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Executive Retirement Benefits. Purpose of Retirement Benefits Income replacement at retirement Maintain standard of living at retirement Need about 80% of pre-retirement income from all sources Some of retirement income is not taxed such as Soc. Sec. & income from Roth IRAs
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Executive Retirement Benefits Purpose of Retirement Benefits • Income replacement at retirement • Maintain standard of living at retirement • Need about 80% of pre-retirement income from all sources • Some of retirement income is not taxed such as Soc. Sec. & income from Roth IRAs • Use as asset to create wealth, borrow, or form estate to leave to your heirs (children, spouse, charity). MBAO 6600 - Executive Compensation
Sources of Retirement Income When you Decide to Retire you want a 3-legged stool of resources to generate retirement income 1. Social Security (10 percent or less for executives) 2. Retirement Benefits (50-60 percent) - most significant source of retirement income: • pensions (defined benefit plan) • retirement benefits (defined contribution plan) 3. Personal Savings (30-40 percent) • home equity • personal investments in stocks, bonds, vacation property MBAO 6600 - Executive Compensation
Retirement Benefits: Defined Benefit Plans Features of Defined Benefit (DB) Plans • Retirement benefit is known in advance based on a formula • Traditional retirement plan used by large firms • Employer assumes all the financial risk and makes contributions while managing them • Formula based on two variables: 1. Average Salary for last 5 years (year prior to retirement) 2. Number of years of service (may need 20 or more yrs.) • Examples: pensions, cash balance plans MBAO 6600 - Executive Compensation
Retirement Benefits: Defined Contribution Plans Features of Defined Contribution (DC) Plans • Employer contributions to plan are known • But…amount of retirement income when employee retires is unknown. • Employee shares risk with employer • Employee takes active role in managing investment contributions - and also can keep all of the upside investment gains (not the case with DB plans). • Examples: 401(k) Plan, IRAs, SEP MBAO 6600 - Executive Compensation
401(k) Plans Plan Characteristics • Refers to sec. 401(k) of IRC - 1981 • Fastest growing retirement plan • Contribution limit: 15% salary up to $10,000 per year • Employer matches: 25% to 100% in most firms • Plan contributions not taxed and accumulations tax deferred • Distributions taken out after age 59 1/2; tax penalty of 20% for early withdrawal, except emergency • Loans of up to $50 K possible; repay @9% interest MBAO 6600 - Executive Compensation
401(k) Plan: Compare to taxed investment 401(k) Investment Taxed Investment before taxes $1000 $1000 after taxes (28%) $1000 $720 ‘er match (75%) $750 00 fund gain (20%) $350 $144 taxed gains (28%) 00 $40 net gain $350 $104 Total after 1 year $2100 $824 ROI (1 year) 110% 14% MBAO 6600 - Executive Compensation
401(k) Plan Tips • Start your 401(k) plan immediately, to take advantage of “miracle” of compound interest • some companies now have automatic enrollments • If 20 or more years from retirement, invest aggressively in stocks • If employer match is paid in company stock, sell some of the stock when vested so there is diversification of assets and reduced exposure to risk. • When changing jobs, roll over money into new employer’s 401(k) if > $5K, if < $5K roll into an IRA - there are tax penalties for cashing out early. MBAO 6600 - Executive Compensation
Characteristics of best 401(k) Plans • Diverse Investment Choices • at least 8 investment options to choose from • employees are able to change fund allocations • Asset Diversification • stocks and bonds • large and small cap stocks • domestic and international stocks • index and sector funds • Limited Employer Stock Holdings • less than 10% of portfolio • limited employer stock when matching MBAO 6600 - Executive Compensation
Important Considerations for 401(k) plans • Invest at least up to the maximum employer match - don’t leave free money on the table • Avoid loans • loss of compounding is costly • make loan only for an emergency • Prevent allocation drift • reallocate contributions periodically to maintain investment within risk comfort zone MBAO 6600 - Executive Compensation
IRA Plans: Traditional IRA Plan Characteristics • There are both personal and employer-sponsored IRAs • Contribution limit: $2,000 per person and $4,000 if joint with spouse • Used by self-employed or entrepreneurs without company retirement plan or may those who have put maximum in company plan. • Plan contributions not taxed and accumulations tax deferred • Full pre-tax benefit limit: $30K (single), $50K (joint) AGI MBAO 6600 - Executive Compensation
IRA Plans: Traditional IRA Advantages of Traditional IRAs • Immediate tax savings and accumulations tax deferred • A person with AGI above $40K ($60K for joint filers) can start an IRA with tax deferred interest benefits, but without tax savings on contributions. • More investment choices than 401(k) plans. Disadvantages of Traditional IRAs • Distributions are taxed - high income people get hit • Must make min. distributions by age 70 1/2 • Early withdraw (< 59 1/2) incurs tax penalty MBAO 6600 - Executive Compensation
IRA Plans: Roth IRA Characteristics of Roth IRAs • Amount of Contributions same as other IRAs • Contributions are made with after tax money • Accumulations are not taxed • Distributions are not taxed • Attractive investment for people who have put maximum in 401(k) plan • At retirement non-taxed distributions allow retiree to have tax diversification from other retirement income that is taxed - so a lower income tax bracket is possible. MBAO 6600 - Executive Compensation
IRA Plans: Roth IRA Advantages of Roth IRAs • Singles who earn up to $95K get full benefits and up to $110K partial ($150K & $160K for joint). • Can continue making contributions after age 70 1/2 which is not possible with traditional IRA • Not required to take min. distributions age 70 1/2 • Can convert traditional to a Roth IRA • Past 59 1/2 take lump sum distributions w/o tax Disadvantages of Roth IRAs • Contributions are taxed - may not be beneficial if expect to be in low tax bracket at retirement. • 5 year holding period requirement MBAO 6600 - Executive Compensation
Simplified Employee Pensions (SEPs) Plan Characteristics • An individual retirement account or individual retirement annuity for an employee to which the employer makes tax-deductible contributions. • For self-employed or employees of small business without a retirement plan. • Similar tax rules as IRA with no tax on contributions, tax deferred accumulations and taxed on distributions after age 59 1/2 MBAO 6600 - Executive Compensation
Simplified Employee Pensions (SEPs) Plan Characteristics • The employer’s contribution limit for an employee is the lesser of 15% of employee’s annual salary or $30,000. • Employee may contribute an additional $2,000 to a personal IRA while participant in an SEP. • SEP distributions taxed similar to IRA rules. MBAO 6600 - Executive Compensation
Simplified Employee Pensions (SEPs) SEP Advantages • Minimal amount of record keeping to start and maintain the plan. Less need for lawyers, etc. • Employer can be flexible in providing contributions, compared to qualified pensions. • Employees choose own investments in SEP. SEP Disadvantages • More employees such as part-time must participate than qualified pension plans. • Employees must be fully vested at all time, which is not the case with qualified pensions. MBAO 6600 - Executive Compensation