Retirement accounts contain money that you have set 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. Employers can receive up to $500 of tax credit per year if they create a 401(k) or SIMPLE IRA plan with automatic enrollment.
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.
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.
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 of this type available. Some non-profit employers offer them, but it is less common.
Eligible employees can make tax-deferred contributions from their salary/wages on a post-tax (Roth) and/or pre-tax (traditional) basis. Employers may make matching or non-elective contributions to the plan and may also add a profit-sharing feature.
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.
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.
Contributions are taken out of your take after-tax home salary.
There is also a federal limit on total annual additions of employer contributions plus employee contributions (elective deferrals). It is the lesser of 100% of your includible compensation (earned income) for the year; or
If you are 50 years old or older and have no contributed the maximum amount in previous years you can make a catch-up contribution of up to $6,500 per year.
The contributed funds are invested to increase the value of the 401(k).
403(b) plans can only be offered by the government or non-profit organizations, such as 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 employee contributions in 2022 of $20,500, and the ability to add $6,500 in catch-up contributions if you are 50 years old or older. If you have worked for your employer for at least 15 years and your employer is considered a “qualified organization” you are entitled to a Lifetime Catch-up that lets you contribute up to an additional $3,000 per year.
There is a federal limit on total annual additions of employer contributions plus employee contributions (elective deferrals). It is the lesser of 100% of your includible compensation (earned income) for the year or:
A thrift savings plan is similar to the 401(k) and 403(b), but is only available to federal employees and members of the armed forces. It has the same limits.
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) and 403(b) including:
Like a 403(b), a 457(b):
There are a number of differences from a 401(k) and 403(b).
You can have a 457(b) and a 403(b) (or rarely a 401k) at the same time and be able to contribute up to the limit for both.
A 457(f) plan has all the features of a 457(b) plan except that:
457(b) and 457(f) plans can work independently or in combination with each other.
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, 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. The plan allows pre-tax contributions by employees and employers to traditional IRAs set up for employees.
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 2022 limit for contributions is $14,000. If you are 50 years old or older you may contribute an additional catch-up amount of $3,000 per years. 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.
Unlike a 401(k), a SIMPLE IRA cannot be rolled over into a traditional IRA without a two-year waiting period from the time you first joined a plan. SIMPLE IRA accounts can accept transfers from SEP IRAs, traditional IRAs, and employer-sponsored plans such as a 401(k).
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 gives employers the ability to contribute to traditional IRAs (SEP-IRAs) set up for employees.
An 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) or individual 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) up to the individual limits described below. There is no equivalent solo 403(b)..
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 you have a second job where you are an employee and have access to a 401(k) through your employer, your contribution limits are a combination of your employer 401(k) and solo 401(k), not to each separately.
A Keogh plan is available to you if you are self-employed or employed in an unincorporated business. These are not available to employees of independent contractors. Contributions are tax-deferred and can be either an employee benefit and funded by the employer, like a pension, or funded with your contributions.You may contribute up to the lesser of 100% of your compensation or $61,0000 in 2022.
Keogh plans have more administrative requirements and higher upkeep costs than the other types of retirement plans.
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). An IRA is a type of retirement account to which individuals can make contributions where the investments in the account grow tax-deferred. They are available at financial-services companies like large banks, brokerage companies, federally insured credit unions, and savings and loan associations. The institution will manage your account by investing the money according to your preferences.
Each spouse can have their own IRA under their name and tax identification number, but joint IRA accounts do exist.
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, non of which have an age limit to contribute. The biggest differences between them are when you pay income taxes, whether or not there are modified adjusted gross income eligibility limits to contribute, and any age limits for required minimum distributions.
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.
You cannot take loans from an IRA account, although there are specific times outlined below you that can remove funds without penalty before you reach 591/2 years old.
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. You must make any contribution before the IRS tax-filing deadline of April 15, 2022.
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), just the $6,000/$7,000 (50 years or older) annual limit and limits on tax-deductible contributions.
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, with some exceptions. Although you’ll owe taxes on the distribution, t here will be no penalty if you withdraw:
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. You can contribute to a Roth even if you have a 401(k). Whether you can contribute directly to a Roth IRA depends on your marital status and modified adjusted gross income.
2022 Income Categories
You can invest in things other than the traditional ones, like cryptocurrency, if you choose a self-directed Roth IRA.
You can circumvent the income limits by starting with a traditional or nondeductible IRA that has no income limits and convert it to a Roth IRA following specific rules. This is referred to as a Backdoor Roth IRA.
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:
Rollover IRAs are traditional IRAs that receive funds from another retirement account before you can remove money without penalty at 59½ years old. There are advantages of doing this, such as moving money from an employer sponsored to an individual retirement account to have more control over the investments or moving the money to a less restrictive IRA, whether it’s to have easier access to the money or not have income limits.
Most payments you receive from a retirement plan or IRA before this age can be “rolled over” by depositing the payment in another retirement plan or IRA within 60 days. The money can also be rolled over by having the distribution go directly to the new account. You can roll over all or part of any distribution except:
Tax implications of rollovers can be complicated and best discussed with your agent or plan administrator.
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 process of naming a beneficiary that is not your spouse is complicated and should be handled by a financial advisor that understands the rules.
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. There are three types of beneficiaries:
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
Your surviving spouse can transfer the money from any type of retirement account into their own retirement account. They have 60 days from receiving distribution to do this, as long as the distribution is not a required minimum distribution (RMD). They will then follow the specific rules of the account type based on their age (less than or more than 59½ years old).
Your spouse can take over your IRA account and manage it as if it were their own, including the calculation of required minimum distributions. If you have a 401(k) or similar employer sponsored plan it must be rolled over into an inherited IRA.
Since non-spousal beneficiaries of inherited IRAs and 401(k)s or other employer sponsored retirement accounts cannot add inherited account balances to their own, they may have two options.
An inherited IRA, also known as a beneficiary IRA, is an account specifically opened by any beneficiary, spouse, relative, or unrelated person or entity (estate or trust), to roll over any type of inherited retirement account into.
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. You would do this for similar reasons as creating any testamentary trust, such as protecting your children from themselves or a step-parent, providing for a disabled child, or donating to a charity.