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:
Includible compensation does not include:
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.
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.
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.
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.
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.
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.
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.
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.
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.
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).
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.
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) 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.
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.
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):
There are a number of differences from a 401(k) and 403(b).
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.
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.
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.
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.
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.
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.
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.
When you are self-employed you are both employee and employer.
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.
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:
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.
IRA contributions can be made all at once or over time.
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.
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.
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||
|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.
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 Status||Modified Adjusted Gross Income||Ability to Contribute|
|Single, head of household, or married filing separately and you did not live with your spouse at any time during the year||Less than $124,000||Up to limit|
|$124,000 to less than $139,000||Less than limit|
|More than $139,000||Unable to|
|Married filing jointly or qualifying surviving spouse||Less than $196,000||Up to limit|
|$196,000 to less than $206,000||Less than limit|
|More than $206,000||Unable to|
|Married filing separately and you lived with your spouse at any time during the year||Less than $10,000||Less than limit|
|More than $10,000||Unable to|
Contributions are not tax deductible; you pay income taxes on your contributions.
Having already paid income tax has many advantages.
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 IRAs allow you to grow your account without paying taxes until gains are withdrawn. They blend some features of traditional and Roth IRAs.
The major reasons to opt for a nondeductible IRA is when you have too much income to:
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.
Options available to beneficiaries of your retirement account
Inherited IRAs do not have the same protection from creditors as the original plans did.