
individuals from taking full advantage of both limits. Nevertheless, for
almost everyone, the repeal provides an opportunity for substantial
additional benefits or contributions.
Defined benefit plans
tend to provide greater value for older and long term employees. Defined
contribution plans tend to provide greater benefits for younger and short
term employees. The break point, the age where the value of a maximum
defined benefit accrual exceeds the value of a maximum defined
contribution allocation, is somewhere in the 30s, depending upon the
anticipated retirement age, form of payment, and marital status.
For an individual age
40, the maximum contribution to a defined contribution plan would be
$30,000. In contrast, the value of the maximum annual accrual in a defined
benefit plan, and potential associated deductible contribution, could
range from $35,000 to $50,000. At age 55, it could be $90,000 to
$140,000.
The repeal of section
415(e) means that some who could not contribute, or whose contributions
were limited, to a defined contribution plan -- because of their previous
coverage by a defined benefit plan -- may now participate fully in defined
contribution plans. And because of cost-of-living adjustments to the
limits, they may even be able to accrue additional benefits in a defined
benefit plan as well.
The repeal means that
professionals may participate fully in defined contribution plans in their
early years, and if they chose, then switch to a defined benefit plan in
their later years. The benefits they accrue in the new defined benefit
plan would not be reduced on account on their previous participation in
the defined contribution plan.
Indeed, it may make
sense, to maximize benefits, contributions, and flexibility, for some
professionals to participate in both types of plans at the same time. With
a combination of plans, an individual earning $170,000 per year, and over
age 30, could accrue and contribute up to $42,500 per year. By using a
discretionary profit sharing plan as part of the combination, an employer
could build in flexibility, so that the annual contribution could vary
between $17,000 and $42,500.
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