Tax Rates Will Be Lower at Retirement
The fourth reality is that the taxes imposed when you withdraw from your retirement account will be at a much lower rate,
for three reasons. First, payroll taxes and
investment surtaxes don’t apply to retirement income. Investing through a qualified
plan washed them out. Secondly, a portion
of your income at retirement isn’t taxed at
all, because of exemptions and the standard deduction. Thirdly, taxes on income in
excess of your exemptions and deductions
are imposed at low 10% and 15% rates until total income reaches $96,500 (at 2014
tax rates).
A married couple at age sixty-five using
the standard deduction in 2014 pays no
taxes on their first $22,700 of income. Even
if they earn $100,000 per year, they still pay
no taxes on the first $22,700. The tax on
their income in excess of $22,700 is taxed
at 10% on the next $18,150. Their federal
tax rate on the next $55,650 is only 15%.
They would not hit the 25% tax rate until
their income exceeds $96,500, at today’s
indexed tax rates.
The point is that with a retirement plan
you avoid state and federal income taxes
at combined rates of 32%, 35%, and 48%,
plus payroll taxes at 15.3% (or more with
single-payer), and take it out at federal and
state combined rates of 12.65%, or less,
since the standard deduction, exemption,
and tax rates are indexed.
Once upon a time, long ago, when tax
aficionados like Wilbur Mills and Dan Rostenkowski roamed the House of Representatives, tax policy or retirement policy had a
rational basis. Today, there is no such thing
as tax policy or retirement policy. Internal
Revenue Code changes are revenue measures with no greater good being taken
into account. In this uncertain atmosphere
the wisest planning is to take advantage of
tax deductible plan funding while it lasts.
The current retirement plan funding rules
are highly advantageous. Don’t wait until
the next budget compromise limits your
ability to significantly fund a qualified plan.
Funding Objectives and Employee Cost
There are a number of options in choosing the best retirement plan for your situation. If you have no employees or you are
willing to fund heavily for your employees, first consider a Simplified Employee
Pension Plan (SEP). Your broker or a mutual fund can help you set one up. Contributions are invested in individual IRAs and
your only administrative cost is what you
pay your accountant to calculate the fundwww.vtbar.org
ing. The downside is that the same percentage of pay must be funded for employees and employers alike in a SEP, and all
funding comes out of the employers’ pockets. If you have more than one employee,
that can be fairly expensive.
If your largesse to your employees has
limits, but you are willing to commit to
funding a certain amount for them, you
need a profit sharing plan, or a 401(k) plan.
A 401(k) plan is a type of profit sharing plan
that permits participants to make individual, pre(income)-tax, deferrals. 401(k) plans
are popular with columnists, but they are
hardly a panacea. The percentage of income deferred by the employer/owner is
limited by the average percentage that
his employees defer. 401(k) deferrals are
subject to payroll taxes, which takes away
some of the pre-tax advantage. If it is our
destiny to have single-payer health care,
deferrals will be subject to a single-payer
payroll tax as well.
In a profit sharing plan employee cost is
a function of plan design. What you have to
fund for your employees is determined by
the sophistication of your plan document
and the knowledge of the persons implementing your plan. An actuary or ERISA attorney, for example, will know much more
about how to design a plan to keep employee cost in line than someone whose
primary expertise is investments.
A rough rule of thumb concerning employee cost is that you need to be prepared to fund at least 3% of pay for eligible
employees. If you are not willing to fund
that percentage, qualified plans are not for
you. If you want to maximize your funding of a profit sharing plan, such as funding the current limit of $52,000 per year
for yourself, be prepared for a staff cost in
the neighborhood of 5% of pay, which is
achievable in a well-designed profit sharing plan. Finally, if you can afford to really sock it away for yourself, in the range of
$100,000-$250,000 per year, anticipate a
staff cost of approximately 8½%, in a well-
designed pension and profit sharing plan
combination.
More to Come
Under IRS compliance rules every existing profit sharing plan needs to be amended and restated between now and April 30,
2016. If you currently sponsor a plan, don’t
simply accept what a mutual fund or investment platform sends you to sign. Even in
a standardized document there are choices, and their impact will be financially significant. The document you sign should reflect what you want to fund for yourself,
and what you are willing to fund for your
employees.
In our next article we will review the
choices that are available to you in almost
every plan document, and the choices that
could be available in the right plan document. Please wait for our article in the fall
issue before updating your document.
You’ll be glad you did.
Finally, we will be speaking at the annual bar meeting in September about the tax
advantages of corporations over LLCs (discussed in the spring issue of the Journal)
and how that affects the design of a qualified plan. We will provide more detailed information at that time, with examples and
calculations. Please join us then. We believe that Vermont attorneys pay far too
much in taxes, and we intend to do something about it.
____________________
John H.W. Cole, Esq., practices as a C
corporation in South Burlington, VT, and
concentrates his practice in the areas of
tax planning, design of qualified retirement
plans, plan administration, and QDROs.
Mark E. Melendy, Esq., is a member of
Melendy Moritz PLLC, with offices in Hanover, NH, Burlington, VT and Woodstock,
VT, where he concentrates his practice in
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