Chapter 5
IN THIS CHAPTER
Reviewing the features of retirement accounts
Surveying the different types of accounts you can choose from
Taking care of your retirement account balances
Naming beneficiaries for your retirement accounts
Becoming familiar with required minimum distributions (RMDs) from retirement accounts
One of the virtues and drawbacks of living in the United States is that you have plenty of choices — sometimes too many. And that’s certainly the case with the numerous types of retirement accounts and variety of investments; far more options exist here than in just about any other country in the world.
With so many choices you may be confused about which options are best for you. Selecting the best ones is important because you can end up saving yourself more tax dollars and making more after-tax money in the long run. And whether you’re entering retirement or still a decade (or more) away, you should understand the nuances and rules of each type of account so you can not only make good decisions but also comply with the myriad tax rules.
In this chapter, we discuss the common types of retirement accounts to which you may contribute. We also discuss early withdrawal penalties, beneficiary decisions, transfer and rollover rules, and borrowing from or against retirement accounts.
Before you can use retirement accounts to your benefit, you first need to know the advantages to using them and the potential drawbacks. We lay out these pros and cons in the following sections. Keep this important information in mind as you consider the different types of retirement accounts available. (We discuss your options in the section “Identifying the Different Types of Retirement Accounts” later in this chapter.)
The main attraction of any retirement account is the tax savings it provides. You generally receive upfront tax breaks on your contributions up to a certain limit. For example, suppose you’re able to contribute $1,000 per month ($12,000 per year) into a tax-deductible retirement savings plan like a 401(k), 403(b), or SEP-IRA. (The various types of retirement accounts are detailed later in the chapter in the section, “Identifying the Different Types of Retirement Accounts.”) Assuming that between federal and state taxes you’re paying about 35 percent in taxes on your last dollars of income, you should see your federal and state tax bills decrease by about $4,200 ($12,000 × 0.35). This immediate savings is usually enough of an incentive to encourage folks to build wealth by funding retirement accounts.
Because the money contributed to the retirement account isn’t taxed at the federal or the state level in the year in which the contribution is made, your take-home pay shrinks by much less than the $1,000-per-month contribution. In the example in the prior paragraph, income taxes would go down $350 monthly, so the after-tax cost of the $1,000 monthly contribution would be just $650 monthly. Unfortunately, directing money into retirement accounts doesn’t allow you to avoid current Social Security and Medicare taxes on wages you earn during the year.
Your income tax rates need to rise significantly from current levels to eliminate the tax-deferral benefits. Even though income tax rates for some individuals may rise in the future, the benefits of tax-deferred contributions and investment income should outweigh the increased tax burden you may face when these funds are withdrawn. For example, say your tax rate at the time of contribution is 35 percent. Table 5-1 shows how high your tax rate would need to increase to wipe out all your tax-deferral benefits over the years.
TABLE 5-1 Retirement Tax Rates That Would Negate Tax-Deferral Benefits
Number of Years Contribution Compounds |
Tax Rate That Eliminates Benefits |
---|---|
10 |
50% |
15 |
56% |
20 |
61% |
25 |
66% |
30 |
70% |
35 |
74% |
40 |
77% |
As you can see from the table, the longer your money is invested, the higher your tax rate would have to rise to wipe out the tax-deferred compounding benefits you reap when using a retirement savings plan. After the money is in the account for 30 years, your tax rate would have to double (from 35 percent to 70 percent) to eliminate the tax-deferred compounding benefits.
Some people contribute little or no money to retirement accounts because of worries about having access to their funds. Although investing your money in a retirement account may limit your access to the money in the short term, overall the investment is a smart move for your retirement in the long run.
Different employers and employment situations present unique retirement account options. In this section, we explain the common retirement accounts you’ll confront and how they work.
When you work for a company or organization, you may have access to an employer-sponsored retirement savings plan. In this case, the company provides access to an investment firm through which you can contribute money via payroll deductions. Plans have rules specifying, for example, how long after becoming an employee you must wait to begin participating in the plan, company matching contributions, and the overall limits of how much you may contribute to your account.
The good news with this type of plan is that your employer has done the legwork and maintenance for the plan. The potential bad news is that you’re at their mercy if they don’t have a good plan.
For-profit companies may offer 401(k) plans. Nonprofit organizations can offer 403(b) plans. Government employees may have their own plans such as a 457 plan for state and local government workers and the Thrift Savings Plan for federal government employees. These plans are similar in that contributions into them from your employment earnings aren’t taxed at either the federal or state level.
Another type of retirement plan is the self-employed retirement savings plan. One of the biggest benefits of earning self-employment income is the ability to establish a tax-sheltered retirement savings plan. Some of these plans allow you to contribute more than you likely would be saving on a tax-deferred basis for an employer.
With a Simplified Employee Pension Plan-Individual Retirement Arrangement (SEP-IRA), you may contribute up to 20 percent of your self-employment income up to a maximum of $58,000 for tax year 2021. In order to determine the exact maximum amount that you may contribute from self-employed income, you need to have your completed Schedule C tax form so you know your business’s net income for the year. When you as the employer establish an SEP-IRA, you must offer this as a benefit to employees if you have them. To find out more about setting up these types of accounts, see the nearby sidebar “Establishing and transferring retirement accounts.”
Your contributions to an SEP-IRA are excluded from your reported income and are thus exempt from current federal and state income taxes. The earnings that accumulate on your savings over time also are exempt from current income taxes. You pay taxes on your contributions and earnings when you withdraw them, presumably in retirement, which is when you’re likely in a lower tax bracket.
Self-employed people also can consider an individual Roth 401(k). As with a Roth IRA, an individual Roth 401(k) enables you to contribute money on an after-tax basis into an account that allows for tax-free compounding of investment returns and tax-free withdrawals after age 59½. This latter benefit — tax-free withdrawals — doesn’t exist for other traditional retirement plans such as 401(k)s, 403(b)s and SEP-IRAs and can be quite valuable. The 2021 contribution limit for the individual Roth 401(k) is $19,500 if you're younger than age 50. Those age 50 and older can contribute up to $26,000.
So, why might you want to contribute to an individual Roth 401(k)? Those who are later in their careers may consider these company-based Roth accounts if looking ahead to their retirement years, they are likely to be in a high or higher tax bracket. This may be the case for folks who have already accumulated significant balances in tax-deferred retirement accounts.
As retirement income rises, a portion of Social Security benefits is taxed. (See Chapter 10 for details.) Higher-income retirees also are subject to a Medicare premium surtax, known as the Income-Related Monthly Adjustment Amount (IRMAA). (See Chapter 11 for details.) Distributions from a Roth 401(k) aren’t included in income when these two taxes are computed, unlike distributions from traditional 401(k)s and IRAs.
The Roth 401(k) can also make sense for those currently in a relatively low-income tax bracket and therefore won’t save much on current income taxes by contributing to a traditional retirement account that offers upfront tax breaks. Thanks to the Tax Cuts and Jobs Act that took effect in 2018, federal income tax rates are relatively low in the United States now.
What if you work for an employer that doesn’t offer a retirement savings plan? You can certainly lobby your employer to offer a plan, especially if it’s a nonprofit, because little cost is involved. Absent that, you can consider contributing to an Individual Retirement Arrangement, or IRA. You may contribute up to $6,000 in 2021 as long as you have at least this much employment (or alimony) income. Those folks who are age 50 and older may contribute up to $7,000 in 2021. The annual limit is adjusted for inflation annually but the additional contribution for those age 50 and older is fixed by law at $1,000.
One of the most important decisions you’ll make with your retirement accounts is what to do with your money in your accounts when you retire. Make the right choice and do the transaction properly, and your after-tax retirement income will be greatly increased. Make a mistake, and you’ll pay far more taxes than you need to. You may also incur additional fees and expenses.
The most common rollover is from a 401(k) plan to an IRA. There are other types of rollovers, however. Money can be moved from one 401(k) to another, from one IRA to another, and from a defined benefit pension plan to an IRA, to give three common examples. But the 401(k)-to-IRA rollover is the most common and probably the most important. In this section, as an example, we focus on the important (and common) decision of how to handle a 401(k) account balance when leaving an employer.
You should begin planning what to do with your 401(k) account balance before you leave the sponsoring employer to ensure that you have sufficient time to research and get comfortable with what you’re going to do with your money. Too many people make their plans for travel and other activities for the first six months of retirement, but then they give no thought to what to do with their 401(k) balances until presented with their options as they’re leaving the job.
Most 401(k) plans offer several options for handling an account balance when you leave your employer. Here, we discuss those options and the issues to consider for each one:
Leave the balance in the plan until distributions begin. This option can be a good idea when you like the plan because of its investment options, low costs, or other features. The plan also may allow you to take loans from the account, which can make the plan a source of emergency cash.
However, depending on your circumstances, you may not want to leave your money in the plan for several reasons. For example, you will have more investment options by rolling the balance into an IRA. In addition, the employer could increase fees and change plan offerings between the time you quit and the day you begin receiving distributions. Due to rules and restrictions, most 401(k) plans also are less flexible about post-retirement distributions than IRAs.
Look into annuity options. The plan may offer an annuity option, making fixed, guaranteed payments to you for life or for a period of years, which can be attractive. Look at all your options though; you may find higher payments available through commercial annuities purchased through an IRA. (For more on annuities, check out Chapter 7.)
When your employer offers an attractive annuity but you don’t want the entire account turned into an annuity, you can purchase the annuity with part of the account. The annuity portion can be distributed directly to you, and then taxes are paid only as annuity payments are received. The rest of the account can be rolled over to an IRA.
After deciding that you want to roll over your 401(k) balance to an IRA, determine who will be the IRA custodian. The custodian is a broker, mutual fund firm, bank, insurance company, or other financial services company that offers IRAs. When considering which custodian to choose, consider the following (check out Chapter 4 for more details):
After you select your custodian, you basically have two ways to roll over a retirement account balance:
Option 1: The trustee for your employer’s plan can issue a check to you or make a direct deposit into your bank account. You have 60 days to deposit the check (or an equivalent amount) into an IRA or other qualified retirement plan. If you fail to make the transfer within 60 days, you’ll owe income taxes; and if you’re under age 59½, you may owe a 10 percent early distribution penalty.
This type of rollover has a potential land mine. When the check is made out to you, the trustee must withhold 20 percent of the account balance for income taxes. The taxes will be refunded to you after you file your tax return and show that you rolled over the account balance within 60 days. But you must deposit in the IRA the entire 401(k) account balance, not only the amount distributed to you. As a result, you must come up with an amount equal to the 20 percent that was withheld and roll that into the IRA along with the amount that was distributed.
Option 2: The other form of rollover is the trustee-to-trustee transfer. The 20 percent withholding isn’t required when the distribution check is made payable to a specific IRA custodian instead of to you.
Here’s how this easy transaction works:
This method is the easier and safer way to roll over your IRA, because it avoids the possibility of missing the 60-day deadline of the other method and can be done an unlimited number of times. All you have to do is be sure the 401(k) balance is transferred to your IRA. Sometimes a mistake is made, and the transfer is made to a taxable account instead of an IRA. If this isn’t corrected promptly, you will owe income tax on the entire amount.
Why would anyone choose Option 1 when they can avoid the hassle of rounding up the extra cash by choosing Option 2? Some employees choose inferior Option 1 because they don’t know better and their employers don’t warn them before issuing the check. You’ve now been informed and won’t make that mistake!
When you create a retirement account, you need to make sure you select the beneficiaries who will receive the proceeds in the event of your passing. Your will doesn’t determine who inherits your IRA and other qualified retirement plans. The account is inherited by whoever is named beneficiary on the beneficiary designation form on file with the plan custodian or trustee.
When choosing your beneficiary, take the time to select the person (or persons) you want to receive your money. Often people don’t give much thought to this important designation. Most folks simply write down an obvious beneficiary when they open the account and don’t give much thought to it again. In the meantime, they may have been married or divorced, or had children or grandchildren. The account probably has grown into a significant asset over time, yet the beneficiary choice hasn’t been reconsidered through all these changes.
You need to give some thought to your beneficiary choice as part of your overall estate plan, and you should review that choice every few years. Here are some guidelines to follow:
Consider splitting your IRA. When you have children but no surviving spouse (or your spouse will have significant non-IRA assets), your children likely will be named equal beneficiaries of your IRA. When children inherit IRA funds, they must agree on investments and distributions.
Your children have the right to split the IRA into separate IRAs for each of them. You may want to split the IRA now instead of waiting for the kids to work things out. This split gives you more control over the amount of assets each child inherits. It also allows you to name different contingent beneficiaries for each IRA. If you want a trust to control the inheritance of only one beneficiary, splitting the IRA makes this easier. Otherwise, the other beneficiaries have to coordinate their management of the IRA with the trustee.
But a 2019 law changed that. Now, most inherited IRAs have to be fully distributed to the beneficiaries within ten years. There are exceptions for IRAs inherited by surviving spouses, minor children, those who are disabled, and someone who is fewer than ten years younger than the IRA owner. The ten-year rule applies to both traditional IRAs and Roth IRAs, as well as 401(k) accounts.
In your planning, be aware that most beneficiaries won’t be able to defer taxes on an inherited IRA for more than ten years. That might change your choice of beneficiaries or the instructions you give the beneficiaries about how to handle an inherited IRA.
The main purpose of investing in an IRA or other qualified retirement plan is to help you financially during your retirement years. As a result (and because he wants to collect taxes), Uncle Sam requires that you start taking distributions at a certain age. Through 2019, you had to begin annual required minimum distributions (RMDs) from IRAs and other qualified retirement plans no later than by April 1 of the year after you turn age 70½.
Effective with 2020, RMDs must begin no later than by April 1 of the year after you turn age 72. This change came about from the Setting Every Community Up for Retirement Enhancement (SECURE) Act.
The following sections help you calculate your RMD with an IRA and with other types of retirement accounts.
To calculate your RMD for 2020 and following years, you can do the following:
Divide this amount by your life expectancy.
The result of dividing your IRA balance by your life expectancy is your RMD for the year. The good news is you don’t have to do the math regarding your life expectancy. Instead you must consult the life expectancy tables in IRS Publication 590-B (available free at www.irs.gov
). Most people use the “Uniform Lifetime Table.”
You use a different life expectancy table, the “Joint Life and Last Survivor Expectancy Table” if you’re a married IRA owner whose spouse is the primary beneficiary of the IRA and is more than ten years younger.
The IRS finalized new regulations in 2020 with revised life expectancy tables. The new tables are scheduled to take effect for 2022 and later years. Be sure you use the latest tables to calculate the RMDs. The difference is not a lot, but the new tables do reduce the RMD amount.
Repeat the calculation each year.
For the first RMD, use the IRA balance as of December 31 of the year before you turned 72, not the year before the April 1 deadline. The first RMD, though delayed until April 1 of the year after turning 72, really is the RMD for the previous year. If you wait until April 1 to take the distribution, you’ll have to take two distributions in that year: the previous year’s distribution, and the current year’s distribution that’s due by December 31. Taking two distributions in one year could push you into a higher tax bracket. Overall taxes may be lower if the first distribution is taken by December 31 of the year you turn age 72.
So, for example, if Rick turned 72 in January 2021 and Corrine turned 72 in December 2021, each must take his or her first RMD by April 1, 2022. Subsequent RMDs must be taken by December 31 of each year. If you fail to take an RMD, the penalty is 50 percent of the distribution that should have been taken. Ouch!
When you own more than one IRA, compute the RMD for each IRA. You then can add all the RMDs together as one to compute the aggregate RMD. You can withdraw that amount from the IRAs in any combination you want. Take it all from one account, equally from the different accounts, or in any other way you want. Just be sure that by December 31 your distributions equal (or exceed) the aggregate RMD.
All qualified retirement plans — profit-sharing, 401(k), and pension plans — must make RMDs. The basic calculation is the same as for IRAs, but there are some important differences with employer plans.
For employer-sponsored plans (but not for IRAs, SEP-IRAs, and SIMPLE IRAs), the required beginning date is delayed when you’re still working for the employer and don’t own more than 5 percent of the employer’s stock. The first RMD is delayed until April 1 of the year after the year in which you retire. Also, for money contributed to a 403(b) plan before 1987, RMDs may be delayed until age 75.
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