How Retirement Plans Work
IRA, Roth, 401k, 301b, SIMPLE, SEP and Pension
A retirement plan is the best way to save for retirement. There are tax advantages with a retirement plan. The money your retirement plan earns is tax-free, so that interest, dividends and capital gains are untaxed, year after year. You can watch your investment earnings compound more and more quickly. Because of the tax benefit, your retirement money will accumulates faster than your other savings.
Yes, some of the rules are complex, but we can point you in the right direction. The biggest financial mistake you can make is to ignore retirement planning. The earlier you start a retirement plan, the quicker you reach your goal.
Financial advisors generally agree on the best retirement strategy for most people. You should contribute to your employer's plan only as much money as the employer will match. Then you should put the rest of your annual contribution into your individual Roth IRA retirement account. If you can contribute more than the Roth annual limit, the balance should go into your employer's retirement plan, which has a higher limit. If you are a highly-paid employee, or if you self-employed, another strategy may work better for you.
1. The Scope of Retirement Plans
Historically, the employee was covered by a pension plan. The pension guaranteed a fixed retirement income, called the defined benefit. No contributions were required from the employee. These defined benefit pension plans placed the entire financial burden and the investment risk on the employer. They are virtually extinct.
The defined benefit pension plan has been replaced by a tax-sheltered retirement plan. If your employer has set up the plan, you can contribute to the employer's plan through payroll deductions. The employer may make small contributions to the plan in your name, called matching contributions.
These employer plans can be a 401(k), a 403(b), a SIMPLE 401(k) or a SIMPLE IRA. If you work for a self-employed person, your retirement plan can be a SEP IRA or a SEP Keogh.
You can also set up an individual retirement account for yourself on your own initiative. This plan is either an IRA or a Roth IRA. Even if you have a plan through your employer, you can set up a personal plan for yourself. Limits are set by tax law for your total contribution to multiple plans.
2. The Basic Rules of All Tax-Sheltered Retirement Plans
The requirements of any retirement plan, whether it be an IRA, a Roth, a 401(k) or any other plan, are:
- You make a contribution of money to the plan each year, as much as you want, up to the limit specified by law.
- Each plan has a different limit on your annual contributions. The contribution limit will increase every year as the cost of living increases. If you are at least 50 years old, you are allowed to contribute a little more, called a catchup contribution.
- If the plan is set up by your employer, the employer has the option of making a matching contribution to your account.
- You must have earnings in any year you make a contribution.
- In any year, you can never contribute more than you earn to the account.
- The non-working spouse can also have an IRA or Roth retirement account.
- You cannot withdraw your money from the plan until you reach retirement age, 59 1/2 years.
- If you do withdraw money from the plan prematurely, before age 59 1/2, you pay a 10% tax penalty.
- If you want to take early retirement at 55 or older and begin withdrawals from your retirement plan, there are special rules to allow this.
- There are a few times you can withdraw money from the plan without paying the 10% tax penalty. Example: you use the money for a medical emergency.
- If you are at least 50 years old, most plans allow you to make larger, catch-up contributions each year.
- If you are 70 1/2 years old and have an IRA plan, you must begin making withdrawals from the plan. Withdrawals are also called distributions. Tax law specifies the required minimum distribution, based on a life-expectancy table.
3. The Four Tax Benefits of a Tax-Sheltered Retirement Plan
No matter what plan you use, your money earns interest, dividends and capital gains tax-free as long as it remains in the plan. This is the primary benefit of a tax-sheltered retirement plan.
You will get ONE of these three additional tax benefits, depending on the retirement plan.
- Either 1. With some plans you pay no income tax on the money you contribute. Example: a 401(k).
- Or 2. With some plans you take an income tax credit on the money you contribute. Example: Individual IRA.
- Or 3. With some plans you pay income tax on your contributions, you take NO income tax credit for your contributions, but your withdrawals of money in retirement are tax-free. Example: Roth IRA.
4. How Your Retirement Withdrawals are Taxed
If you have a before-tax plan, and did not pay income tax on your contributions, you must pay income tax on any money you withdraw, before or after retirement. Example: an employer's 401(k) or a SIMPLE-IRA.
If you took a tax credit on your income tax for your plan contribution, you must pay income tax on any money you withdraw, before or after retirement. Example: an IRA plan.
If you have an after-tax plan, and paid income tax on the money you contributed, you can withdraw your money tax-free before or after retirement.
5. How Individual IRA and Roth Retirement Plans Work
Here at Surfer Sam is more about the
IRA retirement savings plan, including "What is an Individual Retirement Account, IRA?"m "How Much Money Will You Need to Retire?" and "Three Steps to Set Up Your IRA Retirement Plan."
6. How 401(k) Retirement Plans Work
401(k) plans are retirement plans your employer can offer.
They are named after the section of the tax code that created them. Your contributions are deducted from your payroll check. No federal or state income tax is withheld on your contributions, although Medicare and Social Security taxes are withheld on your contribution. You can contribute up to $15,500 for 2008. Your employer can also contribute to your retirement savings with a partial contribution or a matching contribution.
The employer sets rules for the 401(k) plan. You may have to wait a year or more to join the plan. Your employer's share of the contribution doesn't belong to you until you work for the company for a few years. After a specified waiting period, the employer's contribution vests and belongs to you. Your 401(k) account and vested company contributions always belong to you. Even if you leave the company, you still keep your 401(k) money.
401(k) plans are complicated and costly, so a plan administrator is usually retained for the company paperwork. It is important that the company 401(k) plan not discriminate in favor highly-paid employees. One of the benefits of the 401(k) is that if the workforce contributes more, the highly-paid workers are permitted to contribute more.
7. How 403(b) Retirement Plans Work
403(b) plans are retirement plans offered by nonprofit organizations to their employees. As in a 401(k) plan, your contributions are deducted from your payroll check. Federal and state income tax is not withheld on the money. You can contribute up to 20% of your salary, and up to $15, 500. The retirement money is often invested in a tax-sheltered annuity with an insurance company, or in a no-load mutual fund. For your employer, 403(b) plans are inexpensive and easy to set up and administer.
These 401(k) and 403(b) plans are called before-tax plans, because you pay no income tax on the money you contribute. There are also a variety of after-tax 401(k) and 403(b) plans. You get no tax savings when you contribute, but when you are retired, you pay no income tax on the money you withdraw.
8. How SIMPLE Retirement Plans Work
The SIMPLE plan is a retirement your employer can offer. Employers with less than 100 employees can set up a SIMPLE plan, Savings Incentive Match Plan for Employees. An employee can contribute up to $10,500 and the employer can match that amount. If you are 50 years or older, most plans allow you to make a larger, catchup contribution each year. Your employer can match your contributions, up to a maximum of 2% or 3% of your earnings. As in all retirement plans, the more people contribute, the more the employer has to contribute in matching money. The limit on your contribution for 2008 is $10,500, or if you are at least 50 years old, $13,000. There are two types of SIMPLE plans, a SIMPLE 401(k) and a SIMPLE IRA.
9. How SEP Retirement Plans Work
A SEP is a retirement plan for a self-employed person and any employees. A SEP is a Simplified Employee Pension. It is a combination IRA/profit sharing plan and is available only for self-employed individuals and their employees. A SEP is not available to a corporation. The contribution limit is generous. You can usually contribute up to 20% of your net income from self-employment, up to the limit of $46,000 this year. Your contributions are before-tax, that is, not subject to federal or state income tax. You can set up your plan and make a contribution for 2008 up to the day you file your income tax return in 2009, even if you have a late filing extension.
Your SEP can be one of two types: a SEP-IRA or a SEP-Keogh. Both have the same contribution limits of 20% of net income, up to $46,000.
10. How SEP-IRA Retirement Plans Work
To repeat, a SEP-IRA is a retirement plan for self-employed people and their employees. With an SEP-IRA retirement plan, you will make contributions for any employees at the same percentage as for yourself. You may exclude part-time and recently-hired employees from the SEP. But, if you have many employees and want to make larger contributions to a retirement plan, an SEP-IRA may not be your best choice. A Keogh plan, a 401(k) or a SIMPLE plan will wind up saving money for the self-employed employer with a large workforce.
11. How SEP-Keogh Retirement Plans Work
The SEP-Keogh Plan is also for self-employed people and their employees. Keogh plan allows highly-paid employees and owners to contribute more than other employees, through a feature called Social Security integration. The plan can also use vesting requirements to delay for years the right of employees to claim the business matching contributions. If you have high employee turnover, unvested money remains in the plan pool and reduces the amount of matching contributions you have to make. Keogh plans have higher administrative costs.
There are three types of SEP-Keogh plans, Profit-Sharing, Money-Purchase and Defined-Benefit. Historically, the three types were created by tax law to favor highly-paid owners and employees. Profit-sharing Keoghs and Money-Purchase plans have the same limits as the familiar SEP-IRA, that is 20% of net income up to $46,000. The Defined Benefit Keogh plan is for self-employed people who want to sock away more than $46,0000 per year for retirement. The annual contribution to a defined benefit plan varies, depending on how much you want to receive every month when you retire. It requires an actuary to compute the required annual contribution.
I hope life brings you much success.
I wish you a very happy day.
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