In this article we are going to cover everything you need to know about retirement plans and how they will be tested on your FINRA Exam
In a taxable account, the account balance is reduced annually when the investor is taxed on interest, dividends, and capital gains. In a tax-deferred account, however, the principal and income are not taxed unless and until the individual begins taking distributions from the account. The account balance grows faster when growing on a tax-deferred basis.
Tax-deferral is an important advantage of deferred annuities, education savings, and retirement accounts. Whether one’s contribution is tax deductible, the fact that the interest, dividends, and capital gains are not taxed each year is an advantage to the investor.
Some retirement plans are offered through an employer; others are initiated by the individual. An IRA is an individual retirement account or, alternatively, an individual retirement arrangement.
To contribute to a traditional IRA, the individual must have earned income (salary, wages) for the current year. If the individual’s income consists solely of portfolio income (bond interest, dividends) or passive income (rental income, partnership interests), no IRA contribution can be made for that year.
Contributions to an IRA are typically tax deductible. That means if the account owner contributes $5,000 to an IRA during the current year, that $5,000 no longer counts as taxable income. If the individual would have paid tax on $52,000, it is now only $47,000 of taxable income for the current year.
If the individual does have earned income for the year, the maximum contribution is 100% of that earned income up to the current maximum. But, if the earned income is only $3,800, then $3,800 is the maximum IRA contribution for that year. People 50 years and older can add a catch-up contribution; that amount is currently an extra $1,000.
At the time of this writing, the maximum contribution to a traditional IRA is $6,500/$7,500 for those 50 or older. However, most exams will not test you on the exact contribution limit. For current limit information you may visit the IRS website here:
Whatever the annual contribution limit, over-funding an IRA results in a 6% tax penalty on the amount above the maximum contribution for the year and any earnings associated with it. If the individual realizes the IRA has been overfunded for the year, the excess can be removed by the tax-filing deadline of the following year or re-characterized as part of the following year’s contributions by the deadline. If it is not removed or re-characterized, the excess—and any earnings associated with it—is subject to a 6% penalty tax.
A larger problem for most individuals is avoiding the temptation to withdraw funds early to cover a financial emergency. If they withdraw funds before age 59 ½, they pay a 10% penalty on top of the ordinary income tax due on the withdrawal. So, for example, a withdrawal of $20,000 would involve a $2,000 penalty plus taxes on $20,000 of income, which could easily be anywhere between $5,000 and $8,000.
After settling up with the IRS, the individual might be left with just over half the amount withdrawn, an extremely inefficient movement of funds.
However, the following are qualifying exemptions to the 10% penalty. Although the withdrawal is taxable as always, the 10% penalty is waived for withdrawals before age 59 ½ made pursuant to the following:
A withdrawal pursuant to death means the IRA owner has died before reaching age 59 ½, and someone else is receiving the account balance as a named beneficiary. In this case, the beneficiary will be taxed but will not be penalized. Unlike a taxable account, which may or may not name a beneficiary, IRAs and other retirement accounts are presumed to name one or more beneficiaries.
Therefore, although the probate process can be slow and costly, assets such as insurance policies, bank accounts, and investment accounts are typically transferred outside that process, directly from account owner to the named beneficiaries.
On the back end, the account owner is required to begin taking required minimum distributions (RMDs) by age 72. If not, the IRS will impose a 50% insufficient distribution penalty. This is 50% of what should have been taken out at this point, not half the account value.
Although the SECURE act allows Traditional IRA owners to continue making contributions from earned income after age 72, required minimum distributions are still required. Therefore, such account owners will make both contributions to and distributions from the account.
Unlike a traditional IRA, a Roth IRA is funded with non-deductible contributions—sometimes termed, “after-tax dollars.” Contributing to a Roth IRA does not reduce taxable income for the year. However, the money is withdrawn tax-free in retirement provided the owner is 59 ½ years old at that time and has held the account for at least five years.
To illustrate the differences in the two account types, assume that the withdrawals taken from a traditional IRA are taxable income. If the account owner withdraws $30,000, perhaps only $22,000 is left after taxes. A withdrawal of $30,000 from a Roth IRA, on the other hand, leaves $30,000 to spend.
Unlike the owner of a Traditional IRA, the Roth IRA owner is not required to take a distribution by age 72. Since the IRS does not tax that money, it does not care when or even if it is withdrawn. Therefore, while both Traditional and Roth IRA owners can contribute to their accounts from earned income past age 72, only Roth IRA owners can refrain from taking withdrawals.
Individuals or a married couple having an adjusted gross income above a certain amount cannot contribute any amount to their Roth IRA. Therefore, investors should begin depositing to Roth IRA accounts while still young and before becoming financially well-off. The money contributed during an individual’s 20s and 30s can compound for decades, even if the IRS cuts off new contributions by age 40 based on income level.
If an individual has both a traditional and a Roth IRA, the contribution limit is the total allocated among the two accounts, currently either $6,500 or $7,500 depending on age.
Also, the Roth IRA allows an individual younger than 59 ½ to remove her cost basis, or the amount contributed, after five years without penalty. Thus, if $25,000 has been contributed to a Roth IRA and seven years later the account is worth $40,000, the account owner could withdraw the $25,000 without penalty and retain the remainder of $15,000 in the account. The account owner could not re-deposit that $25,000, however, and would, therefore, not earn the tax-deferred and tax-free returns going forward that she might have.
However, if faced with a financial emergency, this would almost certainly be preferable to taking funds out of a traditional IRA.
Some individuals start with a traditional IRA and then convert it to a Roth IRA later on. However, this requires the individual to pay taxes on the entire amount going into the new Roth IRA, since Roth IRAs are funded with after-tax dollars. Even those individuals making too much money to contribute to their Roth IRAs can convert traditional IRAs to Roth IRAs.
Some people like to use their IRAs to invest in collectible items such as artwork, Persian rugs, antiques, coins, gems, stamps, etc. Funds withdrawn from the IRA to buy such items are considered distributed, meaning that the individual would pay ordinary income rates plus a 10% penalty if he is not yet 59 ½ years in age.
Investment in U.S.-minted gold or silver bullion coins is allowed for IRAs, as these possess intrinsic value. Collectible coins, on the other hand, are not considered suitable for this purpose.
Tax-exempt municipal bonds make poor investments for traditional IRAs. Because all money coming out of a traditional IRA is subject to taxation, the municipal bond’s tax advantage is destroyed, and the investor would therefore be left only with a lower yield than she could have received through corporate bonds.
It might seem strange, but the only way to obtain the tax advantage offered by tax-exempt municipal bonds is to hold them in a taxable account. As a general rule, high-tax-bracket investors hold municipal bonds in taxable accounts and corporate bonds only in tax-deferred accounts such as IRAs.
Does this imply that tax-exempt municipal bonds are suitable for Roth IRAs?
No. If it’s all coming out tax-free, there is no need to purchase tax-exempt bonds that, again, pay lower yields than corporate bonds.
An outstanding use of the Roth IRA, on the other hand, is for holding equity investments paying ordinary dividends, such as REITs. Rather than paying their marginal tax bracket on such dividends—as they would if holding them in taxable accounts—investors holding REITS in their Roth IRAs end up paying no tax on those dividends.
The best way to move a traditional IRA from one custodian to another is through a direct transfer, in which the current custodian transfers the account balance to the new custodian. The IRA owner can do as many of these direct transfers as needed. However, a rollover is subject to restrictions. First, the IRA owner can only do one rollover per year, and, second, it must be completed within 60 days to avoid tax ramifications, explaining why this is typically referred to as a “60-day rollover.”
Completing a rollover on the 61st day would not work. And, if an individual withdrew $50,000 during the rollover but could only come up with $10,000 sixty days later, that $40,000 difference would be taxed as ordinary income. In addition, the taxpayer/account owner would be charged a penalty tax of $4,000.
Plans offered through an employer either state the benefit to be received when the employee retires or, more commonly, the contributions made to the account. The former are “defined benefit pension plans,” while the latter are “defined contribution plans.”
Unlike a defined benefit plan, a defined contribution plan only defines the contributions that can or will be made to the plan. It does not promise a benefit the employee will receive at retirement. Rather, the contributions from the employee and/or employer are allocated into various investment vehicles, typically mutual funds, as directed by the employee. From there, the employee bears all the investment risks we explore in a separate section—market risk, inflation risk, and regulatory risk, etc.
At many companies, newly hired employees receive paperwork to complete concerning the 401(k) plan the employer sponsors as an employee benefit. Here, these employees indicate to the HR department the number of dollars that are to be deducted from their paychecks to pay into these 401(k) accounts and the allocation of these dollars among the selection of mutual funds available. Thus, part of their salaries goes into a retirement fund and is not currently taxable, just like the money that goes into a traditional IRA and the other defined contribution plans discussed in this section.
This benefit is attractive, especially when an employer matches the amount the employees elect to defer from each paycheck. The amount of an employee’s contribution is known as an elective deferral. As stipulated in their plan literature, employers generally match all or part of an employee’s elective deferral up to a stated percentage of compensation. However, employers are not required to make matching contributions.
Why might someone choose to participate in a 401(k) even if the company did not make matching contributions? Perhaps because of the higher maximum contribution limit compared to those for a traditional or Roth IRA.
For the business owner, an advantage to setting up a 401(k) plan is the ability to create a vesting schedule that is laid out over several years, meaning that employer contributions do not belong to an employee until he becomes fully vested. However, 401(k) plans come with complicated top-heavy rules that restrict the plan from providing benefits to only key, highly compensated employees. A plan in which 60% of the benefits go to key employees is a plan that shows signs of being “top-heavy,” and consequently the employer would be required to make the plan less top-heavy or face tax problems.
Traditional 401 (k) plans are funded with elective deferrals that are deductible from gross income, reducing the participant’s tax burden for the year. In other words, they are made pre-tax. That means all withdrawals in retirement are taxed at the retiree’s marginal rate of tax. Therefore, if the company offers it, many employees take advantage of the Roth 401 (k), funded with after-tax dollars. Like a Roth IRA, the Roth 401 (k) allows retirees to take tax-free distributions, provided the individual is at least 59 ½ and has had the account for at least five years. While any employer matches to the Roth 401 (k) are taxable, the after-tax elective deferrals from the employee’s paycheck come out tax-free in retirement.
While the Roth IRA has income limits that often prevent the account owner from making a contribution, no such limit exists for the Roth 401 (k). Also, as with the Roth IRA, the Roth 401 (k) has no required minimum distributions by age 72.
Whereas for-profit companies often offer 401(k) plans to their employees, non-profit organizations such as schools and hospitals often offer 403(b) plans to their employees. As with a 401(k) plan, an employee indicates how much of her paycheck should go into the 403(b) account, which simultaneously gives her a current tax break and helps her save for retirement later in life. Typically, employers match elective deferrals, as they do with 401 (K) plans. And, as with a 401(k) plan, contributions to a 403(b) plan enter pre-tax but come out taxable as ordinary income when the participant takes distributions.
Then again, as with the 401 (k) plan, many organizations offer participants a Roth 403 (b) plan, also funded with after-tax contributions. Provided the account owners are 59 ½ and have had the account at least five years, withdrawals from such accounts are tax-free. As with the Roth IRA and Roth 401 (k) the participant is not required to take minimum distributions at any particular age, and there are no income limits for purposes of eligibility.
403(b) plans can also be referred to as tax-sheltered annuities, or TSAs. Although the plans were once restricted to an annuity as the investment vehicle, since 1974 participants have been able to choose mutual funds as well, or instead.
Some states and cities have begun to shift the burden of funding retirement benefits to their employees. These so-called 457 plans are for state and local government employees, e.g., police and fire workers. Contributions are tax-deductible, and the plans use the same maximum contribution limits as those used for 401(k) and 403(b) plans.
Profit sharing plans are also defined contribution plans, but contributions to these are never required. If the company does contribute, the contribution must be made for all eligible employees based on a predetermined and equitable formula. For example, each employee comprises a percentage of the company’s total payroll, and so that employee’s share of the plan receives that same percentage of the total contribution made by the employer. The profit-sharing plan uses much higher maximum annual contributions than the 401(k), 403(b), and Section 457 plans.
A money purchase plan is not flexible in the same sense that a profit-sharing plan is. The money purchase plan requires the employer to make a mandatory contribution to each employee’s account, based on his/her salary. In a money purchase plan, contributions are mandatory on the part of the employer and discretionary on the part of the employee.
Keogh plans are for individuals with self-employment income or for those working for a sole proprietorship that has a Keogh plan in place. They are not for S-corps, C-corps, LLCs, etc.—only sole proprietors. Thus, an individual described in a test question as earning side income or as being self-employed can have a Keogh, and such individuals can contribute a certain percentage of their self-employment income into the Keogh.
How much? As with a SEP-IRA (discussed below), the business owner can put 20% of her compensation and 25% of her employees’ compensation annually into a Keogh.
Although Keogh plans are for sole proprietorships only, sole proprietorships are not restricted into having only a Keogh plan. A SEP-IRA would also be available to a sole proprietor, for example. The IRS refers to Keogh plans as “qualified plans for the self-employed.”
A small business can establish a SEP-IRA, which stands for “Simplified Employee Pension” IRA, and which allows the business owner to make pre-tax contributions for the owner’s account and any eligible employees. Twenty-five percent of compensation can be contributed to an employee’s SEP, up to the current maximum. As with a profit-sharing plan, SEP contributions are not mandatory, but if a business does make contributions to employee SEPs, they must do so for all eligible employees as stipulated in the plan agreement.
Notice that the business makes the contributions, not the employees. So, self-employed individuals can contribute to their own SEP-IRAs, but employees at a company with a SEP-IRA do not make elective deferrals. The employer either contributes to all employee accounts or chooses not to.
To establish a SEP, the employer employs a model agreement put out by the IRS that it and its employees sign. This agreement does not have to be filed with the IRS, however, which therefore does not issue an opinion or approval.
Even though a large contribution can be made to a SEP-IRA, that amount must represent 25% of employee wages. In other words, we often focus on the maximum amounts that can be contributed, but, to make contributions at all, a small business owner must be making a profit. Moreover, when contributing for employees, the business owner’s contributions are 25% of compensation, meaning that the only way for a contribution to a SEP-IRA to be large is for an individual employee to be making a high salary. For instance, 25% of a $33,000 salary is not going to make for a large contribution, whereas 25% of $140,000, would allow a $35,000 contribution to be made.
An employer who has only a few employees interested in retirement savings might choose to offer a SIMPLE plan. The SIMPLE plan is for businesses having no more than 100 employees and offering no other retirement plans. A SIMPLE plan can consist of either an IRA or a 401(k).
In a SIMPLE plan, business owners choose to either match employee contributions up to 3% of compensation or to contribute 2% of the employee’s compensation if no elective deferral is chosen. Most employers prefer the first method, so that matching contributions are only made for those employees who choose to defer part of each paycheck.
Unlike with a 401(k) plan, employees are immediately vested in both a SEP-IRA, or a SIMPLE plan.
Many companies reward key employees by offering them employee stock options, which do not trade among investors but are essentially free call options that allow employees to buy the company’s stock at a set strike/exercise price. As a motivation to the employee to remain with the company, employees are gradually awarded these options. In an ESOP, or employee stock ownership plan, a company allows all workers to purchase company stock at a discount and through a payroll deduction. Moreover, the stock and the dividends/cap gains generated on the cumulative shares of stock grow tax-deferred, as in a 401(k) plan.
Whereas the employee enrolled in a defined contribution plan bears investment risk, in a defined benefit plan the employer bears this risk and must, therefore, earn sufficient returns on its investments to pay a defined benefit to retirees and their survivors.
Perhaps the plan credits each year of service with 2.5% of the employee’s salary. After twenty years, the employee could receive 50% of current compensation, while after 30 years maybe the defined benefit maxes out at 75% of the employee’s average salary figured over the last three years of service. Therefore, if retiring from a position paying $70,000, the retiree receives $52,500 annually, plus a benefit to a spouse or child if the retiree should die within a certain period.
For example,
A defined benefit pension plan is established as a trust and so does not pay taxes on the income it generates. In fact, the company deducts the contributions it makes to the pension fund from taxable income. Therefore, since they are already tax-advantaged accounts, these plans do not typically invest in municipal securities.
Because corporations typically try to fund these plans only to the extent required, defined benefit plans require an actuary to certify that funding levels will be sufficient to cover future pension fund obligations.
In late 2019, the U.S. Congress passed the SECURE Act, which stands for Setting Every Community Up for Retirement Enhancement. This law makes sweeping changes to Traditional IRAs and some employer-based plans. First, individuals who turned 70 ½ on or after January, 2020 can now delay their RMDs until April 1st of the year following their 72nd birthday. Additionally, individuals with earned income may continue to contribute to a Traditional IRA indefinitely, as they were able to do only in a Roth IRA up until now.
Individuals participating in a 401 (k), 403b, SEP-IRA or SIMPLE plan have long been able to continue to make contributions as long as they are still working for the employer. While that remains the case, now older workers and retirees can also postpone their RMDs until age 72, as with the Traditional IRA.
However, if an individual chooses to contribute to a 401 (k), or Traditional IRA, etc., after age 72, the required minimum distributions are still required. The account owner will, therefore, deposit into and withdraw from the account, being sure to withdraw at least the required minimum for the year.
We hope this article helped you master retirement plans for your upcoming exam.
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