Retirement Plans & Accounts, Part 2
Welcome to Part 2 of Retirement Plans & Accounts. Congratulations on making it through the wealth of information in Retirement Plans & Accounts, Part 1 (ha ha, no pun intended). In Part 1 we covered some common terms and broad categories of retirement plans. In this post I will cover some of the basic terms you need to be familiar with when learning about any type of retirement plan or account. A thorough understanding of these concepts will help you to determine which plan is right for you.
For those new to my FI Top Ten series of blog posts, the basic idea here is to increase financial literacy. For each post I have chosen to define and discuss what I think are 10 of the most important terms for a given topic within personal finance. For retirement plans and accounts, however, there is so much to cover I couldn’t fit all of that information into a single blog post. So, I have chosen what I think are the top 30 things you should know about retirement plans and accounts and have split it up into 3 different posts. With that, let’s get started with Part 2.
Contributions
A contribution is the amount paid into a retirement plan. That part is easy to understand. The catch is that each plan has its own rules about who can contribute to the plan/account, whether the contribution is made with pre-tax or post-tax dollars, how much can be contributed, when contributions can be made, etc.
In employer sponsored defined contribution plans, such as 401(k)s and 403(b)s, any employee enrolled in the plan can make contributions. This usually comes in the form of what are called elective deferral contributions or salary reduction contributions (both mean the same thing). The amount contributed is typically a percentage of your salary you elect to have withheld from your paycheck and deposited directly into your account. This a pre-tax contribution, so the amount contributed is subtracted from your gross pay, resulting in less income tax owed. But remember, this is tax-deferred money, so you will owe income tax on both the contribution and any earnings when it is distributed in retirement.
Some 401(k), 403(b), and governmental 457(b) plans permit designated Roth contributions. This is different because it is not a pre-tax contribution. The amount contributed must be included in gross income so there is no income tax deduction. However, a qualified distribution from a designated Roth account will not be subject to income taxes, meaning if you follow the rules you won’t pay taxes when you take out the money (more on distributions below).
Employers can also make contributions to defined contribution plans. Employer contributions are usually in the form of an employer match, most common in 401(k) and 403(b) accounts (see Part 1 of this series). They can also make discretionary or nonelective contributions, such as in a profit sharing plan (also covered in Part 1).
Some retirement accounts have income based limits regarding who can contribute to the account. Roth IRAs are the most common example of this. In 2019, if your tax filing status is married filing jointly and your modified adjusted gross income (AGI) is less that $193,000 you can make a full Roth IRA contribution this year (don’t get freaked out with all of those tax terms, we’ll cover those in the future as well). If your modified AGI is $193,00 to $203,00 you can contribute a reduced amount, but if it is over $203,000 you cannot directly contribute to a Roth IRA. Spoiler alert, notice how I snuck the word directly in there. For higher income earners you can still contribute to a Roth IRA, but indirectly through what is called a back door Roth IRA contribution (more on this later).
As for the timing of contributions, elective deferral contributions to defined contribution plans, like 401(k)s and 403(b)s, are deducted directly from your salary so there is not much you have to worry about with regards to meeting a deadline. If you are a small business or self-employed with a solo 401(k), then both employee and employer contributions must be made by the company’s tax return deadline, and this depends on your company’s filing status (sole proprietorship vs LLC vs S-Corp vs C-Corp). IRA contributions must be made by the tax filing deadline for any given year. For example, you can still contribute to an IRA for the 2019 tax year until April 15, 2020, or possibly even October 15, 2020 if you have filed for an extension.
Due to the tax-advantaged nature of retirement accounts, there are limits on how much you can contribute to them each year. In 2019, the contribution limit to a 401(k) or 403(b) plan is $19,000. For a traditional or Roth IRA, the 2019 contribution limit is $6,000. These are the most common plans/accounts people utilize. While I can’t list every single contribution limit for each type of plan/account here, that information can easily be found at irs.gov or through your HR department.
Catch Up Contribution
If you are over age 50, retirement is rapidly approaching and fortunately the government understands this as well. To help people out at this stage there is usually a “catch up provision” that allows an increased amount of money to be contributed each year after age 50. In 2019, 401(k), 403(b), and governmental 457(b) participants over age 50 can contribute an additional $6,000 per year above the standard $19,000 limit. In 2019, traditional and Roth IRA participants over age 50 can contribute an additional $1,000 above the $6,000 limit. Likewise, HSA participants over age 50 can contribute an additional $1,000 above the maximum for single HSA coverage ($3,500) or family HSA coverage ($7,000). For more details on catch up contributions, please visit the IRS website here.
Fees
We all know what fees are, but many people don’t realize they are being charged fees in their retirement plans or accounts. While fees in these accounts are unavoidable, there is a broad spectrum of how hefty these fees can be. When excessively high, these fees can significantly eat into your investment returns and take the magic out of compound interest. So, before you max out contributions of your hard earned money into a any given retirement plan, you better understand what it costs you.
These fees usually fall into one of three main categories. The first category is investment fees. When you buy shares of a mutual fund in your retirement plan, there is an expense ratio associated with that investment. We will dive into this in great detail in future posts about investing, but for now just understand that these fees exist and are highly variable and extremely important. Some funds are actively managed and have high fees (expense ratios usually ranging from 0.5% to 1%, or even higher) and others are passively managed with much lower fees (in the ballpark of 0.04% to 0.25%). In a company 401(k) or 403(b) plan your investment choices are limited to what your plan offers. Some plans offer excellent low cost passively managed funds, while others may only have actively managed high cost funds. There isn’t much you can do to change what is offered, so just make sure you try to pick the best of what is there. Conversely, IRAs are typically with large online brokers so your investment choices are much broader and you can choose pretty much any low fee investment you want.
The second category is participant or plan administration fees. These are the fees required for general management, record-keeping, accounting, legal services, online services, etc. Unlike investment fees that you have some control over, there is not much you can do about this for your employer sponsored defined contribution plan. Whatever 401(k) or 403(b) plan your company has chosen will have associated fees. Sometimes these are covered by your employer, but more often it is passed onto you as an annual fee or percentage of your assets. It is important to look at your plan statement or talk to your HR representative about how hefty these fees are, because that could affect your decision of how much money to invest there. In IRA accounts with online brokers, these administration fees are typically included in the commission cost when you make a trade (purchase a share of stock or a fund).
The last category includes individual service fees. These types of fees apply when you are accessing a special service associated with your account. For example, when you leave your employer and decide to rollover your 401(k) to an IRA, there is likely a fee associated with this. If you decide to take out a loan from you 401(k), fees are required as part of this process (don’t do this by the way). If you wish to obtain special financial advising from your 401(k) or IRA service provider, guess what, there will be associated fees. For this category you do have significant control over these fees and I recommend you minimize any of these types of services.
I recommend you take a look at the fees you are being charged in your retirement accounts and let that help guide where you put your money. For example, if you have a less than stellar 401(k) plan at your company with high plan administration fees and only high cost actively managed mutual funds to choose your investments from, you may not want to maximize your contributions to that account. You may be better served only contributing up to the employer match (get the free money) in the 401(k) and then contributing the rest of your money to an IRA through a low cost online brokerage like Vanguard, Fidelity, or TD Ameritrade.
Earnings
It is important to distinguish between how much you initially deposit into the account (contributions) vs how much that money grows and makes over time (earnings). In tax-deferred accounts, like 401(k)s and traditional IRAs, you will owe taxes on both the contributions and earnings when money is withdrawn. For Roth accounts, like Roth 401(k)s and Roth IRAs, however, this is different. Since these accounts are funded with post-tax dollars (tax has already been paid), the money in the account grows tax free and qualified withdrawals from the account (of both contributions and earnings) are also tax free.
Distinguishing between contributions and earnings becomes more important when considering early withdrawals from an account. For tax-deferred accounts (again, think 401(k)s and traditional IRAs), early withdrawals of any pre-tax (tax deductible) contributions or earnings results in a 10% penalty plus the tax owed is due. However, for a Roth IRA, you can withdraw your contributions at any time tax and penalty free (since you already paid taxes on the contributions), but you cannot withdraw the earnings before age 59 1/2 AND 5 years have passed since you opened the account or you will have to pay a 10% penalty (unless you have a qualifying reason, see IRS website). The IRS views withdrawals from Roth IRAs in this order: first, your post-tax contributions, then any traditional IRA conversions, then your earnings. So, let’s say you have $50,000 in your Roth IRA and $25, 000 is from post-tax contributions, $10,000 is from a traditional IRA conversion (any taxes owed were already paid at time of conversion), and $15,000 is earnings. If you decided to make an early non-qualified withdrawal from your account of $40,000, you would owe taxes plus the 10% penalty on $5,000 because this amount would be considered the earnings after subtracting $35,000 (your contributions plus your conversion), which are considered post-tax contributions and conversions. Roth 401(k)s behave slightly differently. If you take an early withdrawal from a Roth 401(k), it is prorated between contributions and earnings so you will owe at least some tax on the early withdrawal no matter what the total amount is relative to your actual contributions and earnings.
Distributions
This is the IRS term for withdrawing money from your retirement account. Basically the plan or account is “distributing” you money. But essentially you are taking money out of the plan or account. As you would expect, there are very specific rules about when you can withdraw money from these tax advantaged accounts and under what circumstances. When you withdraw money according to the rules associated with that plan or account, it is called a qualified distribution. Withdrawals that don’t meet these criteria are called non-qualified distributions and are typically associated with taxes and penalty fees. The penalty is usually a 10% fee, but can be as high as 20%. Don’t underestimate the significance of this. For example, if you are in the 32% tax bracket and take a non-qualified distribution from an account with an additional 20% penalty fee, you have already lost 52% of the money before you even have a chance to spend it.
For nearly all retirement plans and accounts, the primary rule governing distributions is that you must wait until you are 59 1/2 to withdraw any money (that’s why they are retirement accounts). Roth IRAs have another important rule, which is you have to have had the account open for 5 years AND be 59 1/2 before you can withdraw the money tax and penalty free. But remember, that only applies to the earnings in the account since you already paid taxes on the contribution. Distributions from Health Savings Accounts or HSAs (which I haven’t covered much yet but will explain more in the next post in this series) don’t have an age requirement because they weren’t originally designed as retirement accounts, but require that you spend the money for a health related expense.
There are some specific exceptions to the standard rules for distributions. These may include financial hardship, unreimbursed medical expenses, medical insurance, and some higher education expenses. This varies by account and situation and starts to gets into the weeds a bit, so I won’t discuss this further here. But if you are in one of these situations I recommend you review the IRS rules pertinent to the account you have and your situation.
Transfers
These next 3 terms involve moving money from one retirement account to another. These terms can seem very similar, but are quite different in regards to the situations they apply and their associated tax implications. Many will confuse these terms or use them interchangeably, including what you read online or hear from financial experts. This can lead to unexpected tax bills and financial mistakes. So let’s shed some light on the differences, starting with transfers.
A transfer is when you move money from one retirement plan to another retirement plan of the same type. For example, moving your traditional IRA at Bank A to a traditional IRA at Bank B. A transfer is not not a taxable event because the money is moved directly from one financial institute to another into the same account type with the same rules. Money was never distributed directly to you, the taxpayer. Furthermore, a transfer is not reportable to IRS since there was no taxable event and there are no limits on the number of transfers you can do in a given year. Common examples include transferring an old 401(k) into your new 401(k), a traditional IRA to another traditional IRA, or a Roth IRA to another Roth IRA at a different brokerage or investment firm.
Rollovers
A rollover is when you transfer money from one type of retirement account to another type of retirement account. The most common example of this is moving money from your 401(k) to a traditional IRA. If both are pre-tax accounts, and if you follow the rules and do it correctly, you don’t have to pay any taxes when rolling it over and your money can continue to grow tax deferred.
In the simplest terms, there are two types of rollovers: direct and indirect rollovers. A direct rollover is when funds move directly from one account to another (you never have the funds). Typically the administrator of one retirement plan sends the funds electronically directly to the administrator of the new plan. While you must report rollovers to the IRS when you file taxes, it is not a taxable event if the money was rolled over directly from one pre-tax account like a 401(k) to another pre-tax account like a traditional IRA.
An indirect rollover is very different. In essence, your retirement plan is cashed out and you personally take possession of the funds. The plan administrator will send you a check for the account balance, minus a percentage they are required to withhold for income tax. That’s right, now that you have the money it is considered taxable income and you owe tax on it. To cover for at least some of this, 10% is withheld if you are rolling over from an IRA into a qualified employer plan like a 401(k) or 403(b) vs 20% if you are rolling over the other way from a 401(k) or 403(b) into an IRA. Here is the kicker. You then have a 60-day window to deposit the full amount of the original account into the new qualified account or you will owe the IRS taxes on these funds AND an early withdrawal penalty if before age 59 1/2. This includes the amount that was withheld for taxes by the original plan administrator. Here is an example. Let’s say you have $100,000 in your 401(k), you leave your job, and now you want to do an indirect rollover into a traditional IRA. Your old 401(k) administrator writes you a check for $80,000 and withholds $20,000 (20%) for taxes. You now have 60 days to deposit $100,000 into the traditional IRA or taxes are due plus you incur the 10% penalty for early withdrawal if you are under age 59 1/2. This means you must come up with $20,000 of your own money to cover the difference. Well what the heck happens to my $20,000 in the original 401(k) you might ask? You are given this $20,000 back in the form of a tax credit the next time you file taxes.
Needless to say, I would recommend the direct rollover over the indirect. Much less of a headache and much less of a chance for an error that could cost you thousands of dollars in taxes and penalties.
One more key point. Unlike transfers, for which there are no limits on how many you can do a year, you are limited to only one rollover in a 12 month period and again, you must report this when filing taxes. Make sure you know which you are doing to avoid taxes and penalty fees.
Conversions
So where do conversions come in? A conversion is a special type of rollover, and as the name implies, you are converting from one account type to another, but now with a different tax status. This term typically applies when converting money from a 401(k), 403(b) or traditional IRA to a Roth IRA. Because 401(k)s, 403(b)s, and traditional IRAs are pre-tax accounts, and a Roth IRA a post-tax account, when a conversion is made, taxes are due on any untaxed amounts being transferred. Why would anyone want to do this? Well, this is the method by which back door Roth IRA contributions are made. It is also the basis for a Roth conversion ladder. I will post more on both of these later, but in brief here is what happens with a back door Roth IRA contribution.
If your tax filing status is married filing jointly and your income is higher than $203,000 in 2019 ($137,000 for single filers), you are not eligible to directly contribute to a Roth IRA. However, you can still contribute to a traditional IRA. While a traditional IRA is most commonly considered a pre-tax account, the current tax code phases out that tax deduction as your income goes above $123,00 if you have a separate retirement plan at work. So, if this same high earner has a retirement plan at work like a 401(k), the amount contributed to the traditional IRA is a non-deductible contribution (post-tax dollars). If the money is left to grow in the traditional IRA, at the time of distribution you would not be taxed on the contribution since it has already been taxed. However, this is a tax deferred account, so when you did withdraw funds at retirement you would owe taxes on the earnings. It would be better to have had the money in a Roth IRA where it would grow tax free and could be later withdrawn tax free. But remember, your income level was too high to directly contribute to the Roth IRA (through the front door). This is where the back door Roth IRA contribution comes in. The IRS allows you to convert your traditional IRA to a Roth IRA. This can be done through a same trustee transfer (all at the same financial institution) or a trustee to trustee transfer (one financial institution to another). Most people do it at the same institution and usually all that is required is filling out a form requesting the conversion. Since you already paid taxes on the traditional IRA contribution, no taxes are owed on the transfer of that same amount to the Roth IRA. Now you have essentially contributed to a Roth IRA “through the back door.”
Is this legal you might ask? Yes, the IRS describes the steps of converting a traditional IRA on their website and confirmed this is a legal process in December 2017 and July 2018. When you do a Roth conversion, the IRS requires you to fill out form 8606 with when you file your taxes. There are several factors to consider when doing this to avoid taxes and penalties, and they are best summarized on the White Coat Investor website where I first learned about this strategy. He is one of the leading experts I have come across on this strategy and the information on his website has helped thousands of people. Check out his posts here and here to learn more.
Required Minimum Distributions (RMDs)
Tax advantaged retirement accounts are excellent for saving and investing money because your money can earn so much more without the drag of taxes. However, you can’t keep your money sheltered in these accounts forever. You can bet that Uncle Sam wants to get his cut one way or another. This is where required minimum distributions or RMDs come into play. Essentially all retirement accounts, with the exception of Roth IRAs, are subject to RMDs when you turn 70 1/2. This means you are required to take a minimum distribution (withdrawal) from each of your retirement accounts every year.
The amount of the distribution is based on the account balance at the end of the previous calendar year divided by a number called the “distribution period” which is based on your age. Based on the worksheet that applies to most people, in 2019 the distribution period was 22.9 at age 75, and 6.3 at age 100. Let’s see how this plays out. If you had $1,000,000 in your retirement account at the end of the last calendar year and you were 75 years old, we would take this amount and divide by 22.9, and this would give us $43,668. Not an insignificant amount of money by any means. This is the amount you would be required to withdraw AND pay taxes on that year. If you were age 100, then we would divide the $1,000,000 by 6.3 and that would give us $158,730. Wow! Using the same initial balance demonstrates that the smaller the “distribution period,” the larger the RMD. The system is set up such that as you age you are required to withdraw a larger percentage of your balance. This allows the government to be sure to get their cut before you die.
So what happens if you fail to take the RMD each year? It’s not good. If you neglect to take the RMD, fail to withdraw the full amount of the RMD, or miss the deadline, the amount not withdrawn is taxed at 50%. That’s right, the government will keep HALF. So, the take home lesson is don’t fail to take the RMD each year.
Remember, the RMD rules apply to all employer sponsored retirement plans, including profit-sharing plans, 401(k) plans, 403(b) plans, 457(b) plans, traditional IRAs, and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs. RMD rules DO NOT apply to Roth IRAs while the owner is alive, but they DO apply to Roth 401(k)s. In the FI community there are strategies to avoid or reduce RMDs and I will discuss these in future posts.
Beneficiaries
What happens to your retirement accounts when you die? There can be substantial wealth in these accounts so this is an important question to consider. Even if you don’t die early and use a significant portion of your retirement accounts to live on in your later years, odds are there will still be some balance left in your accounts when you pass away. This is why you need to designate a beneficiary when establishing a retirement plan or account. A beneficiary in the context of retirement accounts is any person or entity designated to receive the distributions from the retirement account in the event of death of the account owner. Both primary and contingent beneficiaries can be designated. A contingent beneficiary would inherit the account if the primary beneficiary could not (for example, if your spouse died with you in an accident and was the primary beneficiary). Possible beneficiaries include your spouse, children, other relatives, friends, trusts, charities, and institutions.
The reason I thought this would be important to discuss is because not all beneficiaries are treated equally under the tax code and this is very important to consider when designating beneficiaries. Discussing the specifics for each type of account and for each type of beneficiary is beyond the scope of this post (and would probably put you to sleep), so I’d recommend you review the IRS website or speak with an estate attorney or accountant for more details, but here are some generalizations. Spouses can generally inherit a retirement account and either assume ownership of the account or roll it over to their own account. This means normal account distribution rules will continue to apply (no RMDs until age 70 1/2). Other heirs, such as children or other relatives, may be required to either take the account balance as a lump sum up front and pay the associated taxes or begin taking RMDs every year with their associated taxes. Charities and other non-profit groups are not required to pay any taxes and can inherit the full account balance from a retirement plan. It is important to note that Roth IRAs can pass onto beneficiaries tax free since taxes have already been paid on the contributions (and if the account is more than 5 years old). However, there are some rules regarding distributions.
It is also important to keep the designated beneficiaries in your retirement accounts up to date reflecting your most recent wishes because your will typically cannot override them. This should be done on a regular basis (annually) or after any major life events such as marriage, divorce, or the birth of a child.
Conclusion
That wraps up Retirement Plans & Accounts, Part 2. Hopefully a better understanding of these common terms associated with retirement will help you to decide which plans or accounts are right for you. Go on to Part 3 to learn more about each specific retirement plan and account. Also, please subscribe to the blog to receive future posts automatically by email. Thanks, and good luck as you continue to seek Freedom Through FI!
