The Financial Planner

What is a Stretch IRA?

A Stretch IRA is a way to take an IRA and stretch the deferred earnings over the course of many years. Many times it is used to “stretch” that term over the course of generations. When the original owner of an IRA dies, and they have established a stretch IRA, the beneficiaries are allowed to keep that money in the IRA instead of having to take a lump sum right away and pay all the taxes up front. The beneficiaries will have to take required distributions that are defined by the plan so beneficiaries of such a plan should be informed prior to receiving the IRA from an estate so they can be prepared.

Do you need a Stretch IRA?

Before you decide to get a Stretch IRA you need to take into account your goals and decide if it is the right option for you. Most people that would use this type of IRA are those that are going to have more money than they can spend while they are alive. If there are no plans in place, the beneficiary would have a major tax payment due when they inherit a traditional IRA in the year they receive it. They would get a lump sum payment and is would be part of their income! A Stretch IRA allows your beneficiaries to spread that tax burden over a course of years so that the tax hit is minimized. This also allows the money to keep accumulating tax free while it is still in the plan. As always, you will want to discuss the situation with your financial adviser so that you have looked into all the possible options for your personal situation.

Setting up a Stretch IRA

1. Review your personal situation. You must make sure that you have all your bases covered before committing to such a plan. Make sure that your insurance for a long-term health stay is in place, any possible medical expenses would be taken care of, and that any emergency is looked at and reviewed just in case.

2. You must first look at your beneficiaries and what their needs may be. It may actually be more beneficial to them that you give them the lump sum payment as you want to help them pay off a large debt that they wouldn’t be able to do if they were forced to stretch that payment over a number of years. Though it may make sense to lower the current tax burden for your beneficiaries, it may not be in their best interest to do so due to them having a need for the money right away. Many of those that want to leave money after their death do not discuss their intentions with the beneficiaries. In some cases this may be important as you don’t want them to know, don’t want to deal with family squabbles while alive, or it just isn’t all that important. If your beneficiaries are more level-headed and you want them to get the best benefit possible, it should be a priority to discuss your intentions with them while you are still alive.

3. Talk to your financial advisor. Your advisor will need to put together the appropriate documents should the two of you decide this is your best option. Your advisor just may be able to recommend a better solution as well, or at the very least be able to set this up the best way possible. If you have several beneficiaries you may need to set up more than one account for them so that you can mark what percentage each is entitled to.

Possible Negatives for a Stretch IRA

1. If you think you may actually need this money during your life there is no benefit to a Stretch IRA. As I mentioned int he last section, it is very important to review your own situation before committing to any such plan.

2. Tax law changes. It is important to understand that tax laws change over the course of our lives. Although most situations are correctable when a law changes this is something to consider.

3. This point is so important that I will mention it again. If you think there is going to be any need during your life-time for this money then you do not want a Stretch IRA.

Continuing with more detailed descriptions from my Small Business Retirement Plans Quick List, the next plan I wanted to detail was the Savings Incentive Match Plan for Employees, or as it is more commonly known, the SIMPLE IRA. Just as the name suggests, it is a Simplified plan. Here I will discuss the SIMPLE IRA from the employer and the employee perspectives highlighting the pros and cons of each.

What is a SIMPLE IRA and How Does it Work?

In order to have a SIMPLE IRA plan, you must be a small business – generally, you must have 100 or fewer employees. However, there is a 2-year grace period for growing employers to still be considered a small business even if they go over the 100-employee limit. If you do opt for a SIMPLE IRA plan, your employees can elect to defer part of their salary. Each employee is immediately 100% vested in (or “owns”) all contributions to his or her SIMPLE IRA.

A SIMPLE IRA plan is a Savings Incentive Match Plan for Employees. Because this is a simplified plan, the administrative costs should be lower than for other, more complex plans. Under a SIMPLE IRA plan, employees and employers make contributions to traditional Individual Retirement Arrangements (IRAs) set up for employees (including self-employed individuals), subject to certain limits. It is ideally suited as a start-up retirement savings plan for small employers who do not currently sponsor a retirement plan.

Employers MUST make contributions, however employees can if they would like.

Setting Up a Simple IRA

The process behind establishing a SIMPLE IRA is incredibly easy. It only requires a couple of forms to get it up and running. A SIMPLE IRA can only be established if you have fewer than 100 employees and no other current retirement plan available.

Step 1: Contact a retirement plan professional or a representative of a financial institution that offers retirement plans. Many financial institutions will probably have a pre-approved SIMPLE IRA plan form that you can review.

Step 2: Choosing a financial institution to maintain employees’ SIMPLE IRAs is one of the most important decisions you will make, since that entity becomes a trustee to the plan. (Alternatively, you can decide to let employees choose the financial institution that will receive their contributions.)

Regardless of who makes the choice, only the following institutions can be designated as trustees of SIMPLE IRA plans: banks, mutual funds, insurance companies that issue annuity contracts, and certain other financial institutions that have been approved by the IRS.

Trustees agree to:

a) Receive and invest contributions, and

b) Provide the employer with a summary description of the plan features each year.

Step 3: Choose a model form or other plan document offered by your financial institution. If your financial institution offers a model SIMPLE IRA plan document, you will have a choice of two forms to use:

a) IRS Form 5304-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) – Not for Use With a Designated Financial Institution; or

b) IRS Form 5305-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) – for Use With a Designated Financial Institution.

The model form you use will depend on whether you decide to select the financial institution that will receive contributions or to let your employees select financial institutions.

c) If employees are allowed to select the financial institutions that will receive their SIMPLE IRA plan contributions, you will fill out Form 5304-SIMPLE.

d) If you require that all contributions under the SIMPLE IRA plan be initially deposited with a designated financial institution, you will fill out Form 5305-SIMPLE.

Your choice of the employees covered will be set out in your selected plan document. You can choose to cover all employees without restriction. Alternatively, you can limit the employees covered to those who received at least $5,000 in compensation during any 2 years prior to the current calendar year and who are reasonably expected to receive at least $5,000 during the current calendar year.

Step 4: Complete and sign the selected IRS form (or other plan document, if not using a model form). When it is completed and signed, this document becomes the plan’s basic legal document, describing your employees’ rights and benefits. Do not send it to the IRS; instead keep it handy.

Employee Eligibility for a SIMPLE IRA

Eligibility for a SIMPLE IRA is any employee who has made $5,000 or more in the previous 2 years, and who is expected to earn at least $5,000 this year.

SIMPLE IRA Contribution Limits

Employee – $10,500 in 2007 and 2008. If the employee is age 50 or over, a “catch-up” contribution is also allowed. This additional catch-up contribution amount is: 2007 and 2008 – $2,500.

Employer – Generally, a dollar-for-dollar match up to 3% of pay or a 2% non-elective contribution for each eligible employee.

SIMPLE IRA Filing Requirements

An employer generally has no filing requirements. The annual reporting required for qualified plans (Form 5500 series) is not required for SIMPLE IRA plans. The financial institution that holds the SIMPLE IRAs for the plan handles most of the other paperwork.

SIMPLE IRA Withdrawals:

Permitted, but withdrawals are included in income and are subject to a 10% additional tax if the participant is under age 59-1/2. Also, if withdrawals are made within the first two years of participation, the 10% additional tax is increased to 25%.

SIMPLE IRA Pros and Cons

SIMPLE IRA Pros and Cons

Pros:

1. Easy to set up and run – usually just a phone call to a financial institution gets things started.

2. Administrative costs are low.

3. Employees can contribute, on a tax-deferred basis, through convenient payroll deductions.

4. You can choose either to match the employee contributions of those who decide to participate or to contribute a fixed percentage of all eligible employees’ pay.

Cons:

1. Employers MUST contribute to the plan regardless of whether and employee contributes or not.

2. Contributions are not flexible.

3. Contribution limits are lower than other retirement plans.

Overall this plan is really more of a benefit to the employee than the employer, or small business owner. Though it is a nice incentive to maintain employees, it is fairly skewed into the employee’s favor. This plan is something I would typically use if you have some employees that are with you for many years. People you just want to reward for their service and dedication to your business since you are required to contribute every year regardless.

If you are considering a SIMPLE IRA, the IRS has put together a nice little SIMPLE IRA Checklist that will help you in determining if the play is right for you.

Since I have already written the small business retirement plans quick list it is now time to break down each retirement plan that I listed before in more depth. The first that we will cover is called the Simplified Employee Pension Plan (SEP). Most of the information involves using it as an employer, but I have included the exceptions and differences in rules if you plan to use the SEP IRA as self-employed persons, partnerships, sole proprietors, independent contractors, and owner-employees of an unincorporated trade or business; however, it may be set up by any type of business.

What is a SEP?

The Simplified Employee Pension Plan, or SEP IRA as it is more commonly known, is one of the many options for funding a retirement account for your employees of any business, or just for yourself if you are self-employed. The SEP IRA is very easy to understand and the administration costs are very low, unlike other plans such as the most widely known retirement plan , the 401k. The costs are almost non-existent if you are self-employed and have no employees. Contributions are made directly to an Individual Retirement Account or Annuity (IRA) set up for each employee by the employer. No employee contributions are allowed.

Standard withdrawal rules for qualified retirement plans apply. Withdrawals before the age of 59.5 are subject to penalty, and withdrawals are taxable upon taking the money out. Money in the plan is able to grow tax-deferred while it is in the plan like any other IRA.

Setting Up a SEP IRA

The process of setting up a SEP IRA is a short and painless process. An employer must set up a SEP IRA agreement and have eligible employees. There are three basic steps according to the IRS that must be satisfied in order to create a Simplified Employee Pension Plan:

1. A formal written agreement must be executed. This written agreement may be satisfied by adopting an Internal Revenue Service (IRS) model SEP using Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement. A prototype SEP that was approved by the IRS may also be used. Approved prototype SEPs are offered by banks, insurance companies, and other qualified financial institutions. Finally, an individually designed SEP may be adopted.

2. Each eligible employee must be given certain information about the SEP. If the SEP was established using the Form 5305-SEP, the information must include a copy of the Form 5305-SEP, its instructions, and the other information listed in the Form 5305-SEP instructions. If a prototype SEP or individually designed SEP was used, similar information must be provided.

3. A SEP-IRA must be set up for each eligible employee. SEP-IRAs can be set up with banks, insurance companies, or other qualified financial institutions. The SEP-IRA is owned and controlled by the employee and the employer sends the SEP contributions to the financial institution where the SEP-IRA is maintained.

Employee Eligibility for a SEP IRA

To be eligible for a SEP IRA as an employee the following conditions must be met:

1. The employee is at least 21 years of age.

2. has worked for the employer in at least 3 of the last 5 years

3. has received at least $450 (subject to annual cost-of-living adjustments) in compensation from the employer for the year ($500 for 2007).

Employees may be excluded from the plan under only 2 conditions: (a) employees covered by a union agreement whose retirement benefits were bargained for in good faith by the employees’ union and the employer; and (b) nonresident alien employees who have no U.S. source compensation from the employer may be excluded.

SEP IRA Contribution Limits

Annual contributions an employer can make for an employee in a given year may not exceed the lesser of the following:

1. 25% of an employee’s income

2. $44,000 for 2006 ($45,000 for 2007 and subject to annual cost-of-living adjustments for later years).

The limits apply in the aggregate to contributions an employer makes for its employees to all defined contribution plans, which includes SEPs. Only up to $220,000 in 2006 ($225,000 in 2007 and subject to annual cost-of-living adjustments for later years) of an employee’s compensation may be considered. Contributions must be made in cash. Property cannot be contributed.

Regardless of the limits, an employer can choose any percentage, or total below the amount stated as the maximum allowable by the IRS. Employers are NOT required to contribute to the employees’ SEP IRAs every year. It is at the full discretion of the employer, but when contributions are made, they must be made into the SEP IRA accounts of every eligible employee.

Deducting SEP IRA contributions

Of course when contributing to an employee retirement plan an employer has the right to deduct some, or all of that contribution from the business’s taxes. Let’s look at exactly how much you can deduct for your SEP IRA contributions.

The most that may be deducted on the business’s tax return for contributions to its employees’ SEP-IRAs is the lesser of its contributions or 25% of compensation. (Compensation considered for each employee is limited to $220,000 in 2006, $225,000 for 2007 and subject to annual cost-of-living adjustments for later years.)

If the employee is self-employed and contributes to his or her own SEP-IRA, a special computation to figure out the maximum deduction for these contributions must be made. When figuring the deduction for contributions made to a self-employed individual’s SEP-IRA, compensation is net earnings from self-employment which takes into account the following deductions:

1. the deduction for one-half of the individual’s self-employment tax, and

2. the deduction for contributions to the individual’s own SEP-IRA.

See Publication 560 for details on determining the deduction.

SEP IRA for Self-Employed Individual

Self-employed individuals are subject to the same contribution limits as they would be for the sontributions they made for employees. 25%, or $45,000, whichever is less. Although the plan is very easy to use, there may be better options than using a SEP IRA if you have a significantly higher income and would like to contribute more to a retirement plan. Especially if you are married. In a leter post I will discuss the option of using the Solo 401K plan, or the Individual 401k plan as an option for sole proprietorships, partnerships, LLCs and corporations (including both subchapter S and C corporations) who have no employees.

SEP IRA Pros and Cons

Pros:

Contributions do not have to be made every year, which is very appealing. Contributions are not set at any level, and do not have to be the same every year. Very easy and cheap to set up and administer. Immediate vesting for the employee (which is an employer con). Employees must have worked for you for 3 out of the last 5 years to be eligible for contributions. If you have a high employee turnover rate, or you have a few employees that are important to your business this can be a plan that sort of disqualifies short-term employees, but at the same time rewards your loyal ones.

Cons:

Must cover all qualifying employees. Employees cannot contribute. Vesting is immediate. This means that once you put the money in it is theirs.