Glenn Bailey, CPA

A client asked me the other day if she should contribute to her Simplified Employee Pension (SEP) plan since she was almost 70 and a half and would just have to take required minimum distributions (RMD) soon.  “Why bother when I just have to take it back out?” she asked, “unless there is an exception because I am still earning at quite a hefty level – for a girl anyway.”

Explaining the Pension Options

So I explained the options to my client:  If you are an employee and not a 5% or more owner of a business, you can continue to contribute to a pension and are exempt from the mandatory distribution rules until April 1 of the year following the year that you retire.  Owners have no exceptions.  Since she was the owner that rule didn’t help.

But even if you have to take a withdrawal immediately, your distribution is 3.65% of your account balance for the first year.  So unless your balance was over $1M, the required withdrawal would be less than the contribution, and the additional contribution of the plan maximum of $49K in this case would only raise the required distribution by about $2000. That still gives the money a number of years to earn tax deferred income before it must be taken out.  Any money left in the account when you die can be distributed over the life expectancy of the beneficiary, leaving potentially 50 years or so to continue growing tax deferred.

Wait There’s More…

“That makes sense,” she said.  It sounded like a good idea.

“On the other hand…” I said, and explained that tax rates are likely to be higher starting in 2011, and if she continues to be in a high tax bracket she might pay more tax in the future than she would this year on the same income.   However, pension withdrawals are exempt from the additional tax imposed on “investment” income in the new Health Care Reform law, so they might be taxed at a lower rate than the earnings on funds invested outside a retirement plan.

And More…

“On the other other hand”, I continued, “The compounding effect of the tax deferral period should make up for that over time.  If your income drops in retirement and you can withdraw the money at a lower rate, then you would get an additional bonus.”

“Not much chance of that,” she replied.

“Still,” I said, “It comes down to this: you can pay a certain dollar of tax today, or you can pay an uncertain dollar of tax tomorrow.  Who knows exactly what the future will bring – besides death and taxes – but you can base your decision on whether you’d rather pay now or pay later.”  And with that she went home to think about it.

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