There are lots of different types of retirement plans out there. Among others, there are IRAs, 401(k)s, 403(b)s, 457(b)s, TSAs, and pensions. What are they? What do they do? And how are they taxed?
Today, we will discuss the most common retirement plans that we see come through our office. Before we can talk about the specific retirement plans, we have to discuss the two general types or categories of retirement plans, defined benefit plans and defined contribution plans.
Defined Benefit Plans. Defined benefit plans were once the most common type of retirement plan, and what is often called the traditional pension plan. With a defined benefit plan, when you retire, you receive a monthly pension benefit. There is usually no lump-sum that is available for you to withdraw upon retirement.
With defined benefit plans, the company is taking the investment risk. As a result, many employers have huge unfunded pension liabilities. In order to minimize this liability, many employers have frozen and/or eliminated their defined benefit plans, and now have defined contribution plans.
Defined Contribution Plans. On the other hand, with defined contribution plans, there is usually an account that is set up for you. Deposits are made into the account, either by you, your employer, or both. With a defined contribution plan, your employer’s liability is limited to the contribution and you are taking the investment risk. Upon your retirement, you make regular withdrawals out of the retirement fund, in order to pay your bills.
Generally, you can start to make withdrawals out of your retirement fund after age 59½ without penalty. Prior to age 59½, unless you qualify for certain exceptions, withdrawals carry a 10% early withdrawal penalty tax. After age 70½, you must start to take the required minimum distribution out of your retirement fund each year. If you do not take your required minimum distribution in any given year, you are usually subject to an excise tax of 50% of the shortfall.
Traditional Pension Plans. The defined benefit plan that we see most frequently are traditional pension plans. With traditional pension plans, you qualify for a monthly pension benefit after you have worked a certain number of years with your employer and/or reached a certain age. If your employer made all of the contributions to the pension fund, the monthly distributions to you generally would be taxed as ordinary income.
Some pension plans allow (or require) you to make contributions to the plan from your wages. Your contributions can be pre-tax, on which you have paid Medicare and Social Security taxes, but not income taxes. Or your contributions can be post-tax, on which you have paid Medicare, Social Security and income taxes.
If all of your contributions are pre-tax, then your entire pension benefit will be taxable. On the other hand, if some of your contributions are post-tax, then a portion of your monthly pension benefit will typically be income tax free.
Wage Deferral Plans. Wage deferral plans are probably the most common retirement plans that we see nowadays. For private employers, they are usually 401(k)s or SIMPLE plans, with a few SEPs still out there. With governmental employers, we see 403(b)s, also called tax sheltered annuities or TSAs. Nonprofit employers often have 457(b)s.
If you have a wage deferral plan at work, you may not realize it, but it can be one of the best deals going for you. With a wage deferral plan, you take part of your paycheck and deposit it into a plan account. And with some of these plans, your employer may make contributions or match all or a part of your wage deferral. Take advantage of these employer matches. It is free money.
Your wage deferral and any company contributions are pre-tax dollars. Some plans allow you to make post-tax contributions. The amounts in these accounts are never taxed until withdrawn. In the meantime, they compound income tax-free. Upon withdrawal, with the exception of the portion that is allocated to your post-tax contributions, the amounts are taxed as ordinary income. The age 59½ and the age 70½ rules also apply.
Some financial advisors recommend deferring 15% of your wages. I recommend deferring at least 20%. And you should start as soon as possible. When you start saving when you start working, you won’t miss it. You then start living on the reduced income. You will thank yourself later. If you invest $500 per month starting at age 20 and it earns 5%, you will have over $1 million when you retire at age 65.
Traditional IRAs. Traditional IRAs are generally treated like employee pre-tax contributions to a wage deferral plan plan. Your contributions to your IRA are reductions of your taxable income. When the contributions and earnings come out, it is all taxable as ordinary income. The age 59½ and the age 70½ rules also apply.
Be careful of the investment vehicles you use for your IRAs. There is no shortage of annuity peddlers out there who will encourage you to “invest” your IRA dollars in deferred annuities, which are among the highest commission financial products available. Annuities are not investment vehicles, they are a wrapper to defer taxes on your investments, often for a fee of 1% per year.
IRAs are already deferring your income taxes until withdrawn. You do not need a tax deferral vehicle within a tax deferral vehicle. Also, most deferred annuities I have seen have the same or similar investments you could make outside the annuity, without the 1% fee. And in addition, annuities have surrender charge penalties if you make withdrawals before a certain time period which I have seen as long as 20 years and/or you make withdrawals in excess of your required minimum distribution.
I saw one case in which a husband had to cash in his wife’s IRA annuity in order to qualify her for Medicaid to pay for her nursing home care. Because the withdrawal was more than the required minimum distribution, the annuity company levied a 50% surrender charge penalty. They had had to pay income taxes on the other half of the IRA she did receive, to the tune of around 30%. After all was said and done, they only ended up with about 35% of the IRA.
Roth IRAs. Your contributions to your Roth IRA are made with post-tax dollars which do not reduce your taxable income. You are not required to make any minimum distributions from your Roth IRA during your lifetime. However, generally, if distributions from your Roth IRA occur after age 59½ and at least 5 years after your first contribution to your Roth IRA, all distributions are income tax free, including all your Roth IRA earnings. For Roth IRAs, the 10% early withdrawal penalty before age 59½ is only upon the income portion of the distribution, but it also applies when distributions are made within the five tax years after the year the Roth IRA is established, regardless of age.
There are a number of other tax advantaged retirement plans out there. We have only touched upon the most common ones that we see on a regular basis in our practice. There are contribution and income limitations on many retirement plans. There are also many special rules and exceptions to the general rules that we have not covered today. When you are contemplating these types of investments, please consult with knowledgeable investment and/or tax advisor.
By: Matthew M. Wallace, CPA, JD
Published edited February 1, 2015 in The Times Herald newspaper, Port Huron, Michigan as: There are plenty of options for retirement plans