Planning for Retirement: The 401k Plan - Case Study Example

Outline Planning for Retirement: the 401k Plan A. Introduction B. Retirement Planning in the US Retirement planning rationale 2. History and evolution 3. Current status of retirement planning C. A Survey of Existing Retirement Plans. 1. General types of retirement plans 2. Specific types D. Most prevalent retirement plan 1. The individual retirement account (IRA) 2. The 401k plans a. Traditional 401k b. The Roth 401k c. Comparison between the two 401k plans E.. Conclusion F. Appendix PLANNING FOR RETIREMENT: THE 401K PLAN A. Introduction. This paper seeks to study the retirement planning practice in the United States with a view to identifying their various features and characteristics. If possible, the research would be conducted in a way that would help the accountant understand the history, evolution, and the current status of retirement planning in this country. The insights are hoped to broaden the understanding and perspectives of the accountant in conducting his practice. B. Retirement Planning in the United States. 1. Retirement planning rationale Planning for ones retirement is an essential task every working individual should do in order to secure for himself a future free from worries and hardship when the time comes to stop working. While some individuals intend to work for as long as they can, particularly because idleness and loss of accustomed status can bring depression, illness, and even early death, it is always pleasant to contemplate that one has a nest egg to fall back on when a contingency or extreme need for money arises. "Whatever your situation - even if you want to continue working - youll need to do some planning for the future." (Shwab-Pomerantz & Schwab, 2002). Thus everyone should begin to plan for retirement even during the first few years of employment or starting a business. Retirement planning, according to the Small Business Encyclopedia, describes the financial strategies individuals employ during their working years to ensure that they will meet their goals for financial security upon retirement. This applies to self-employed persons, small business owners, and employees of companies large and small (Retirement planning, SBE) 2. History and evolution of retirement planning. Retirement planning was unknown prior to the twentieth century because the US national economy and presumably the economies in other parts of the world were still predominantly agrarian. Farmers toiling in the fields continued to work until they could no longer do physical labor, and transferred ownership and management of their properties to their eldest children in return for services to them during their old age (US History Encyclopedia). Even with the onset of industrialization, there were still a limited number of employees, and farming continued to dominate as a means of livelihood. As workers aged, they continued to work using their skills and wisdom in lieu of strength and stamina to remain employed in their later years. (Retirement planning, US) Later, because of concerns about productivity and efficiency in the workplace, it was deemed necessary to replace aging workers with young and strong ones. There was concern and apprehension about these workers who would become redundant, fueling the move towards mandatory retirement programs. By the turn of the century very few businesses had any pension or similar programs. Thirty-five years later, the US Social Security Act, as part of President Franklin Roosevelts New Deal, set up old-age pension programs for workers providing also survivor benefits for victims of industrial accidents, and aid for dependents and for the blind and disabled. However, the fixed benefits of Social Security and private pension programs did little to provide financial security for retirees, with inflation eroding purchasing power. In 1972, however, Social Security benefits were linked to the Consumer Price Index. The Employee Retirement Security Act of 1974 (ERISA) was also enacted to protect workers from loss of benefits due to embezzlement by trustees and provided for vesting requirements from employer contributions for businesses with 25 or more employees. Tax exemptions and tax deferments were also put into effect and have come to constitute the main features of pension plans today. With todays longer life expectancies, such provisions are becoming more and more important (See Retirement planning, US). C. Survey of Existing Retirement Plans. 1. General types Generally there are two types of retirement plans: 1) Defined contribution plans, and 2) Defined benefit plans. Defined contribution plans use an allocation formula to specify a percentage of compensation to be contributed by each participant, while for the defined benefit plan a desired level of benefits is calculated to be paid upon retirement by way of a fixed monthly payment or percentage of compensation. An actuary determines the amount of annual contributions based on such variables as age, salary levels, years worked, and interest and inflation rates. The employer bears the risk of providing the assured level of benefits. While the defined contribution plans are voluntary in the sense that contributions are subject to the employees choice of the amount to contribute; the defined benefit plans however requires that contributions be done automatically without the employees participation. In the 1980s defined benefit plans began to decline in popularity. On the part of the employees, the reason was that few of them now wanted to remain with the same employer throughout their working lives for the sake of a pension - in other words, the workers became more mobile. Arrangements with regard to the alternative were in consonance with this trend. On the part of the employers, the defined benefit plans meant pressure to fund a pension plan that stimulated fixed benefits, and this became particularly more keen when in 1996 nondiscrimination rules were imposed whereby it was mandated that the same benefits be given to all employees regardless of compensation (Retirement Planning, US). Today the dominant generic type of retirement plan, the defined contribution plan, gives the employee the convenience of rolling over his account into an account with another employer. In addition, this facility would spare him the 20 per cent withholding tax on a lump sum given by the previous employer if not rolled over. But the defined contribution plan has not always been free from doubts or incredulity from financial advisers, for two reasons: firstly, investment decisions might be too limiting or restrictive if the company handles these plans, and secondly, employees are not taught about the risks and rewards inherent in the investment vehicles available to them through the companys plan. Because contributions are voluntary, it is also asked whether employees would receive as much compared to what they would get under the defined benefit plan.(See Retirement Planning, US) 2. Specific types There are a variety of retirement plans in force in the United States, which this paper will enumerate and briefly describe below: a. Defined benefit pensions. Although in decline, this plan remains an option for employers. A specific monthly payment is made to the employee from time of retirement to death. The benefit is calculated on the basis of the retirees final pay multiplied by the number of years of service. b. Profit sharing plans. This is employer funded but with the employee having the option to contribute. The employee gets a lump sum upon retirement, tied to the business profits. c. Savings plans. This has the same contribution modality as the profit sharing plans, but not tied to profits. The employee can borrow against the equity in this plan. d. Employee stock ownership plan (ESOP). The employee receives company shares contributed towards the retirement. e. Tax-sheltered annuities (403b) plans. Offered by tax-exempt and educational institutions, these are funded from employees tax-deductible contributions. The employee receives either a lump sum or a series of monthly payments upon retirement. f. Employer-funded money-purchase pensions. As the name suggests, it is funded by the employer, with the employee receiving the benefits either in lump sum or a series of monthly payments. g. Savings Incentive Match Plans (SIMPLE Plans). Designed for small businesses, it is set up as an Individual Retirement Account (IRA) or as a tax-deferred plan such as the 401k. Employees fund them pre-tax and employer make matching contributions. h. Simplified Employee Pensions (SEPs). Also designed for small businesses, the employer funds this program, although the employee may contribute. Again the benefit may be received as a lump sum or as a series of payments. i. Keogh plans. Designed for the self-employed, it is entirely funded from the individuals tax-deductible contributions for the most part, and like the other plans, may be received in lump sum or periodically. D. The Prevalent Retirement Plans 1. The Individual Retirement Accounts. Individual Retirement Accounts (IRA). This account is entirely funded by the employees or workers tax-deferred contributions. IRAs are held in an account with an institution such as a commercial bank, savings bank or association, insurance company, credit union, brokerage, or a mutual fund firm. There are several types of Individual Retirement Accounts: Traditional or regular IRAs, Roth IRAs, SIMPLE IRAs, and SEP IRAs. Traditional and Roth IRAs are very popular . The rules regarding both traditional IRAs and Roth IRAs are somewhat complex and will not be discussed in detail in this brief paper , but suffice it to say that the main distinction between them is that while the contributions in the former are tax-deductible, those in the latter are not tax deductible (See Appendix). 2. The 401k plans a. The Traditional 401k Plan The Financial & Investment Dictionary defines the 401k plan as a Plan "whereby employees may elect, as an alternative to receiving taxable cash in the form of compensation or a bonus, to contribute pretax dollars to a qualified tax-deferred retirement plan." (401k plan) The traditional 401k plan arose from an innovative interpretation by benefits consultant Ted Benna of Section 401k of the US Tax Revenue Act of 1978 which stated that cash or deferred bonus plans qualified for tax deferral , by virtue of which Benna sought a combination of pre-tax salary reduction, employee contributions, and company matching contributions (Retirement planning, US ) . This interpretation of the law was consistent with subsequent IRS regulations in 1981, thereby affirming his 401k plan. For employers, this marked the shift from the provision of the defined benefit pension plans to the use of defined contribution retirement plans. There are several advantages or benefits inherent in the 401k retirement plan- namely, tax deferral, employer matching programs, investment customization and flexibility, portability, and loan/hardship withdrawals. Dividends, interests, and capital gains are not taxed until they are distributed and are allowed to continually increase by compounding. Employers can provide matching contributions, depending on length of service in the company, to as much as 100 per cent at its option. The employee can design his investment mix from time to time or depending on the stage of his life, but it would be unwise to place more than 10 of his contributions in his own companys shares. The ability to roll over his plan to an IRA or his next employers 401k plan is a feature of portability that was not present under the now outdated defined benefit pension plan. Finally there are provisions concerning withdrawals and hardship loans which offer alternatives in case emergency funds are needed. (Kennon, 2009) b. The Roth 401k Plan Since 2006, some employees have been given the option to choose Roth-IRA 401(k) plans, whereby after-tax –- not pre-tax – dollars are contributed, while earnings grow tax-free. Present elective deferrals are limited to $16,500 a year (amount is revised each year by the IRS based on inflation, with increments of $500). To encourage employee participation, some companies match employee contributions by 10% to 100% on a annual basis to this alternative 401k plan. The fund accumulated in either the traditional 401k plan or Roth 401k plan through employee contributions and the employers matching contributions can be invested in various investment vehicles, among them, mutual funds, shares in the employees own company, retail stocks, bonds, money market funds, and even a guaranteed investment contract. The plan owner has the option with regard to restructuring his portfolio with varying proportions of stocks (domestic, small company, large company, global, or international), bonds, and money market funds. Early in his working life the participant may deposit 50 per cent of his fund in stocks which can be relatively volatile, 25 per cent in bonds, and 25 per cent in liquid money market funds. As he grows older, such proportions can change in favor of the more stable investments, with less of common stocks. When nearing retirement in his 50s, the mix might tilt heavily in favor of bonds and money market funds and only a small portion remains with the relatively stable shares of large companies (See Ellis, 1997). c. Comparisons of the 401k Plans There is no income limitation to participate in either of the two versions of 401k, unlike in the Roth IRA. Aggregate elective contribution limit is $16,500 as of 2009, but this increases to $22,000 for employees age 50 or over for both 401k plans. This is contrast to the corresponding limits of $5,000 and $6,000 in the case of Roth IRA. The plan participant may split his annual elective contribution between the traditional pre-tax contributions and the qualified Roth 401k distributions, provided the combination does not exceed the deferral limit of $16,500 and $22,000 (in 2009). (See Kennon, 2009) Withdrawals from the traditional 401k plans before age 59-l/2 are subject to a 10 per cent penalty with the exception of death, disability, loss or termination of employment or qualified hardship. Withdrawals of contributions and earnings after age 59-1/2 are subject to Federal and state income taxes. For the Roth 401k, withdrawals of contributions and earnings are not taxed if it is a qualified distribution in the sense that it has been held for at least 5 years and made for any of he following reasons: a) disability, b) death, or c)attainment of age 59-l/2. Upon reaching the age of 70-1/2 the employee is required, for both 401k plans, to receive at the least the minimum distributions unless he is still working and not a 5 per cent owner. This is contrast to the Roth IRA where there is no such requirement while the owner is still alive. Failure to collect at least the minimum will subject the remainder to a 50 per cent penalty. Conclusion: For the accountant, the knowledge of retirement plans, particularly the hugely popular 401k Plans and its new cousin, the designated Roth 401k plan, can serve to expand his horizons concerning the availability of schemes whereby an employee or worker can provide for himself a comfortable nest-egg for his retirement years. The 401k Plan has advantages with regard to tax deferral, employer matching contributions, ease of rollover, and investment customization by the participant himself. Thanks to Benna and the supportive US governments through the years, the 401k plan will enable the American retirees to avoid poverty and want and instead enjoy ease and financial well-being in their golden years. The present structure of the retirement planning industry is certainly working for the benefit of millions of working Americans and those who are retired. The 401k plan, in particular , and its variant the Roth 401k plan, are helping many workers reap the benefits of compounding while still paying taxes either on a deferred or post-tax basis. For this reason, and because it is receiving a great deal of political support, this writer believes that the present structure will continue to exist.. BIBLIOGRAPHY Ellis, J. (1997). Your top investing moves for retirement. New York: Times Inc. 401(K) Plans, Small Business Encyclopedia. Retrieved November 6, 2009 from http://www.retirementdictionary.com/categories/401%28k%29-Plans/faq Individual Retirement Accounts, IRS. Retrieved November 6, 2009, from http://www.irs.gov/retirement/article/0,,id=152956,00.html Kennon, J. (2009 September) 401k retirement plan. About.com. Retrieved November 6, 2009 from401k Retirement Plan http://beginnersinvest.about.com/od/401k/a/aa122104a.htm Kobliner, B. (1996). Get a financial life. New York: Simon & Schuster Orman, S. (1998) Youve earned it, dont lose it. New York: Newmarket Press Retirement planning, Small Business Encyclopedia. Retrieved November 6, 2009, from http://www.answers.com/topic/retirement-planning Retirement planning, US History Encyclopedia. Retrieved November 7, 2009 from http://www.answers.com/topic/retirement-planning APPENDIX Source:http://beginnersinvest.about.com/od/401k/a/aa122104a.htm Read More