Small Business Gets Tax Credit for Providing Health Insurance
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- Written by Jerry Love, CPA
The Affordable Health Care Act (AHCA) is being called the most historic overhaul of the U.S. health care system since Medicare and Medicaid. After its passage, many people believed the law would never go into effect because either the Supreme Court would overturn it or Congress would repeal it. Now that the general consensus has shifted to accepting it will become law, we are hearing about provisions contained in the Act. One that has gone unnoticed by many taxpayers is a credit for small business.
For the AHCA a small employer is defined as an employer with less than fifty full time employees (or more accurately stated less than fifty full time equivalent employees). Whitehouse.gov indicates, “The law specifically exempts all firms that have fewer than 50 employees - 96% of all firms in the United States or 5.8 million out of 6 million total firms – from any employer responsibility requirements. These 5.8 million firms employ nearly 34 million workers.” (http://www.whitehouse.gov/files/documents/health_reform_for_small_businesses.pdf)
However, AHCA states that small employers who pay for health insurance for their employees may be entitled to a tax credit for tax years beginning after Dec. 31, 2009. Of course, the cost of providing the health insurance is an ordinary and necessary business expense and a tax-free benefit for the employees. But thanks to a provision in the 2010 Health Care Act, as Amended by the 2010 Health Care Reconciliation Act, some small employers are entitled to a tax credit in addition to the tax deduction. According to sba.gov, “The credit is specifically targeted for those businesses with low and moderate-income workers. The credit is designed to encourage small employers to offer health insurance coverage for the first time or maintain coverage they already have.”
This is a much welcomed relief to small businesses that pay on average as much as 18% more for the coverage they provide their employees compared to similar policies offered by larger firms, (http://www.whitehouse.gov/sites/default/files/docs/the_aca_helps_small_businesses.pdf). Some industry observers indicate that insurance premiums are expected to increase 10% or more. However, sba.gov indicates in an article dated January 25, 2013 that, “The Affordable Care Act will help small businesses by lowering premium cost growth and increasing access to quality, affordable health insurance.” (http://www.sba.gov/community/blogs/top-three-things-small-businesses-should-know-about-affordable-care-act)
For purposes of this credit, health insurance coverage means benefits consisting of medical care (provided directly, through insurance or reimbursement, or otherwise) under any hospital, medical service policy, medical service plan contract, or any health maintenance organization contract offered by a health insurance provider. A health insurance provider is either an insurance company or another entity licensed under state law to provide health insurance coverage.
Small employers with fewer than 25 full-time equivalent employees and average annual wages of less than $50,000 that purchase health insurance for employees are eligible for the credit. The maximum credit will be available to employers with 10 or fewer FTE employees and average annual wages of less than $25,000. To be eligible for a tax credit, the employer must contribute at least 50% of the total premium cost. For 2010 through 2013, eligible employers will receive a small business credit for up to 35 % of their contribution toward the employee’s health insurance premium. Small tax-exempt organizations meeting the above requirements are eligible for tax credits of up to 25% of their contribution. In 2014 and later, eligible employers who purchase coverage through the Small Business Health Options Program (SHOP) can receive a tax credit for two years of up to 50% of their contribution. The enhanced credit can be claimed for any two consecutive taxable years beginning in 2014 through the SHOP.
To be eligible for the credit the employer must have paid the premiums under a qualifying arrangement. According to the IRS instructions, “A qualifying arrangement is generally an arrangement that requires the employer to pay a uniform percentage (not less than 50%) of the premium cost for each enrolled employee's health insurance coverage. However, an arrangement that requires the employer to pay a uniform premium for each enrolled employee (composite billing) and offers different tiers of coverage (for example, self-only, self plus one, and family coverage) can be a qualifying arrangement even if it requires the employer to pay a uniform percentage that is less than 50% of the premium cost for employees not enrolled in self-only coverage.”
Certain employees are excluded for purposes of the credit including 2% shareholders, 5% owners, self-employed individuals, and certain individuals related to those individuals. It is presumed that you exclude these employees when determining if the employer has 25 or less FTE and when calculating the average annual wage. Furthermore, the rules require aggregation of controlled groups of corporations and affiliated service groups.
The determination of FTE for the credit is based on 2,080 hours per employee. Therefore, if the employer has part time employees it may be that they still qualify as having less than 25 FTE. Any hours worked by an employee in excess of 2,080 is excluded as you determine the FTEs. Further, you are allowed to exclude seasonal employees but would include part-time employees and any leased employees. The determination of the average wage is the average compensation of just the employees who make up the employees counted in the FTE calculation.
The credit changes for tax years after 2013. After 2013, the credit is only available for small employers that purchase health insurance coverage for its employees through a state exchange and is only available for a maximum coverage period of two consecutive tax years. However, the maximum two-year coverage period does not take into account any tax years beginning in years before 2014.
The credit is also available to small tax-exempt employers who are exempt under section 501(c). The credit available to them is generally 25% of the premium paid and is allowed based on payroll taxes paid. The tax-exempt entity would claim this credit by filing a Form 990-T.
For all other small employers, the credit is generally 35% of premiums paid, can be taken against both regular and alternative minimum tax, and is claimed as part of the general business credit on Form 3800. This credit is calculated on Form 8941. You must reduce your deduction for the cost of providing health insurance coverage to your employees by the amount of any credit for small employer health insurance premiums allowed with respect to the coverage.
According to whitehouse.gov, “These tax credits will benefit an estimated two million workers who get their insurance from an estimated 360,000 small employers who will receive the credit in 2011.” (http://www.whitehouse.gov/sites/default/files/docs/the_aca_helps_small_businesses.pdf)
Furthermore, whitehouse.gov emphasizes one of the goals of the AHCA is to increase the coverage by small employers. “Small businesses are the backbone of our economy, but high health care costs and declining coverage have hindered small business owners and their employees. Over the past decade, average annual family premiums for workers at small firms increased by 123%, from $5,700 in 1999 to $12,700 in 2009, while the percentage of small firms offering coverage fell from 65 to 59%.” (http://www.whitehouse.gov/sites/default/files/docs/the_aca_helps_small_businesses.pdf)
Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at This email address is being protected from spambots. You need JavaScript enabled to view it. .
10 Tax Tips On Implications for Debt Forgiveness
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- Written by Jerry Love, CPA
In general, if you are liable for a debt that is reduced, canceled, forgiven, or discharged, you must include the canceled amount in gross income unless you meet an exclusion or exception such as the taxpayer is in bankruptcy or insolvent. Other possible exceptions include: qualified farm debt, qualified real property business debt, a certain type of student loan, or qualified principal residence indebtedness. A special rule also applies to a reduction of a seller-financed (i.e., purchase money) debt owed to the seller of the property.
1. If your debt is secured by property and that property is taken by the lender in full or partial satisfaction of your debt, you will be treated as having sold that property and may have a reportable gain or loss. The gain or loss on such a deemed sale of your property is a separate issue from whether any cancelled debt also associated with that same property is includable in gross income.
2. If your debt is canceled by a private lender such as a relative or friend and the cancellation is intended as a gift, there is no income to you. While it’s not income to you, if the lender forgives more than $13,000 in a year (the gift tax annual exclusion), it may count against his or her own lifetime exemption from the gift tax. A debt canceled by a private lender’s will, upon his death, isn’t income to you either.
3. No amount is included in a debtor’s gross income by reason of a discharge of indebtedness in a bankruptcy case, even if the debtor is solvent after the discharge. If the indebtedness is discharged when the debtor is insolvent (but not in a bankruptcy case), the discharge is excluded from the debtor’s gross income up to the amount of the insolvency. The amount excluded under these “insolvency exceptions” must be applied to reduce the debtor’s tax attributes such as loss or credit carryovers or basis in assets.
4. A reduction of debt may also cause the recognition of income. A debtor may satisfy an outstanding “old” debt by issuing a “new” debt. The old debt is treated as having been satisfied with an amount of money equal to the issue price of the new debt. The excess (if any) of the “old” adjusted issue price over the “new” issue price is cancellation of debt income to the debtor.
5. Another exception that is available to taxpayers who are homeowners whose mortgage debt is partly or entirely forgiven during tax years 2007 through 2012 is for indebtedness discharged before January 1, 2013, gross income doesn’t include any discharge of qualified principal residence indebtedness. Qualified principal residence indebtedness is acquisition indebtedness under Code Section 163(h)(3)(B) with respect to the taxpayer’s principal residence, but with a $2 million limit ($1 million for married individuals filing separately).
It includes indebtedness incurred in the acquisition, construction, or substantial improvement of a principal residence that is secured by the residence. It also includes refinancing of debt to the extent the amount doesn’t exceed the amount of the refinanced indebtedness. “Principal residence” has the same meaning as under the home sale exclusion rules. The basis of the taxpayer’s principal residence is reduced by the excluded amount, but not below zero.
6. An exception to the usual treatment of debt discharge income may apply to contested liabilities. If a party demands payment for a liability over which there is a dispute, the eventual agreement to pay a reduced amount may not give rise to debt discharge income. In one court case, the taxpayer disputed the amount of interest and late fees added to his credit card balance. When he settled the debt for less than the balance on the credit card company’s books, only the amount of the liquidated debt (i.e., the amount fixed by agreement or by the operation of law) over the amount paid was taxable debt discharge income. The cancellation of the disputed charges did not generate debt discharge income.
7. In addition, farmers do not have to recognize debt discharge income if the forgiven debt is qualified farm indebtedness. For this exception, the following conditions must be met: (1) the debt was incurred directly in the business of farming; (2) at least 50% of the taxpayer’s gross receipts from all sources, including farming, for the preceding three years were attributable to the business of farming; and (3) the lender is unrelated to the taxpayer and is actively and regularly engaged in the business of lending money or is a government agency or instrumentality.
The amount of debt discharge income excludable by farmers is limited to the total of certain tax attributes plus the aggregate bases of business property and property held for the production of income. To the extent the debt discharge exceeds these attributes, income must be recognized.
8. A taxpayer who is not insolvent or bankrupt can elect to exclude from gross income any income from the discharge of qualified real property business debt.
Qualified real property business debt includes debt: (1) that was incurred or assumed in connection with real property used in a trade or business and that is secured by such real property; (2) that was incurred or assumed (a) before January 1, 1993, or (b) on or after January 1, 1993, and is qualified acquisition debt (i.e., debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business); and (3) with respect to which an election to invoke the special rules of IRC Sec 108(a) (1)(D) has been made.
9. Cancellations of all or part of certain student loans obtained to attend qualified educational institutions do not result in gross income to the borrower. This special rule applies only to student loans that contain a provision stating that all or part of the loan will be cancelled if the borrower works for a certain period of time in certain professions for any of a broad class of employers (i.e., a public service requirement), and the borrower satisfies such requirement. To qualify, the loan must be made by either: (1) a federal, state, or local government unit, or instrumentality, agency, or subdivision thereof; (2) a tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law; or (3) an educational institution that makes the loan under (a) an agreement with an entity described in item 1 or 2, or (b) a program of the institution to encourage students to serve in occupations or in areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or other tax-exempt organization.
10. If the taxpayer’s debt is reduced or eliminated they will normally receive a Form 1099-C, Cancellation of Debt. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.”
Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at
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The HSA Alternative for Small Business to Address Health Care Costs
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- Written by Jerry Love, CPA
It seems that one topic that is on the forefront of every small business owner's mind this summer is what impact will the Obama Care legislation have to their bottom line.
Without any question, health care costs are skyrocketing. One possible alternative for a small business to address the health care mandate is to use the Health Savings Account (HSA). Health Savings Accounts are really pretty simple: it is a savings account for your medical expenses. An HSA is a tax-advantaged account that's paired with a high-deductible health plan (HDHP).
In 2003, Congress created the Health Savings Accounts to allow individuals who are covered by HDHPs to receive tax-preferred treatment of money set aside for medical expenses. The HSA was part of a larger agenda to promote consumer-directed or consumer-driven health care. HSAs have been promoted by companies and the government as a way to help control health care costs, because consumers will spend their health care dollars more wisely when they are spending their own money.
In an article written by John K. Iglehart, he points out how vastly different Americans are in our health care expenditures than other countries: (http://content.healthaffairs.org/content/24/4/902.full), " The United States always leads all nations in the amount of money it spends on health care, and explanations abound about why. Truth to tell, there is no constituency with any real influence that favors constraining these expenditures."
Fundamentally, the Health Savings Account provides coverage much like traditional health insurance, but it can save you money in three ways.
1) HSA plan premiums are expected to be lower, because the coverage is the HDHP and historically these plans have not seen as large of rate hikes as seen in other health plans,
2) You get a tax deduction (above the line like an IRA) when you fund the HSA and,
3) Any funds left in the HSA at the end of the year can grow with tax-free earnings to accumulate for later years when your health care needs may be greater during retirement.
Essentially, Health Savings Accounts are like a personal savings account earmarked for health care expenditures. And as long as the money is used for health care expenses, the distributions are tax free.
Many believe that the HSAs are a key shift that can help reduce the growth of health care costs for both individuals and small business. HSAs shift responsibility for health care to the individual for much of the routine care expenditures. Proponents believe this shift makes the individual more aware of the costs of health care. Further, HSAs encourage the individual to save for future health care expenses. An HSA allows the individual to receive needed care without a gatekeeper to determine what benefits are allowed and makes the individual more responsible for their own health care choices. It is also believed that as an individual takes more responsibility for paying for their health care, it will increase the efficiency of the health care system. And finally, those providing medical care will have an incentive to lower their rates, because they're competing for consumers' business.
An HSA is a tax-exempt trust or custodial account that you set up with a qualified HSA trustee to pay or reimburse certain medical expenses you incur. No permission or authorization from the IRS is necessary to establish an HSA. The funds contributed to an account are not subject to federal income tax at the time of deposit.
Among the advantages of HSAs over the Flexible Spending Accounts (FSA) are that unlike FSAs, HSAs do not have a "use it or lose it" provision and the HSA funds remain in your account at the end of the year to accumulate tax free year after year until withdrawn. If your health expenses are relatively low, you may be able to build up a significant balance in your HSA over time. You can even let your money grow until retirement, when your health expenses are likely to be substantial.
Individuals who are covered by HDHPs are eligible to contribute to an HSA. An HDHP is "catastrophic" health coverage that pays benefits only after you've satisfied a high annual deductible. In 2012, a qualifying HDHP (1) has an annual deductible of at least $1,200 for individual coverage or $2,400 for family coverage (unchanged from 2011), and (2) limits annual out-of-pocket expenses (e.g., co-pays, deductibles) to $6,050 for individual coverage or $12,100 for family coverage.
Because the individual is paying a greater portion of their own health-care costs with higher deductibles, in most cases they will pay a much lower premium than for traditional health insurance. The theory is that the individual would then contribute the premium dollars they save to their HSA. Contributions made to an HSA that do not exceed the maximum limit are tax deductible on the individual's federal income tax return.
For tax year 2012, the contribution limits are $3,100 ($3,250 in 2013) for individual coverage or $6,250 ($6,450 in 2013) for family coverage. This annual limit applies to all contributions, whether made by the individual or the employer. The taxpayer may also be eligible to make "catch-up contributions of $1,000 to their HSA if they are 55 or older.
Because the HSA is an "individual plan" much like an IRA, it is "self directed". Thereby, the individual has the discretion to direct how the funds are invested subject to the investment options offered by the qualified trustee or custodian. Any interest and investment earnings in the HSA grow tax-deferred until withdrawn, and will not be taxed when withdrawn if used to pay qualified medical expenses.
Distributions for nonqualified expenses are considered taxable income and are subject to an additional 20 percent penalty tax if withdrawn prior to age 65. After age 65, the funds can be withdrawn penalty-free for any reason but the money withdrawn, which is not related to medical expenditures, is subject to tax.
Qualified medical expenses are health-care expenses, as defined by Internal Revenue Code 213(d). These include laboratory fees, prescription and nonprescription drugs, dental treatment, ambulance service, eyeglasses, and hearing aids, as well as many other health care expenses. HSA funds may also be used to cover health insurance deductibles and co-payments. Although funds cannot be used to pay regular health insurance premiums, money can be withdrawn to pay for specialized types of insurance such as long-term care or disability insurance. IRS Publication 502 contains a list of allowable expenses.
HSAs encourage people to save for their future medical expenses. They also provide an incentive for people to take more care in making medical decisions, instead of agreeing to any and all proposed tests and treatments regardless of their medical benefit, since it’s their money on the line.
Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at This email address is being protected from spambots. You need JavaScript enabled to view it. .
14 Tips to Inderstand the Fundamentals of Annuities
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- Written by Jerry Love, CPA
An annuity is an investment option that many people find difficult to understand and frequently turn to their tax professional for financial planning advice. The purpose of this article is to offer a basic explanation of the annuity.
The annuity is basically an insurance product that pays out income, which is frequently used as part of a retirement strategy or other long-term financial strategy. Annuities are generally used as a vehicle to provide a steady stream of income for a period of time.
1. An annuity is a contract between the issuer (generally an insurance company), the owner (the individual purchasing the annuity contract), the annuitant (the person whose life will be used in the measuring the payment period) and the beneficiary (the person who will receive the death benefit when the annuitant dies, if there is a death benefit). In most cases, an individual is both the owner and the annuitant of the contract.
Simple Annuity
2. The annuity contract is based on the owner making either a lump-sum payment or a series of payments to the issuer (i.e. insurance company) in exchange for the issuer agreeing to later make periodic payments to the designated person (generally the annuitant) that can begin either immediately or within a year of the purchase (thus called an immediate annuity) or at some future date (thus called a deferred annuity). Annuity pay-outs are based on a variety of factors, including age, gender, investment amount, and type of pay-out. An annuity has two phases: an accumulation period and a payout period.
In its simplest form, the annuity contract would provide for a payment period based on the annuitant’s life and have no provision to make any payments after his/her death. If the annuity does not have a death benefit, then there is a risk to the owner and annuitant that the annuitant will not live long enough to receive a return of the amount invested. For the issuer (the insurance company) there is a risk that the annuitant will live well beyond what the actuarial tables predict and they will have to make payments indefinitely.
3. However, most annuity contracts are more complicated than the described simple annuity. Many annuity contracts are based on more than one life, perhaps both spouses or have a provision to guarantee a payment will be made for a minimum period of time (such as 10, 15 or 20 years). Some annuity contracts will provide for variable payments, although the most common seem to provide for a fixed payment.
Longevity Annuity
4. Another type of annuity that has become available is called a longevity annuity. This product was designed to provide protection against the annuitant outliving his income. This product is also known as an advanced life delayed annuity. This type of annuity is a deferred annuity contract which provides for a late life starting point, such as the annuitant turning 80 or so, and provides for a payment for the remaining life of the annuitant. The later you choose to begin your payments, the larger your payments will be. The longevity annuity generally does not have a fixed payment period and often does not have a death benefit. In fact, many of these contracts provide for no payment to anyone if the annuitant dies before the start date.
5. The next aspect of an annuity is to understand that premium dollars will be invested during the accumulation phase. There are generally three types of annuities — fixed, indexed, and variable. In a fixed annuity, the issuer (the insurance company) agrees to pay you no less than a specified rate of interest during the time that your account is growing.
With an indexed annuity, the issuer will base your account on an investment return that is based on changes in a specific index, such as the S&P 500 Composite Stock Price Index.
A variable annuity is an annuity contract for which the investment returns will fluctuate and the principal value, when redeemed, may be worth more or less than the original investment. In this annuity, you may choose from a range of different investment options such as mutual funds. The value of the annuity and your future benefit will vary depending on the performance of the investment option you selected.
6. A variation of the fixed, indexed and variable annuity is known as a modified guaranteed annuity. This annuity is designed to offer predictable earnings for a selected guarantee period, such as five, seven, or ten years. They can be attractive to investors who want returns without the uncertainty of the equities markets.
7. Now to the tax treatment - annuities are afforded special rules by the IRS. Similar to retirement-styled assets like IRAs and retirement plans, annuities are tax-deferred. This means that you do not pay taxes on the income inside the annuity during its accumulation phase. When you take your distributions from the annuity, it will be taxed to you as ordinary income and you do not get the preferred capital gains treatment of any of the internal accumulation.
8. Generally, annuity payments are treated in part as a return of capital and part income. This taxation of income for an annuity is allowed only for individuals. Thus, if the owner is an entity (e.g., corporation, employer, or trust), the distributions from the contract each year are taxable as ordinary income. However, these non-individual owners would enjoy the tax-deferred growth built up during the accumulation period of the contract. Another difference is that any death benefit from an annuity is taxable income to the beneficiary, and is not afforded the tax-free treatment that life insurance enjoys.
9. You may also transfer your money from one investment option to another one within the annuity without paying tax at the time of the transfer. There is a tax-free exchange available under Section 1035 if you exchange one annuity for another annuity. For exchanges occurring after 2009, no gain or loss will be recognized on the exchange of (1) an annuity for a qualified long-term care contract, (2) a life insurance contract for another life insurance contract, (3) a qualified long-term care contract for another qualified long-term care contract, or (4) a life insurance contract for an annuity contract.
10. And finally, distributions before age 59 ½ may be subject to a 10% premature distribution penalty (additional tax). Variable annuities are not subject to the mandatory distribution rules beginning at age 70 ½; however, many annuity contracts require the owner to begin annuity payments by a certain age.
11. Premiums you pay to purchase the annuity, however, are not tax deductible like an IRA contribution. On the bright side, because they are not tax deductible, there is not a limit on how much you can invest in an annuity.
12. An item that may cause confusion is that sometimes an annuity is purchased inside an IRA, 401k, 403b or other qualified retirement plan. When this is the case, the rules related to the applicable retirement plan take precedence over the annuity tax rules.
13. One key characteristic of an annuity is the surrender charge. The "surrender charge" is a penalty you must pay if you withdraw the funds from an annuity during the initial few years of the contract. This time period varies and is identified in the annuity contract but is generally the first four to eight years.
14. Overall, it is important to understand that the annuity is a contract between the issuer and the owner. By its nature, it is more complicated that buying a CD or investing money in a mutual fund. Because it is contractual in nature, it is important that the financial planning professional help their client understand the contract terms. As with any financial product, there are times when an annuity is the appropriate solution, and just as can be said for most other investment vehicles, it is not the answer to every financial need of the individual.
Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at This email address is being protected from spambots. You need JavaScript enabled to view it. .
Can Anyone Fund Their Own Retirement?
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- Written by Jerry Love, CPA
One thing that anyone active in a tax practice understands is that you must adapt to an ever-changing environment. One huge change over the last century is how the average worker’s retirement is funded while at the same time the life expectancy has significantly increased. The combination of these two elements is a major financial planning topic for the CPA to address with all of their clients because a large majority are reaching retirement age without adequate savings.
When this country was founded and the most common way of life revolved around the family farm and agriculture when 90% of the work force was agricultural, retirement meant living with the family members who had taken over the farm. As we read the accounts of those years, we come to understand that life was hard and life expectancy was not very long.
In 1776 life expectancy was 35 years. In 1900, just more than a century later, the life expectancy had risen to 49 years and only 38% of the US work force was agricultural. By comparison in 1960 only 8.3% of the US work force was agricultural and medical science was beginning to show significant strides as life expectancy was recorded at 69.8 years. Today, in the US the average life expectancy is 78.7 years (women’s life expectancy is approximately 80 years).
Parallel to this rise in life expectancy was a transformation of how the average worker’s retirement was funded. As America became an industrialized country and the work force moved from the farm to the factory, companies began to provide lifetime pensions to their workers. As the medical technology advanced through the 1900s so did the financial burden of providing this lifetime pension. By the end of the last century, it seems that only a small percentage of the largest corporations and governmental entities were still providing a lifetime pension.
In an article titled A Brief History of Retirement In America (Part 1) by MELP on October 18, 2009 (http://www.thenexthill.com/a-brief-history-of-retirement-in-america-part-1.htm) the author states, “nearly everyone in America over the age of 40 obsesses about retirement. It is the epilogue of the American Dream. A secure retirement is the end mark of a life well lead, even something of a status symbol… But retirement wasn’t always the stuff of sweet daydreams. 150 years ago, almost no one thought of retiring. In fact, the idea of retirement as something we should all aspire to has only been around for about 60 years.”
As the US moved from an agriculturally based work force to people working in factories, the funding of retirement changed. As factory owners sought to maintain a highly productive work force, they implemented incentives for older workers to retire and provided limited funding. By about 1920, as much as 40 plus percent of the white males over 60 were retired. Then Congress enters the mix by passing The Social Security Act of 1935. It was originally framed by Congress as a way to deal with large levels of unemployment coming out of the depression with a permanent benefit that allowed a small replacement to the wages the worker previously earned. Although, the first versions of the bill provided for the benefit to start at age 70, Congress voted on age 65. Think back to 1840, only 4% of the US population was over age 60 and by 1935 this had only grown to just over 6%. In 2010 due to increased life expectancy and the baby boom generation’s aging, this segment accounts for approximately 12.5% of the total US population.
In 1945 an estimated 17% of those retiring from a private sector job had a pension. The next thirty years saw a tremendous growth in the number of companies providing a pension. In 1975 it was estimated that as much as 55% of the private sector provided pensions for their retiring employees. So once again Congress enters and passed Employee Retirement Income Security Act (ERISA) and created the Pension Benefit Guaranty Corporation to ensure that employees received their pensions if their plans went bankrupt.
The long-term result of ERISA was that corporate America began to recognize that they could not fund the pensions promised to workers. Those looking back and analyzing this lay the blame in part to the extended life expectancy but also that ERISA mandated a survivor’s benefit that further extended the cost of providing a pension.
In Tax Reform Act of 1978, the tax code saw the introduction of the 401k plan. Section 401 provided for a qualified savings plan. This was the birth of the 401k as we know it today. Over the next few decades the responsibility of funding an individual’s retirement was shifted to the retiree as companies quickly moved from defined benefit plans to defined contribution plans with an increasing emphasis of the employee self funding via the 401k plans. In 1975 over 70% of the workers in the private sector who had a retirement benefit were covered by a defined benefit plan whereas by 2006, over 75% of the workers in the private sector covered by a retirement plan were covered by a defined contribution plan.
But some will ask, what about Social Security? The fact is that Social Security was never intended to be the sole source of a person’s retirement. It was meant to be a supplement to that company pension. On the Social Security’s Web site (http://ssa.gov/pubs/10024.html) it says: “Social Security was never meant to be the only source of income for people when they retire. Social Security replaces about 40 percent of an average wage earner’s income after retiring.”
However over the past few decades many have reached retirement with very little in savings and no pension. According to (http://www.retirement-income.net/blog/retirement-savings/average-retirement-savings-all-measurements-lead-to-the-same-conclusion/) published: August 14th, 2008, “The ‘baby boomer generation’ are those people between 45 and 62 years of age (as of 2008). This generation has saved on the average retirement savings of $38,000, excluding pensions, homes, and social security. However, “baby boomers” with qualified retirement plans have an average retirement savings of $88,000. The $88,000 of average retirement savings will generate an annual retirement income of about $5,000 yearly.” The online article continues to say: “It’s estimated that the average projected post-retirement income replacement needed among employees of large U.S. employers is 126% of final pay, a level only about 19 percent of employees are expected to satisfy, according to a Hewitt Associates report released July 1. If we assume that the average person earns $40,000 annually, they would need about $50,000 in retirement income, requiring an average retirement savings of $833,000 (not taking into account any social security income). In fact, according to the report, Total Retirement Income at Large Companies: the Real Deal 2008, about 67 percent of the more than 1.8 million employees of 72 large U.S. employers tracked in the study are expected to have accumulated less than 80 percent of their projected needs at age 65.”
In another online article posted (http://20somethingfinance.com/average-retirement-savings/) by G.E. Miller on October 19, 2009, The Shockingly Low Amount of Retirement Savings per American: “According to the Employee Benefits Research Institute’s (EBRI) 2009 Retirement Confidence Survey, 53% of workers in the U.S. have less than $25,000 in total savings and investments. The typical American household (headed by a 43 year old) has just over $18,000 in savings!”
According to the 2011 Retirement Confidence Survey, Employee Benefit Research Institute and Mathew Greenwald & Associates, “retirees say Social Security makes up a major share of their income (68%). However, EBRI research found in 2009 that 60% of those 65 or older received at least 75% of their income from Social Security.”
The EBRI study further states: “The age at which workers expect to retire is gradually rising. In 1991, half of workers planned to retire before age 65, compared with 23 percent in 2011. …. Seventy-four percent of workers now say they plan to work for pay after they retire. Almost all retirees (90%) who worked in retirement name at least one financial reason for doing so, such as wanting money to buy extras (72%), a decrease in the value of their savings or investments (62 percent), needing money to make ends meet (59%), and keeping health insurance or other benefits (40%). Many workers are also planning to rely on income from employment to support them in retirement. Three-quarters of workers say that employment will provide them (and their spouse) with a major (24%) or minor (53%) source of income in retirement (77% total, up from 68% in 2001 but statistically equivalent to 79% in 2009 and 77% in 2010).”
This stark reality seems to be the bi-product of the two factors mentioned above, the change from companies providing lifetime pensions (defined benefit plans) and the extended life expectancy afforded by advances in medical technology. As CPAs and tax professionals, we need to understand the stark change that has occurred in the retirement landscape and we must be active in this conversation with our clients of all ages. Financial planning is a service your clients need from you.
Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at This email address is being protected from spambots. You need JavaScript enabled to view it. .