Planning for the Future
15 May 2023
Tax advantaged retirement plans are a key component of long term planning.
After several decades during which Social Security and pensions provided many people with a large chunk of the money they needed to live comfortably after they retired, some things have changed. While you may be entitled to income provided by your employer during your retirement, you’re increasingly likely to be responsible for contributing toward your own retirement needs.
Employer sponsored plans
Employers can offer different types of qualified retirement plans, though it’s legal to provide none at all. Some plans are funded and controlled by the employer, while others require your active participation. Some plans make promises about what your benefits will be when you retire, and others make no promises at all.
A defined benefit plan guarantees you a specific dollar amount, or pension, when you retire. It’s based on your salary or length of service, or a combination of the two. Your employer contributes enough to meet that amount and manages the way the assets are invested.
In a defined contribution plan, you or your employer, or sometimes both of you, contribute money to your retirement account each year. The amount you’ll receive in retirement is not guaranteed because it depends on the amount that’s contributed, the way the money is invested, and how those investments perform. However, because the plans are tax-deferred, no taxes are due on any earnings as they accumulate. This means your account has the potential to grow faster and ultimately provide more retirement income than an account on which you paid income tax on earnings each year.
Profit-sharing retirement plans are funded by your employer, based on annual profits. They make no payment guarantees. The company determines the rate of contributions each year. In lean years, there may be none at all. In some but not all of these plans, you can choose the way the money contributed in your name is invested.
Time on the job
If you’re part of a defined-benefit plan and change jobs frequently, you’ll probably end up with a smaller pension than if you’d stayed put. Four jobs in 40 years rather than 40 years in one place can cut a pension in half.
Most defined benefit pensions are not adjusted for inflation, which means that each year the fixed amount you receive will cover fewer of your expenses. And some plans, known as paired pensions, reduce the pension to which you would be entitled by the amount of Social Security you receive. Income taxes are due on this retirement income, at the same rate as you pay on other regular income.
When you retire with a defined contribution plan, the money that has accumulated may be paid out as:
- A lump sum, known as a distribution
- A pension annuity, or in regular payments that vary over time based on the investment performance of the products in which your money is invested
You owe income tax on amounts you receive from a traditional tax-deferred account at the same rate that you pay on your ordinary income. However, if your employer has offered a tax-free retirement savings plan, such as a Roth 401(k) or a Roth 403(b), as well as a traditional plan, you may have chosen that way to save. Your contributions are not tax deferred, but you’ll never owe federal income tax on earnings that you withdraw, provided your account has been open at least five years and you are at least 59½.
Types of retirement plans
401(k)s and 403(b)s are two of the employer-sponsored plans that you are most likely to come across. But there are also IRAs, which you set up for yourself.
You participate in a 401(k) plan by contributing part of your salary into an account set up in your name. You defer pretax income, which reduces the income tax you owe in the year you make the contribution. Any earnings in the account are federal income tax deferred. You pay tax on all withdrawals at your regular rate, determined by your filing status and tax bracket. You can contribute up to the federal maximum allowed, plus an annual catch-up contribution if you’re 50 or older. Your employer may match some or all of your contributions.
With a 401(k), you are responsible for making your own investment decisions by choosing from among investment alternatives offered by the plan. These alternatives may include mutual funds, variable annuity separate accounts, fixed-income investments, and sometimes company stock. If you change jobs, 401(k) plans are portable, which means that you can move your accumulated assets to a new employer’s plan, if the plan allows transfers, or to a rollover IRA.
A 403(b) plan, sometimes known as a tax-sheltered annuity (TSA) or a tax-deferred annuity (TDA), is for employees of not-for-profit organizations. Your contributions to a traditional 403(b) are tax deductible, and any earnings are tax deferred. There’s an annual contribution limit, but you can add an additional catch-up contribution if you’re 50 or older.
With a 403(b), you may be responsible for making your own investment decisions by choosing among investment alternatives offered by the plan, though not all plans offer choice. You can roll over your assets to another employer’s plan if the plan allows transfers or an IRA when you leave your job, or to an IRA when you retire.
IRAs, or individual retirement accounts, are tax-deferred, personal retirement plans. Their tax-deferred status means that you owe no tax on your earnings until you withdraw. You can contribute every year you have earned income whether or not you participate in an employer’s retirement plan. There are two types: the traditional IRAs, to which contributions may be deductible or nondeductible, and the Roth IRA.
IRAs are not employer-sponsored. Instead, you open an individual retirement account with a financial services firm, such as a bank, brokerage firm, or investment company, as custodian. The accounts are self-managed, which means you can choose among the investments available through your custodian.
There are annual contribution limits, catch-up provisions if you’re 50 or older, and restrictions on withdrawals before you turn 59 1/2. IRAs have required minimum distributions (RMDs) after you turn 73.
Earnings withdrawn from a traditional IRA are taxed at the same rate as your ordinary income. So are the contributions if you qualified to deduct them for the year they were added to your account.
With a Roth IRA, you make after-tax contributions and may withdraw earnings tax free any time after you turn 59 1/2, provided your account has been open at least five years. You can make a nondeductible annual contribution, up to the annual federal limit, any year you have earned income, even after you turn 73, though you can never contribute more than you earn. If you are 50 or older, you may also make annual catch-up contributions.
You may also be able to withdraw earnings before 59 1/2 if you qualify for certain exceptions, such as using up to $10,000 toward the purchase of a first home. Tax will be due on the earnings you withdraw, but not the 10% early withdrawal penalty.
Unlike with a traditional IRA, Roth IRAs have no required withdrawals during your lifetime, and you can continue to accumulate tax-free earnings as long as you like.
To make a full contribution to a Roth IRA, your modified adjusted gross income (MAGI) must be less than the annual limit set by Congress. You may make partial contributions on a sliding scale if your MAGI is between the amounts that Congress sets for your filing status.
When it’s yours
If you’re part of a retirement plan, what happens if you leave your job? It depends on the type of plan it is.
With a defined benefit plan, you’re entitled to the value of the amount you qualify to receive based on your salary and years or service provided you’re vested, or have worked there long enough to qualify for a pension. In what is called graded vesting, in 2023, you are 100% vested in employer sponsored retirement plans after six years, or 40% after three years, increasing by 20% each year to 100% after seven years. Usually, though, if you leave to take another job, you don’t get any payout until you reach retirement age. And since no contributions are added, the account may not provide much income.
With a defined contribution plan, any contributions you’ve made are automatically yours, though you have to be vested to be entitled to employer contributions. The vesting schedule is a bit shorter, as you either qualify for the full amount after three years, or for 20% after two years increasing by 20% each year to 100% after six years. You can always roll the money in your account into an IRA or sometimes into your new employer’s plan and continue to build it. That’s why the plans are described as portable.
The trade off
Because earnings on retirement plan investments have tax advantages, you agree, as a condition of participating, that you’ll leave the money invested until you reach at least age 59½. If you withdraw it before then, you usually have to pay a 10% penalty in addition to the tax that’s due. There are some exceptions. Often if you’re at least 55 and you retire or lose your job, you can collect retirement income without owing the 10% penalty. Some employers, including the federal and state governments, pay pension benefits to people who have been employed for the required number of years, such as 20. No tax penalty is due on that income.
Retirement plan distributions basics
When you retire or take a new job, you can leave the money in your retirement plan, have it rolled over into an individual retirement account (IRA) to preserve its tax-deferred status, or you can take a lump-sum withdrawal of the entire amount.
- If the assets in your account are worth at least $5,000, you can leave the money in your old employer’s plan. If the balance is between $1,000 and $5,000, your employer has the right to roll the money into an IRA established in your name if you don’t provide instructions about what you want done with it.
- You can have the money rolled over directly into another qualified retirement plan if the plan accepts rollovers or to an IRA, where it can continue to grow tax deferred. You’ll owe no tax until you begin withdrawing.
- You can get the money yourself, keep it for up to 60 days (using it any way you want) and then roll it into an IRA so that it continues to grow tax deferred. However, if you receive the money even briefly, your employer must withhold 20% of the total. If you want to keep the full amount tax deferred, you must make up the missing 20% from another source, such as savings.
- You can withdraw the money, pay the taxes that are due, and reinvest the account value any way you like. If you’re younger than 59½, you may owe a 10% penalty plus the taxes.
- If you’re handling a rollover yourself, you must deposit the entire amount (including the 20% that’s withheld) or be vulnerable to taxes and penalties. The 20% that’s withheld will be refunded after you file your income tax return only if you make the full deposit.
- The one thing you don’t want to do is use a distribution for everyday expenses instead of keeping it invested.
This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information.
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