One of the biggest changes in the workplace in the last 30 years has been the shift away from traditional, or defined benefit, pension plans. In their place are a growing number of alternatives known as defined contribution plans.
Today, the 401(k) plan is the most common defined contribution plan. Congress created it in 1978 by adding section 401(k) (hence the name) to the Internal Revenue Service tax code. Such plans offer distinct advantages, such as tax-deferred growth potential, high contribution limits and, in many cases, an employer-matching contribution.
Choosing a Retirement Plan Strategy
For a high-net-worth individual, it's important to not only maximize the benefits of your 401(k) plan, but also to balance your retirement goals among various retirement savings strategies.
?You?re basically looking at different places to get income in retirement,? says John Enright, a Syracuse, N.Y.-based Private Wealth Advisor with the Sagemark Consulting division of Lincoln Financial Advisors.
Of course, traditional Individual Retirement Accounts (IRAs) set the stage for retirement planning. Congress created them in 1974, and today 40% of all households have at least one, with investments totaling more than $3 trillion, according to the Investment Company Institute.
Since the advent of 401(k)s, retirement plan options have also increased in number and complexity. The Roth 401(k) plan, for example, just became available in January 2006. Contributions are subject to the same rules as 401(k)s. Qualified withdrawals from a 401(k) plan are taxed as ordinary income and, if taken prior to age 59?, may be subject to an additional 10% federal tax penalty and possibly state income taxes. Qualified earnings withdrawals from a Roth 401(k) taken during retirement will not be subject to income tax, provided you?re at least 59? and you?ve held the account for five years or more. Roth 401(k) employer matches will still be made with pretax dollars, and the match will accumulate in a separate account that will be taxed as ordinary income at withdrawal.
Different Tax Scenarios
Taxes-?both current and future?are one of the key points of distinction among various retirement plans, says Enright. Therefore, he often advises high-net-worth clients to consider a combination of accounts depending on their short- and long-term goals. ?People need to keep in mind that taxes will most likely increase. We?re at historical lows for tax brackets, so more than likely, tax rates will rise,? he says.
That's also a major difference between a traditional 401(k) plan and the new Roth 401(k). With a traditional 401(k) plan, contributions are made before taxes. The investment has tax-deferred growth potential, but the money is taxable as income when it's withdrawn. If you are in a high tax bracket now but expect to stop working and be in a lower bracket when you retire, then a traditional 401(k) may make more sense.
With a Roth 401(k) plan, contributions are made in aftertax dollars, but any investment income grows tax-free and withdrawals are tax-free. If you plan to continue working well into retirement age, then a Roth plan may make more sense. The Roth 401(k) also has other advantages, says Enright. For example, if you roll it over to a Roth IRA in retirement, then no minimum distributions are required. Thus, it not only passes to a beneficiary income-tax-free, but it can also be withdrawn over their lifetime income-tax-free, says Enright.
However, in order to enroll in this plan, a corporate sponsor must amend its pension program to make the Roth 401(k) available. Employers may have other plan caveats that high-net-worth individuals should carefully consider. For example, many companies still make employer matches in company stock. But in many cases, since the Enron scandal, employees are allowed to reallocate employer matches as they wish. If they leave it in company stock, however, they may be able to make withdrawals of the gains on the stock at capital gains tax rates?which are typically lower than ordinary income tax rates?if they roll over their 401(k) into an IRA and take the company stock as a withdrawal. Taxes for a stock withdrawal rollover should be paid from non-retirement funds if this strategy is to work.
Coordinating Your Goals
Keep in mind also that not all companies provide a distribution option if you need access to the funds before retirement. Such distributions are subject to an additional 10% federal tax penalty on the amount withdrawn, unless it's for what the IRS legally defines as ?hardships?'such as buying a home, staving off foreclosure, or paying for college tuition or certain medical expenses. Employers may also limit investment options.
In the end, the biggest benefit of retirement plans for high-net-worth individuals is the larger amount of money they can contribute to a 401(k). You can contribute up to $15,000 into your 401(k) in 2006, or $20,000 if you?re 50 or older, compared to $4,000 and $5,000, respectively, for an IRA.
?It all depends on what you are trying to accomplish?whether its deferral of a substantial portion of income or supplementing an employee retirement plan,? says Enright. ?The decision that a client needs to make is how to coordinate their goals in a qualified plan with those outside a qualified plan.?
Your financial planner can help you determine which retirement planning strategy may be appropriate for you. Together, you can focus on managing your assets and identifying strategies that can help you maximize your financial goals.
Talk to Your Financial Planner About:
- Your retirement goals and objectives.
- Which retirement planning strategy may be appropriate for you.
- Distribution strategies to help you get the most out of your money.