Retirement Accounts

Retirement accounts contain money that you have aside to use once you are retired. What makes these accounts different from other investments is that the federal government allows them to grow tax-free. However, you do not have easy access to the money when you are younger. The Employee Retirement Income Security Act (ERISA) of 1974 sets the rules for retirement accounts that protects them, including from creditors, and allows you to receive tax benefits.

Like any savings plan, the earlier you start and the more you can add will leave you in a better position financially. In many cases you can make contributions automatically, though most accounts have a limit on how much you can deposit each year.

Like annuities, retirement accounts can be funded with pre- or after-tax dollars. However, unlike annuities, you can only add includible compensation, which means earned income.

Includible compensation can include:

  • Individual wages, salaries, commissions, bonuses, and other amounts paid to you for your labor, generally any amount shown in Box 1 of your Form W-2;
  • Net earnings from your business, minus any deduction allowed for contributions made to retirement plans on your behalf and further reduced by 50% of the your self-employment taxes, if you are self-employed or a partner in a partnership; and/or
  • Money related to divorce, such as alimony, child support, or a settlement.

Includible compensation does not include:

  • Rental income or other profits from property maintenance;
  • Interest income;
  • Pension or annuity income; and/or
  • Stock dividends and capital gains.

Once funded, the account then earns tax-deferred gains. The sacrifice for this is that you can’t withdraw untaxed contributions before 59½ years old without penalty and the federal government sets yearly limits on how much can be added to each type of account. Your employer may set their own limits on how much you can contribute, either a dollar amount or percent of your salary.

Like annuities, most accounts have a limit on how long you can defer withdrawals. The SECURE act sets this at 72 years old.

  • At that point you must begin taking required minimum distributions (RMDs).
  • For each year you defer after that you will pay a penalty equal to 50% of the amount you should have withdrawn. 

When you begin to make withdrawals from these accounts, the money is taxed as regular income according to how it was funded. All of the withdrawal from 401(k), 403(b), 457(b), profit-sharing plans, and traditional IRA (Individual Retirement Accounts) accounts is taxed as income, since it was funded by pre-tax dollars. Only the gains are taxed on withdrawals from Roth versions of these accounts, since they were funded by after-tax dollars 

There are many account choices, some of which depend on your employer or situation, but you can choose some based on your preference. No matter which ones you choose, service fees for setting up and maintaining a retirement account are quite expensive. The most expensive are employer sponsored accounts where both you and your employer have service fees, while Individual Retirement Accounts have only individual fees that are less expensive.

Employer Sponsored

Many retirement plans are sponsored by employers and allow you to contribute pre-tax or after-tax dollars. In some cases, the employer may match some or all of your contributions.

If your employer offers them, they are available to full-time and part-time employees who work either 1,000 hours per year or have worked three consecutive years with at least 500 hours. You can only make deposits with funds from your salary.

Depending on the type of account, there are three types of contributions.

  1. Elective deferrals – pre-tax contributions you have taken out of your salary which are contributed directly into the account for your benefit.
  2. Non-elective contributions – untaxed contributions by your employer to your account, such as matching contributions, discretionary contributions, and mandatory contributions.
  3. After-tax contributions – contributions to Roth accounts or additional contributions you can make if your plan allows them.

Within the federal limit and any limit set by your employer, you can choose how much to deposit.

Some employers will match some or all of your contributions and get tax relief for them.

  • Most will have a limit, which may or may not be the same as your contribution limit.
  • Because of higher budgets, for-profit companies are more likely to match contributions.
  • Because of lower budgets, non-profit companies are less likely to match contributions. 
  • Employers that provide employees a pension, such as for police officers, firefighters, other civil servants, ministers, school administrators, state college professors, and teachers will usually not match contributions.

While you are entitled to all of your contribution if you leave your job, you will not be entitled to all of your employer’s contribution until you are fully vested.

  • Vesting indicates the percentage of your employer’s contribution you are entitled to.
  • Vesting is usually tied to how long you have been employed.
  • You will usually have to wait for full vesting with a 401(k). You should check with your employer about their vesting policy.
  • You are usually fully vested as soon as you open a 403(b). 
  • The Employee Retirement Income Security Act (ERISA) puts limits on the length of the vesting period.

If you change jobs you can either keep the account with your previous employer, move it, or cash it out. It can be difficult to choose among the options, but the decision is ultimately a financial one. You will be trying to balance the cost of services (fees) for moving the money with the possibility of making them up with a better return on your new account or investments.

  • Your employer may require you to take your money out of their account or only allow you to stay in the account if you have a certain amount invested.
  • If desired or necessary, you can transfer it over into an IRA.
  • Some new employers will allow you to move the funds into the account they offer.
  • You can cash it out, but you will lose the benefits of the account and usually pay surrender and service fees.

Employer retirement accounts can be qualified or non-qualified depending on whether or not they follow ERISA rules.

  • Qualified retirement accounts like 401(k)s are those that are subject to all ERISA rules, such as contribution limits and when withdrawals can start without penalty.
  • Non-qualified retirement accounts may not adhere to all ERISA rules, such as nondiscrimination rules.
    • 403(b)s and 457(b)s have the same limits on contributions and withdrawal rules, but may not follow other rules and are usually considered non-qualified. This is especially true if your employer does not have a matching contribution program.
    • 457(f)s are also non-qualified and do not have a limit on how much can be put into the account. They may be offered if you are a high-salaried employee.

The nondiscrimination rules in the ERISA assure that all employees of the company are eligible for the same benefits, no matter their position within the company.

  • This keeps plans from for-profit companies (401ks) from treating highly-compensated employees and company executives differently when it comes to employer contributions.
  • Plans from non-profit companies or governments (403b and 457b) are not usually at risk for this and are exempt from these rules.
  • Companies that do not match contributions are also exempt from nondiscrimination rules.

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401(k)s retirement plans are only available from your employer. If you work for a for-profit company, a 401(k) is the only retirement account available. Some non-profit employers offer them, but it is less common.

401(k)s from for-profit companies are more likely to be administered by mutual funds companies and to match some or all of your contributions. Some for-profit companies will also add a profit-sharing feature to the plan.

Whether contributions are taken out before taxes (gross salary) or after taxes (take home salary) depends on which of the two types, traditional or Roth, you have. You may or may not have a choice of which one.

Traditional 401(k)
Contributions are taken out of your gross salary and will not count toward your income tax.The Federal Government limit for regular contributions in 2020 is $19,500If you are 50 years old or older you may also add an additional $6,500 per year known as a catch-up contribution.All withdrawals will be taxed as income.If you are in a high tax bracket now, delaying income tax until retirement when your income may be lower makes financial sense.

Roth 401(k)
Contributions are taken out of your take after-tax home salary.There are no federal limits on what you can contribute.Withdrawals from your contributions made after 50½ years old will not be taxed as income.Any earnings and matching contributions from the employer are pre-tax dollars and will go into a separate traditional 401(k) and be taxed at withdrawal.If you are in a low tax bracket now, paying income tax now rather than at retirement when you might have a higher tax bracket makes financial sense.

The contributed funds are invested to increase the value of the 401(k).

  • Your employer will usually present you with a few investment options for you to choose from.
    • The options will frequently be a choice of conservative, middle, or high-risk investments or combinations of them.
    • Choose the options based on your comfort level for risk.
  • About 40% of companies offer a self-directed brokerage account (SDBA).
    • An SBDA allows you to manage your own investments.
    • It gives you direct access to a network of mutual funds.
    • You may be able to invest in stocks, bonds, and exchange-traded funds. 
    • These investments are different than those available in the core plan.
  • The more options you choose and the more complex the investments, the higher the fees.
  • The principal and earnings accumulate tax-free until they are withdrawn, when they are taxed as income according to the tax status of contributions and your tax bracket at that time.

Typical Investment Choices

Certificates of Deposit (CDs) are securities issued by commercial banks and pay a preset rate of interest over the term of the agreement. The Federal Deposit Insurance Corporation (FDIC) often acts as a guarantor of these securities. This oversight makes CDs relatively low-risk.

Money Market Funds invest in short-term (typically less than one year) securities commonly traded in the money market. While there may be some capital gains, most of the gains in value come from interest.

Mutual funds are a managed portfolio of investments with money from various investors that is pooled and invested in a variety of different financial securities including stocks and bonds. 

  • Rather than purchase shares of an individual stock, the manager of the 401(k) buys shares of a mutual fund.
  • These transactions are handled by the mutual fund manager or through a broker, rather than on an open market (exchanges).

Exchange-traded funds are a type of security similar to mutual funds. The investments usually involve a collection of securities such as stocks, but can also be invested in any number of industry sectors or use various strategies. Unlike mutual funds, exchange-traded funds are listed on exchanges and the shares trade throughout the day just like ordinary stock.

U.S. Treasury Bonds (T-bonds) provide you or your 401(k) with steady interest income, usually every 6 months. It is important to know that you must hold the bond through to maturity, usually 20-30 years, to earn a bond’s full yield.

Corporate Bonds provide recurring interest income, but unlike the U.S. Bonds there is risk involved that varies significantly by the issuer. Your 401(k) manager needs to conduct a thorough review of any corporate bond security before investing directly or through a mutual fund.

Annuities are becoming more common after the 2019 SECURE Act reduced liabilities for companies offering retirement plans.

403(b)

403(b) plans can only be offered by the government or non-profit organizations, such aslike a public education institution, religious organization, or 501(c)(3) Tax-Exempt Organization.

  • They are more likely to be administered by insurance companies.
  • 403(b)s offer a much more limited range of investment options, usually only mutual funds and annuities. This is usually to avoid high-risk investments.
  • Organizations that offer 403(b)s are less likely to match contributions.
  • 403(bs) are exempt from many Employee Retirement Income Security Act (ERISA) rules, especially if they do not match contributions. 

A 403(b) works just like a 401(k) including traditional and Roth forms, a federal government limit for regular contributions in 2020 of $19,500, and the ability to add $6,500 in catch-up contributions if you are 50 years old, with two exceptions.

  1. There is a federal limit on total annual additions of employer contributions plus employee contributions (elective deferrals). It is the lesser of:
    1. $57,000 (for 2020); or 
    2. 100% of your includible compensation (earned income) for the year. 
  2. If you have worked for your employer for at least 15 years you are entitled to a Lifetime Catch-up that lets you contribute up to an additional $3,000 per year.

457(b)

A 457(b), also known as a deferred compensation plan, can only be offered by state and local governments and some non-profit organizations such as hospitals, charities, state colleges, and unions. 

A 457(b) works similar to a 401(k) including traditional and Roth forms, a federal government limit for regular contributions in 2020 of $19,500, and the ability to add $6,500 in catch-up contributions if you are 50 years old. There are many differences from a 401(k).

Like a 403(b), a 457(b):

  • Usually only invests in mutual funds and annuities; and
  • Is offered by organizations that are less likely to match contributions; more so since 457 (b) plans are usually offered by organizations that have pension plans for retired employees. 

There are a number of differences from a 401(k) and 403(b).

  • Any matching contributions count toward the annual limit.
  • In your final three years before retirement, you can contribute up to $39,000 a year if you need to catch-up because you did not contribute in previous years. However, you cannot also add the $6,500 in catch-up contribution you could have added if you are 50 years old or older.
  • As long as you don’t exceed the $19,500 in the year 2020, you can contribute up to 100% of your salary.
  • If you do not take advantage the 50 or over catch-up option, you can resort to unused contribution rollovers.
    • These allow you to add any amount below the limit that you did not contribute last year to this year’s contribution.
    • For example, if you only contributed $12,000 to your 457(b) plan in 2019 ($7,000 under the 2019 limit), you can contribute up to $26,500 in 2020 ($7,000 + $19,500).
  • You won’t pay a 10% penalty fee if you withdraw money after leaving your job or retire before 59½ years old.
  • Your money is not protected from creditors.

You can have a 457b and a 403b (or rarely a 401k) at the same time and be able to contribute up to the limit for both.

Profit-sharing Plans

A profit-sharing plan is a retirement plan created for you but funded solely by your company. Also known as a deferred profit-sharing plan (DPSP), it allows you to receive a percentage of your company’s profits based on its earnings. Any size company can set one up.

  • The company decides how much of their profits they want to share and then determines what they allocate to you. 
  • Contributions amounts can be a percentage of your salary or determined by a formula based on your salary and your company’s earnings for that quarter. 
    • The amount of your salary will be used to calculate what percentage of the company’s total salary payments is yours.
    • The amount of your salary that can be considered for a profit-sharing plan is limited, $285,000 in 2020.
    • That number is then multiplied by the total profits being shared, if any.
  • They are typically added to your account quarterly or annually.
  • Once funded, the account grows tax-deferred like the other retirement accounts.
  • Like all non-Roth accounts, the withdrawals are taxed as income.
  • The company has all the control, but there are some rules they need to follow.
    • The 2020 contribution limit for your company is the lesser of 25% of your salary or $57,000.
    • Companies have to follow nondiscrimination rules, in other words the profit-sharing plan cannot discriminate in favor of highly compensated employees.
    • Like other retirement plans, you will pay a 10% penalty for any funds you withdraw from the account before 59½ years old.
    • After leaving the company, you can transfer the money over into a traditional IRA without penalty.
  • Profit-sharing plans usually have a vesting schedule that determines how long you have to work for your company before you are entitled to the full amount.
  • A profit-sharing plan does not restrict the company from also offering a 401(k).
  • You can take your funds in the form of cash or company stock.

SIMPLE IRA Plan

A SIMPLE (Savings Incentive Match Plan for Employees) IRA is a savings plan available to small businesses (fewer than 100 employees) and no other available retirement plan.

  • A smaller company does not require non-discrimination rules, creation of vesting schedules (you are always 100% vested in your employer’s contribution ), or tax reporting at the plan level.
  • SIMPLE IRAs are easier and less expensive to set up and manage than the previously described plans.
  • The amount of possible savings is less than other types of plans.

Rules for SIMPLE IRAs

You must have earned at least $5,000 in compensation in any two previous calendar years and be expected to earn at least $5,000 in the current year to be able to participate.

Your contributions are tax-deductible and the 2020 limit for contributions is $13,500. You must fill out a SIMPLE IRA adoption agreement to open your account

Employers must contribute to the account. There are two options for employer contributions.

  1. Your employer matches your contributions up to 3% of your yearly compensation or $13,500 (salary of $450,000), whichever is lower. Therefore, if you do not contribute, you would have no retirement savings.
  2. Alternatively, your employer can opt to make contributions for every employee, whether or not they elect to contribute (nonelective contributions).
    1. Your contribution will be matched up to 2% of your salary or $5,000 (salary of $250,000), whichever is lower.
    2. You will still have money in the account, even if you don’t contribute.

There is a variety of investment choices, including growth, growth and income, income, and specialized funds such as sector funds or target-date funds.

You are 100% vested from the beginning of the account and will receive the full amount when you leave, whenever that is.

You cannot take loans from the account.

Like other accounts, if you withdraw money before 59½ years old you will pay a 10% early withdrawal penalty on the taxable portion of the money. This penalty is 25% if you withdraw funds within the first two years.

Contributions and earnings may be transferred over tax-free to other individual retirement accounts and retirement plans and must eventually be distributed following the IRA-required minimum distribution rules.

Simplified Employee Pension

A Simplified Employee Pension (SEP) plan has lower start-up and operating costs than conventional retirement plans, but is much different than a SIMPLE IRA. It is like a traditional IRA that your employer contributes to.

  • It is available for any size business, including if you are self-employed.
  • To qualify to participate you must at least be 21 years old, have three years of employment, and earn at least $600 compensation per year.
    • Participation in traditional IRAs and Roth IRAs does not disqualify you from participating.
    • You may be disqualified if you are covered in a union agreement that bargains for retirement benefits or are a nonresident alien that does not receive U.S. wages or other service compensation from your employer.
  • The employer makes contributions, not you or other employees. There are two exceptions.
    • You can contribute to a Salary Reduction Simplified Employee Pension Plans created before 1997. However, elective salary deferrals or catch-up contributions are no longer allowed.
    • If you are self-employed, you can contribute up to 20% of your net self-employment earnings towards your account.
  • The contributions can vary from year to year based on how well the company is doing.
    • Although there may be no contributions some years, the maximum can be higher than other retirement plans.
    • In 2020, your employer can make contributions up to $57,000 or 25% of your salary up to $285,000, whichever is lower.
  • The funds are usually put into traditional IRAs, known as SEP-IRAs, set up for each eligible employee and are taxed accordingly.
  • There are a variety of investment choices, but it is the IRA trustee that chooses the investments and you who make specific investment decisions. 
  • You are always 100% vested in the account and will receive the full amount when you leave, whenever that is.
  • You cannot take loans from the account.
  • Like other accounts, if you withdraw money before 59½ years old, you will pay a 10% early withdrawal penalty on the taxable portion of the money.
  • Contributions and earnings may be transferred over tax-free to other individual retirement accounts and retirement plans and must eventually be distributed following the IRA-required minimum distributions.

Solo 401(k)

A solo 401(k) plan is both an employer sponsored and individual retirement plan. It is available if you are self-employed and have no full-time employees, aside from your spouse. If your spouse works for your business, both of you may contribute to a solo 401(k).

Solo 401(k)s come in two varieties, both of which will grow tax-free until you begin to withdraw the money.

  1. Traditional solo 401(k) – your contributions come from your gross (before income tax) income and you pay income tax when you withdraw the funds in retirement..
  2. Roth solo 401(k) – your contributions come from your net income, but you pay no income tax when you withdraw the funds in retirement.

When you are self-employed you are both employee and employer.

  • You have much more control over investments.
  • You can contribute larger sums each year. Your maximum contribution is the lesser of:
    • The 2020 annual contribution limit of $57,000 ($63,500 if you’re 50 years old or older); or 
    • Your employee contribution, $19,500 in 2020 ($26,000 if you’re 50 or older), plus 25% of your net self-employment income (all your self-employment earnings minus business expenses, half your self-employment tax, and money you contributed to your solo 401(k) for your employee contribution).
  • The drawback is that you will pay both individual and employer fees to open and maintain the account.

You must make any employee contributions by December 31st, but you have until the tax-filing deadline for the year, usually April 15th of the following year, to make your employer contribution.

Federal law prohibits you from withdrawing your solo 401(k) funds without penalty before 59½ years old, unless you use the money for a qualifying exception, such as a first-home purchase or large medical expenses. For a 10% early withdrawal penalty on the taxable portion of the money, you can withdraw Roth solo 401(k) contributions for other expenses at any time before then as long as you’ve had the account for at least five years.

Individual Retirement Accounts (IRA)

If your employer does not offer a retirement account or contribution matching or if they do and you would like to have another retirement account, you can open an individual retirement account (IRA). They are available at financial-services companies like large banks, brokerage companies, federally insured credit unions, and savings and loan associations.

You can also set up an IRA in your name for your non-working spouse called a Spousal IRA. It is a separate account that functions the same as yours and does not interfere with the ability to contribute to yours. The two accounts allow your family to double your annual savings. To qualify for a spousal IRA:

  • You must be married and file a joint tax return;
  • The total contribution for both of you must not exceed the taxable earned income reported on your joint tax return; and
  • Contributions to one IRA cannot exceed the contribution limits for that IRA.

There are different types of IRAs. The biggest differences between them are when you pay income taxes, whether or not there are modified adjusted gross income eligibility limits, and any age limits for required minimum There are different types of IRAs. The biggest differences between them are when you pay income taxes, whether or not there are modified adjusted gross income eligibility limits, and any age limits for required minimum distributions.

Feature Traditional IRA Roth IRA Nondeductible IRA
Income limit to contribute None Yes None
Age limit to contribute None since 1/1/2020 None None
Contributions tax-deductible Yes – depending on marital status and income  No No
Withdrawals and distributions taxable Yes No – if done after you have had the IRA at least five 5 years and withdraw them after you reach 59½ years old
Yes – if done before you have had the IRA less than five 5 years or withdraw them before you reach 59½ years old
Same as Roth IRA
Required minimum distributions Must begin at 72 years old No age limit Must begin at 72 years old
Tax advantage Defer taxes now when you are in a high tax bracket, but expect a lower one after retirement Pay taxes now when you are in a low tax bracket, but expect a higher one after retirement Tax-deferred earning when you make too much to open a Roth IRA

Each company will have their own rules, choices of investments, and service fees.

  • It is important to compare what services they charge for, what the fees are, and if they charge you an account inactivity fee if it’s been too long since you checked on your investments.
  • What your money is invested in affects your long-term earnings much more than the company you use. Get specific details about what investments they will make with your money.
    • There is a lot of variability in the range of investments they offer. Some are quite diverse, while others are rather restrictive.
    • Your risk tolerance and investment preferences should be the major factors in determining your choice of IRA provider.
  • Most institutions will have minimum account balances, but they vary significantly.
    • You must be able to contribute at least that amount to open the IRA.
    • You will need another investment option if you don’t.
  • If you plan on banking with the same institution, see if your IRA account comes with additional banking products or if they will wave or lower some of their fees.
  • You should receive an IRA disclosure statement and IRA adoption agreement and plan document that includes everything you need to know about your specific account.

IRA contributions can be made all at once or over time.

  • There are yearly limits to the amount you can contribute. The Federal Government limit for regular contributions in 2020 is the lesser of:
    • $6,000 ($7,000 if you are 50 years old or older); or
    • Your includible compensation (total taxable compensation) for that year, meaning you can only add money that you earned that year.
  • If you are 50 years old or older you may add an additional $1,000 per year. This is known as a catch-up contribution.
  • The limit may apply to each type of account you have or the combined total of both accounts.
    • You can contribute up to the limit to both an IRA and an employer sponsored retirement plan in the same year.
    • You can contribute to both a traditional IRA and Roth IRA account in the same year, but your combined contribution cannot exceed the IRA limit for that year, $6,000 ($7,000 if you are 50 years old or older) in 2020.
  • Any contributions that happen up to your tax deadline will count toward the previous calendar year.
  • Since January 1, 2020 you can contribute earned income to the IRA at any age.

Once opened, the funds in your IRA are invested to increase the value of the IRA. In general, IRAs invest in the same things as 401(k)s, 403(bs), and 457(b) plans, but offer a wider array of these investments. 

The principal and earnings accumulate tax-free until they are withdrawn, when they may be taxed as income, depending on the IRA type, and according to your tax bracket at that time. You can choose your type of IRA based on when you can better afford income tax on your money, now or after your retirement.

Traditional IRA

Unlike a Roth IRA, there is no modified adjusted gross income limit to being able to contribute to a traditional IRA, although there may be income limits for tax deductible contributions. Like most other retirement accounts, traditional IRA contributions must be made from income earned in the same year as the contribution unless you are rolling over another type of retirement account.

Contributions are usually tax-deductible. If you are in a high tax bracket now, delaying income tax until retirement when your income may be lower makes financial sense. You can claim the tax deduction even if you do not itemize deductions on your tax return.

Whether you can make tax-deductible contributions to your traditional IRA depends on your marital and filing status, whether or not you and/or your spouse have another retirement account from your employer, and your modified adjusted gross income.

  • There are no income limits if you do not have an employer sponsored retirement account (401k, 403b, or 457b).

Income limits if you and/or your spouse also have a retirement account from your employer

Marital and Filing Status Retirement Account from Employer Modified Adjusted Gross Income Tax-deductible
Single, head of household or living apart from your spouse Yes Less than $65,000 Entire contribution
$65,000 to less than $75,000 Part of contribution
$75,000 or more Not deductible
Married filing jointly
Spouse only
Less than $196,000 Entire contribution
$196,000 to less than $206,000 Part of contribution
$206,000 or more Not deductible
Married filing jointly or qualifying surviving spouse You, irrespective of your spouse having one Less than $104,000 Entire contribution
$104,000 to less than $124,000 Part of contribution
More than $124,000 Not deductible
Married filing separately Either you or Spouse Less than $10,000 Part of contribution
$10,000 or more Not deductible
 

If you are over the tax-deductible income limit, you can still contribute up to the federal limit but it can be difficult to keep track of which contributions are after-tax contributions. In addition, you will need to file an IRS Form 8606 for these contributions each year so you’re not taxed again when you take retirement distributions.
It may be better to put that money into other investments, like a Roth or nondeductible IRA or use the money to contribute up to the limit for your employer sponsored account.

As with 401(k)s, you’ll pay taxes on the tax-deductible money once you withdraw it and an additional 10% penalty on the taxable portion of the withdrawal if this is before you are 59½ years old.

Like annuities and employer sponsored retirement plans, there is a limit on how long you can defer withdrawals. The limit is 72 years old.

  • At that point you must begin taking required minimum distributions (RMDs).
  • For each year you defer after that you will pay a penalty equal to 50% of the amount you should have withdrawn. 

Roth IRA

A Roth IRA is funded with after-tax dollars. Whether you can contribute directly to a Roth IRA depends on your marital status and modified adjusted gross income.

2020 Income Categories

Marital and Filing StatusModified Adjusted Gross IncomeAbility to Contribute
Single, head of household, or married filing separately and you did not live with your spouse at any time during the yearLess than $124,000Up to limit
$124,000 to less than $139,000Less than limit
More than $139,000Unable to
Married filing jointly or qualifying surviving spouseLess than $196,000Up to limit
$196,000 to less than $206,000Less than limit
More than $206,000Unable to
Married filing separately and you lived with your spouse at any time during the yearLess than  $10,000Less than limit
More than  $10,000Unable to

You can circumvent the income limits by starting with a traditional IRA that has no income limits and convert it to a Roth IRA. This is referred to as a Backdoor Roth IRA

Contributions are not tax deductible; you pay income taxes on your contributions.

  • Unlike a traditional IRA, Roth IRAs can be funded from many sources such as personal contributions, spousal IRA contributions, transfers from savings, rollover contributions from other retirement accounts, and conversions from other IRA types.
  • You must report all contributions on an IRS Form 8606
  • If you are in a low tax bracket now, paying income tax now rather than at retirement when you might have a higher tax bracket makes financial sense.

Having already paid income tax has many advantages.

  • You do not have to have owned the Roth IRA for a specific time before you can withdraw funds, but penalties and income taxes will vary.
    • You can withdraw your original contributions whenever you want without penalty or income tax. The IRS will always assume your original contributions come out first when you withdraw money from your Roth IRA.
    • You won’t pay income taxes or penalties on the financial gains if you have had the Roth IRA at least five years and withdraw them after you reach 59½ years old.
    • If you have reached 59½ years old but haven’t had the account for 5 years, there’s no penalty but you’ll owe income tax on any earnings that you withdraw.
    • You will pay a 10% penalty and income tax on any earnings withdrawn before 59½ years old.

Unlike annuities and employer sponsored retirement plans, there is no limit on how long you can defer withdrawals. You can arrange to have Roth IRA funds transferred to a living trust so you’re able to use them when you are alive and disperse them as you wish to your beneficiaries after your death.

Nondeductible IRA

Nondeductible IRAs allow you to grow your account without paying taxes until gains are withdrawn. They blend some features of traditional and Roth IRAs.

  • Contribution limits are the same as either the traditional IRA or Roth IRA, the lesser $6,000 ($7,000 if you are 50 years old or older) or your total taxable compensation for that year.
  • Like a traditional IRA:
    • There is no modified adjusted gross income limit to contribute; and
    • Withdrawals on investment gains will be taxed according to your tax bracket.
  • Like a Roth IRA:
    • The contributions are not tax deductible;
    • You can withdraw contributed money after 59½ years old without paying taxes; and
    • You must report your nondeductible IRA contributions each year using IRS Form 8606.

The major reasons to opt for a nondeductible IRA is when you have too much income to:

  • Qualify for tax-deductible contributions to a traditional IRA because you have an employer sponsored retirement account (401k, 403b, or 457b); and/or
  • Open a Roth IRA.

Inheriting Retirement Accounts

Like an annuity, you may use your retirement as an inheritance tool by naming primary (and possibly contingent) beneficiaries if you die before the end of the retirement account term or it is depleted. The primary beneficiary, usually your surviving spouse, will get the money if they claim it. If they have passed away or do not claim the funds, the money then goes to the contingent beneficiaries. Any other beneficiary is free to decline any or all of the account and defer to the next beneficiary.

Another option is to name a living trust as the beneficiary. The trust can be set up in a way that allows you some control of how the funds are distributed after your death. The trust can either distribute the account to the beneficiaries (Conduit Trust) or accumulate the payouts and distribute the money to the beneficiaries over a longer period of time (Accumulation Trust). Like the retirement account beneficiary, the trust beneficiary can refuse to claim the money.

The beneficiary who accepts the account cannot deposit additional funds and must decide how they’d like to receive their inherited funds. The options available to them are similar to those you had when the retirement account was yours. However, they will need to be aware of some minor differences and a few unique to inherited retirement accounts that will depend on the following factors.

  • Whether they are your spouse or a non-spouse
  • Your age at death
  • Their age in relation to yours at death
  • Their health status
  • Any other rules specific to your retirement account

Options available to beneficiaries of your retirement account

  1. Your surviving spouse can transfer the money from any type of retirement account into their own retirement account. They will then follow the specific rules of the account type based on their age (less than or more than 59½ years old).
  2. Any beneficiary can opt for a lump-sum distribution. This can be split among beneficiaries if there are more than one.
    • The withdrawal will not be subject to the usually 10% early withdrawal penalty that you  would have paid.
    • The money will be taxed that year based on the nature of the account.
      • You will pay income tax for traditional accounts.
      • You will pay income tax on earnings from Roth accounts, but not on the previously taxed contributions.
    • There may be a mandatory 20% withholding tax when the money is withdrawn.
  3. Any beneficiary can opt to have the withdrawals spread out over time. Beginning in 2020, the SECURE Act requires non-spouse beneficiaries who are not chronically ill or disabled, less than 10 years older than you, or a minor child to withdraw the entire account by 10 years after inheriting.
    • This option gives them flexibility within that time frame to withdraw the money whenever they need it.
    • Unless it is a Roth account, this will spread the tax liability over a few years.
    • This is probably their best option if a lifetime distribution is not an option.
  4. Minor children can spread the withdrawals over the number of years left until their age of maturity.
  5. Aside from some employer sponsored plans, surviving spouses, chronically ill or disabled beneficiaries, or beneficiaries less than 10 years older than you can spread the withdrawals out over their lifetime.
    • Required minimum distributions will start based on your age at the time of death and whether or not you have already started getting them before then.
      • If you were younger than 70½ when you died, the surviving spouse must start taking distributions by either the end of the year of your death or the end of the year in which you would have turned 70½, whichever date is later.
      •  
      • If you were older than 70½ at the time of your death and not taking withdrawals, your surviving spouse must begin them by the end of the year following your death.
      • If you were older than 70½ at the time of your death and already taking withdrawals, your surviving spouse must begin them by the end of the year of your death.
    •  
    • Every year the IRS Single Life Expectancy Table and remaining balance in the account is used to determine the required minimum distribution for that year, although they can withdraw more.
    • This continues until there is nothing left in the account or their death, whichever is sooner.
    • If a lifetime spread is not offered by your plan, request your employer do a trustee-to-trustee transfer to a retirement account that does. 
  6. Any beneficiary can set up an Inherited IRA with your 401(k) or similar account and traditional, Roth, or Simplified Employee Pension IRAs. In this case, the account is kept in your name for the benefit of your beneficiary.
    • The assets continue to grow tax-deferred and can be withdrawn at any time.
    • Withdrawals will be taxed that year based on the nature of the account.
    • Rules for required minimum distributions are similar to those listed above.
    • These accounts cannot be commingled with your beneficiaries other IRA accounts, although they can name their own beneficiaries.

Inherited IRAs do not have the same protection from creditors as the original plans did.

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