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A Retirement Plan Primer After The 2001 Tax Act

The 2001 Tax Relief Act is a powerful engine of long-term tax deferral and tax-favored economic growth. This includes the Act's enriched education provisions (see below) and even more, its enrichment of retirement plans.


Investments held in retirement plans grow tax-deferred, unless they are in a Roth IRA (in which case they grow without any income taxes ever). Investment earnings are taxable only when they are withdrawn from the fund in a later year. There's a further tax deferral where amounts going into a plan are tax deductible or excludable from taxable pay. Such amounts also become taxable only when withdrawn from the fund in a later year.

There's also obviously a tax saving to be had on funds deferred from the current year, if one’s tax bracket is lower in retirement than it currently is. This is another key element of a retirement plan; because most taxpayers are in a lower bracket after they retire than when they are working. This was enhanced by the 2001 Act, which lowers tax brackets each year from 2001 to 2006. The tax system is now primed to reward retirement plan investment with even greater savings. Second, a new 10% bracket is added to the income tax rate structure.

Retirement Plan benefits. Employers can take tax deductions for contributions they make for their employees.

Every participant in a tax-favored retirement plan — IRA, pension, profit-sharing (including 401(k)), SIMPLE, SEP, 403(b) annuity and other plans — enjoys the benefit of tax deferral for his or her interest in the plan — that is, investment growth. In addition, they enjoy tax deferral (exclusion or deduction) for contributions going into their retirement plan.

Employee Participant deductions are allowed for:

· Self-employed persons investing in their own plans (Profit-Sharing Plans, Money Purchase Pension Plans, Defined Benefit Pension Plans, SIMPLEs, SEPs, etc.)

· Employees and self-employed persons investing in traditional IRAs, subject to certain conditions

Employee Participant exclusions from income are allowed for:

· Employer direct contributions on the employee’s behalf

· Employee pre-tax salary contributions to 401(k)s, SIMPLEs and SARSEPs (certain SEPs formed before 1997)

No deduction or exclusion from income is allowed for a Roth IRA investment. Instead, withdrawals are tax-free if certain conditions are met.

Many retirement plans allow employees to make additional nondeductible, (nonexcludable from their taxable compensation) plan contributions on their own behalf. These contributions, however, will enjoy tax-deferred investment growth in the plan.

Increased Benefits for 2002. The tax law indirectly controls deferrals by limiting the amounts that can be contributed by or for each participant. Effective starting in 2002, the 2001 Tax Relief Act increases these limits pretty much across the board (larger IRAs, larger 401(k)s, and on and on). For example, the limit on employer deductions for profit-sharing plan contributions increases from 15% to 25% of an employee’s salary.

The Strategy:

  1. Since rates are higher now than they will be in the future, most taxpayers will maximize tax savings if they make the maximum tax-deductible contributions allowed under today's rules.
  1. Virtually every business can benefit from setting up a retirement plan under current law.
  1. Employees who are not participating in their company's plan (401(k), thrift, SIMPLE, etc.), should see about participating this year.
  1. For employers, professional advice about the 2001 Tax Act changes is essential. The retirement plan provisions are the Act's most important provisions affecting businesses. Among the many factors to consider (all applicable 2002 and after):

· More can be contributed and deducted

· Allocations towards key executives and owner-employees can be somewhat increased

· Some types of retirement plans - especially profit-sharing generally and 401(k) in particular-become more attractive

· The Act offers modest new subsidies and other relief for starting plans.


The 2001 Act contains a sunset provision eliminating all its tax cuts after 2010, restoring the rules to what they would have been without the Act. Naturally, Congressional supporters of the cuts hope this sunset provision will at some point be dropped. Planning that reaches beyond 2010, as many retirement plans must, should consider this prospect. Professional advice is particularly important here.

For further information, contact Diane M. Pearson, CFP™ at (412) 635-9210 or

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