5 Retirement Plans to Know About

As the year comes to a close, I thought it would be a great time to discuss a few different retirement accounts. Retirement planning is a major part of an individual’s financial plan. The amount a person saves, how frequently they save, and when they begin saving will significantly impact a person’s retirement years. These factors help determine when a person can retire, how much they’ll have to live on, and how much they’ll be able to give away to heirs, charity, or others during their lifetime. Congress has enacted a variety of qualified retirement saving accounts and programs to better encourage Americans to save for their retirement, but most people know very little about them. While these programs can greatly aid most Americans, few truly know what type of accounts they have access to, how these accounts are taxed, or how these programs can benefit the average American.

Before we discuss these 5 different accounts, I think it would beneficial to discuss the difference between defined contribution plans and defined benefit plans. Whereas defined benefit plans promise a specified monthly benefit at retirement, defined contribution plans offer no such promise. See, defined benefit plans (or pension plans) require employers to set a pool of funds aside for their workers’ future benefit. While a pension plan may have a provision to allow workers to contribute parts of their salary to the plan, most plans will only feature employer contributions. The employer is then liable for this promised monthly payment, meaning they’ll be required to make up any gap in benefit if the fund under performs. While defined benefit plans used to cover as much as half of all private-sector employees, they now only cover roughly ten percent of all private employees. This decline can mainly be attributed to their complex administration and comparatively high annual costs.

On the other hand, defined contribution plans provide greater flexibility for employers. Under defined contribution plans, employers will often make contributions contingent upon an employee reducing their salary and contributing to the plan. Some situations, such as a profit-sharing plan, will even allow employers to forgo contributions all together. In comparison to defined benefit plans, the final benefit received under defined contribution plans will depend entirely on the amount contributed to the plan and how well the plan’s investments have performed. Because employers are not responsible for the ultimate monthly benefit, as compared to defined benefit plans, these plans are often much cheaper to maintain. As a result, their use as been on the rise in recent decades.

What follows is a brief breakdown of 4 different defined contribution plans (the traditional 401(K), traditional IRA, Roth IRA, and SEP) and a brief breakdown of pension plans.

1.      Traditional 401(k)

Perhaps the most well-known defined contribution plan, the traditional 401(k) is likely the most common qualified retirement account offered by employers. This type of retirement account allows employees to voluntarily reduce their salary by a specific percentage or amount and stash it away for retirement. To encourage this savings, employers will often match their employees’ contributions by a particular percentage.

Contribution Limits: In 2020, a taxpayer will be able to contribute up to $19,500/year into their 401(k) plan. For those taxpayers aged 50 and over, they’ll be able to contribute an additional $6,500, for a total of $26,000. It’s important to keep track of contributions, however, because excess contributions over this threshold are subject to a 6% penalty.

Investments: Employees will often be limited to the investments offered within the 401(k). To ease the administrative burden of these plans, the plan’s trustee will often limit the number of investments offered to plan participants. While there are usually several low-cost, indexed mutual funds available, compared to the number of funds available on the market, your selection may be severely limited.

Taxation on Employee: Perhaps the biggest benefit for the typical employee, contributions to a 401(k) are tax-deferred until distribution. That is, the money an employee contributes to their 401(k) won’t be taxed until they take a withdrawal in retirement. However, withdrawals from a traditional 401(k) will be taxed at ordinary income rates, whether it’s a withdrawal of principal or earnings.

Penalties: For those taxpayers younger than 59 ?, there is a 10% penalty imposed on distributions from 401(k) plans (on top of tax liability), unless those distributions meet one of several exceptions.

Withdrawals: A 401(k) isn’t tax-free, it’s just tax-deferred. Meaning a taxpayer will be subject to an income tax liability on withdrawal from their account. After 59 ?, plan participants can begin distributions from their 401(k) accounts. Furthermore, traditional 401(k) accounts are subject to required minimum distributions starting at 70 ?.

2.      Traditional Individual Retirement Account/Arrangement (IRA)

If you’re employer doesn’t offer a retirement account, or you would like more flexibility in your investment selection, a traditional IRA is a great option. Although taxpayers are allowed to contribute to an IRA if their employer offers a qualified retirement account, the tax deduction related to the contribution may be limited depending upon the taxpayer’s income. A traditional IRA is a defined contribution plan.

Contribution Limits: In 2020, a taxpayer may be able to contribute up to $6,000/year into their traditional IRA (or $7,000 for taxpayers aged 50 or older). However, a taxpayer may receive a limited tax deduction if the taxpayer is covered by an employer plan. For instance, an active participant (someone with an employer qualified plan) filing single who earns more than $75,000 isn’t eligible for a tax deduction on their traditional IRA contributions. It’s important to keep track of contributions because excess contributions over this threshold are subject to a 6% penalty.

Investments: An IRA, whether traditional or Roth, offers greater investment flexibility compared to 401(k) plans. A participant can use this account to invest in individual stocks, bonds, mutual funds, ETFs, and a variety of other investments.

Taxation on Employee: Similar to a 401(k) plan, a taxpayer contributing funds to a traditional IRA won’t be taxed on the contribution amounts. However, it’s important to remember the income limits that may impact the amount of contributions deductible on your tax return — see Contribution Limits above.

Penalties: For those taxpayers younger than 59 ?, there is a 10% penalty imposed on distributions from traditional IRA plans (on top of tax liability), unless those distributions meet one of several exceptions.

Withdrawals: contributions to a traditional IRA are tax-deferred. As a result, upon withdrawal, taxpayers will be subject to taxation at ordinary income tax rates. This tax is applied to the full distribution amount, which mean both principal and earnings will be taxed at ordinary rates. Furthermore, traditional IRA accounts are also subject to the required minimum distribution rules starting at 70 ?.

3.      Roth IRA

Roth IRAs are nearly identical to traditional IRAs except for the fact that Roth IRA contributions are made with after-tax dollars. In comparison, traditional IRA contributions are made pre-tax, so they come out of your paycheck before taxes are taken into consideration. In addition, Roth IRAs are subject to more restrictions than traditional IRAs. A Roth IRA is a defined contribution plan.

Contribution Limits: Roth IRAs are subject to the same contribution limits as traditional IRAs. In 2020, a taxpayer may be able to contribute up to $6,000/year into their traditional IRA (or $7,000 for taxpayers aged 50 or older). However, unlike traditional IRAs — which aren’t subject to contribution limits, just tax deduction limits — Roth IRA contributions are only allowed for certain income levels. For instance, taxpayers filing single who earn more than $139,000 in 2020 are not eligible to make Roth IRA contributions.

Investments: An IRA, whether traditional or Roth, offers greater investment flexibility compared to 401(k) plans. A participant can use this account to invest in individual stocks, bonds, mutual funds, ETFs, and a variety of other investments.

Taxation on Employee: Dissimilar to 401(k) and traditional IRA contributions, Roth IRA contributions are post-tax. That is, the employee’s income will be subject to taxation and then the employee would contribute to their Roth IRA. After the taxpayer contributes to their Roth IRA, the principal and future earnings will grow tax-free until withdrawn. 

Penalties: For those taxpayers younger than 59 ?, there is a 10% penalty imposed on distributions from Roth IRA plans (on top of tax liability), unless those distributions meet one of several exceptions. Due to the fact that contributions have already be taxed, only earnings are subject to taxes and penalties. In addition, Roth IRAs have a 5-year waiting period from the date of first contribution. If the taxpayer is age 59 ? or older, but doesn’t meet the 5-year rule, then earnings are subject to tax, but not penalties.

Withdrawals: While a Roth IRA holder must be at least 59 ? to take distributions, they must also wait 5 years from the date of first contribution before they’re eligible to take withdrawals. If the taxpayer is age 59 ? or older and meets the 5-year rule, then principal and earnings can be distributed tax-free.

4.      Simplified Employee Pension (SEP, or SEP IRA)

A SEP plan may be one of the most convenient and cheapest forms of employer-sponsored retirement plans. While SEPs are treated similar to traditional IRAs, they have the ability to receive employer contributions. In addition, SEP IRAs have higher annual contribution limits than traditional or Roth IRAs. Under this plan, an employee has an IRA and the employer contributes to it on their behalf. Employers used to be able to setup Salary Reduction SEPs, but plans established after 1996 are no longer eligible for the employee salary reduction feature. A unique feature to SEP IRAs is the immediate vesting of all employer contributions. 

Contribution Limits: SEPs allow for contributions up to 25% of each employee’s salary, however, contributions are capped at $57,000 in 2020. In addition, employers aren’t required to make annual contributions, adding flexibility to the plan for employers. While the potential to not receive contributions is a negative for employees, they do have the added benefit of being 100% vested in all contributions. Unlike 401(k) plans which have various vesting rules for employer contributions.

Investments: Although employers are the only ones to make contributions to this plan, they aren’t responsible for making investment decisions, employees are. Similar to a 401(k) the IRA trustee will limit the eligible investments and then the employee will make specific decisions on investment selection.

Taxation on Employee: Because employees don’t contribute to a SEP plan, only employers do, there are no tax consequences for the employee upon contribution. The employer, however, will receive a tax deduction for the amount contributed.

Penalties: Similar to traditional IRAs, SEP plans are subject to the 10% early-withdrawal penalty on distributions before 59 ?, barring several exceptions. See Traditional IRA above for more details.

Withdrawals: As with traditional IRAs, withdrawal are taxed as ordinary income. Furthermore, SEP IRAs are subject to the same distribution rules as traditional IRAs. As such, SEP IRA account holders will be subject to the minimum distribution rules starting at 70 ?.

5.      Defined Benefit Plans (Pension Plans)

It’s time now to discuss defined benefit plans. As we discussed earlier, the greatest difference between defined contribution plans and defined benefit plans is the fact employers guarantee a monthly benefit for employees in retirement when they use a pension plan. Due to this feature, employees often prefer defined benefit plans. Under a pension plan, employees don’t have to contribute to the plan, manage plan assets, or take the risk of not having enough assets come retirement time.

Contribution Limits: Although an employer can establish a plan that allows employee contributions, these contributions are not required. Frequently these plans only feature employer contributions. In addition, there aren’t contribution limits on how much an employer can contribute for each employee. Plans enlist actuaries each year to determine the amount of annual contribution needed to satisfy the plans stated monthly benefit.

Investments: Unlike defined contribution plans, where employees are responsible for the investment decisions, pension plans make employers responsible for the plan’s investment performance. It’s important to note that employees are guaranteed a definite amount upon retirement, regardless of how well the plan’s investments have performed.

Taxation on Employee: Similar to SEP IRAs, because employees may not contribute to a pension plan, there are no tax consequences for the employee upon contribution. The employer, however, will receive a tax deduction for the amount contributed. In addition, if the plan does allow employee contributions, these employees won’t be taxed on those contribution amounts.

Penalties: Pension plans do not offer early withdrawal and in-service distributions (distributions while the employee is working) are not permitted until the employee reaches 62. Furthermore, taking early retirement benefits will generally result in lower monthly payouts.

Withdrawals: Similar to most pre-tax defined contribution plans, withdrawals from pension plans will be treated as ordinary income. Meaning these withdrawals will be taxed in a similar manner as W-2 wages.