Top 10 Terms You Should Know About Retirement Plans & Accounts, Part 3

Retirement Plans & Accounts, Part 3

This is the final post in my Top Ten Terms You Should Know About Retirement Plans & Accounts.  There is just so much to cover in this area, I had to spread it out over 3 separate posts.  Unless you already understand retirement plans and accounts well, I STRONGLY recommend you read the first two posts in this series before tackling this (Part 1 and Part 2).  Otherwise some of the terms used to explain these accounts here won’t make much sense.  

After you review the first two posts, you will have the vocabulary to really understand the important points I discuss here.  In this final post we will look at 10 of the most common types of retirement plans and accounts and answer some basic questions about each.  

While there are many more retirement plans and accounts than I discuss here, I had to limit this post to 10, otherwise it would be way too long (it’s already long as is).  So, I’ve tried to select the 10 most common types of retirement accounts people come across or deal with.  For those very familiar with retirement strategies, you may feel it is a glaring omission to not include a section on Health Savings Accounts (HSAs) here.  This is because I plan to write a separate post just about HSAs.  I am not going to try to go into too much depth on these 10 accounts because it will get too dry and long, but I am going to limit the discussion to these 5 questions for each account:

• What type of account is this?
• What are the contribution rules?
• What are the distribution rules?
• What are the pros and cons?
• Who is this account good for?

This will help keep things focused and consistent.  If you want to learn more on each account type, I recommend reviewing the information on the IRS website.  

I realistically don’t expect all of my readers to read this entire post.  The big 3 you should know are Traditional IRA, Roth IRA and 401(k)/403(b), since these three are generally the most common plans/accounts most people encounter.  

If you are a state or local government employee or work for a tax-exempt non-profit organization, then check out the 457(b) sections. 

If you are married and your spouse does not work outside the home, be sure to understand what a spousal IRA is.  

If you are self employed or a small business owner, you should check out the SEP IRA, SIMPLE IRA, and Solo 401(k) sections.  

If you are a free spirit and/or more interested in alternative asset classes, check out the self-directed IRA.  
If you are a personal finance geek like me, READ ‘EM ALL and increase your financial literacy.  

Traditional IRA

What type of account is this?

• A traditional IRA is one form of an Individual Retirement Arrangement (aka Individual Retirement Account per many other non-IRS sources).  It is a way to save for retirement in a tax advantaged manner.  For most, this is a pre-tax account, meaning contributions are tax deductible, which lowers your taxable income and subsequent tax bill.  The money then grows tax-deferred.  Taxes are due when money is distributed.  
• A traditional IRA is an individual account and is not associated with an employer.  A traditional IRA can be opened quite easily with a bank (Citi, Chase, local bank, etc.), investment firm (Fidelity, Charles Schwab, Vanguard, etc.), online brokerage (TD Ameritrade, E-Trade, etc.), or other online investment platform (Betterment, Wealthfront, etc.).  

What are the contribution rules?

• In order to make contributions to a traditional IRA you must be less than age 70 1/2  and must have received taxable compensation during the year.  Here compensation generally means money you earn from working (wages, commissions, etc.) and does not include rental income, pensions or annuities, interest, dividends, or deferred compensation.  
• While anyone meeting the above criteria can contribute money to a traditional IRA, there are limits on whether or not those contributions are tax deductible.  In 2019, if you are covered by a retirement plan at work, you cannot deduct traditional IRA contributions from your taxable income IF your modified adjusted gross income (AGI) is more than $123,000 for a married couple filing jointly or $74,000 for single individuals or heads of household.  You can still contribute to an IRA, but it would then be considered a nondeductibleIRA contribution.  
• In 2019, the maximum sum total of all contributions to any IRA accounts is $6,000.  Those over age 50 can contribute an extra $1000, for a sum total of $7,000. 
• Contributions can be made up to the deadline for the previous tax year (April 15, 2019 for the 2018 tax year).

What are the distribution rules?

• Distributions of any deductible contributions and their earnings can be made penalty free after age 59 1/2.  Remember, however, that distributions from a traditional IRA are taxed as regular income.  If you are under age 59 1/2 you will also owe a 10% penalty tax (in addition to your normal income tax) unless you meet one of the few IRS exceptions. 
• Traditional IRAs are subject to required minimum distributions (RMDs).  At age 70 1/2 the IRS requires you to begin taking RMDs, which are based on the total account balance and actuarial data based on your age.  Failure to take the RMDs will result in 50% tax on the amount not withdrawn.  

What are the pros and cons?

• Pros
  • Contributions are tax deductible (up to an income limit)
  • Money grows tax-deferred
  • Wider range of investment choices compared to employer retirement plans like 401(k)s
• Cons 
  • Annual contributions quite limited (can’t be only source of retirement savings)
  • 10% penalty for withdrawing money before age 59 1/2
  • RMDs begin at age 70 1/2

Who is this account good for?

• The biggest advantage of a traditional IRA is the up front tax break.  So if you are in a high income tax bracket, this may be a good account for you to consider, especially if your employer does not offer a retirement plan or if it is a poor plan with limited investment choices and/or high fees.  However, given that the annual contributions are capped at a relatively low amount, I would not recommend limiting your retirement plan strategy to a traditional IRA only.  

Roth IRA

What type of account is this?

• A Roth IRA is another form of IRA, but unlike a traditional IRA, this is a post-tax account.  This means you make contributions to the account with money that has already been taxed, which translates to no tax deductions for contributions.  The perk is that the money then grows tax free and can be withdrawn tax free if it is a qualified distribution (see below).  
• A Roth IRA is an individual account and is not associated with an employer.  Like a traditional IRA, a Roth IRA can be opened through a bank, investment firm, online brokerage, or other online investment platform.

What are the contribution rules?

• You can contribute to a Roth IRA at any age if you received taxable compensation during the year and your modified AGI does not exceed $137,000 if filing taxes as an individual, and $203,000 if married filing jointly (2019 limits).  Remember, compensation generally means money you earn from working (wages, commissions, etc.) and does not include rental income, pensions or annuities, interest, dividends, or deferred compensation.  
• In 2019, the maximum sum total contribution to all IRA accounts is $6,000.  Those over age 50 can contribute an extra $1000, for a sum total of $7,000. 
• Contributions can be made up to the deadline for the previous tax year (April 15, 2019 for the 2018 tax year).
• Contributions to a Roth IRA are separate from conversions.  This may be important for those interested in a Roth conversion ladder (will discuss this in future posts) as a strategy for early retirement.  But basically this means you can convertany sum of money to your Roth IRA from a pre-tax account like a 401(k), 403(b), or traditional IRA and still contribute up to the maximum annual amount to the Roth IRA.  You will, of course owe taxes on both the amount converted AND the amount contributed.  

What are the distribution rules?

• You can withdraw original contributions made to a Roth IRA tax and penalty free at any time, however this is not the case for earnings.
• For distributions of earnings, there are two key factors to consider: age relative to 59 1/2 and if you’ve owned the account for less than or more than 5 years.  If you are over 59 1/2 years old and have had the account for longer than 5 years, the earnings can also be distributed tax and penalty free.  If you don’t meet one or both criteria, then there will be income tax due on the earnings plus a 10% penalty tax if under age 59 1/2.  There are some exceptions to this, which can be found here.  
• Conversions can be distributed penalty and tax free 5 years after the money was originally converted (key part of Roth conversion ladder strategy).  
• Roth IRAs are NOT subject to RMDs.

What are the pros and cons?

• Pros
  • Money grows tax free
  • No taxes on qualified distributions
  • Not subject to RMDs
• Cons 
  • Income restrictions on who can directly contribute
  • Annual contribution maximums quite limited (can’t be only source of retirement savings)
  • No tax break up front (negative for those in higher tax brackets)

Who is this account good for?

• This account is generally good for those in lower tax brackets since you have to pay taxes up front.  There is great appeal in knowing that your money grows tax free and you will never have to pay taxes on it again.  However, those in higher tax brackets would likely do better maxing out their 401(k)s and/or a traditional IRA first.  If these individuals still have money left over to save for retirement, a Roth IRA could be an appealing option.  In these cases, if your income is too high for a direct Roth IRA contribution, you can do a back door Roth IRA contribution (I do this every year).  

401(k) and 403(b)

What type of account is this?

• 401(k)s and 403(b)s are similar in many ways, and thus I have lumped them together here.  While 401(k)s are offered by private for-profit companies, 403(b)s are offered by non-profit organizations and government employers.  For our purposes we will consider them the same and I will just call them 401(k)s here since they are a little more common.  
• 401(k)s are the most commonly known and utilized retirement plans.  They are named for the section of the tax code which they fall under. 
• These plans are qualified tax advantaged employer sponsored defined contribution plans.  Let’s break that down.  Qualified means they are governed by the rules of the Employee Retirement Income Security Act of 1974 (ERISA) and have added tax benefits and government protection beyond those of non-qualified plans (going into more detail on this point is way beyond the scope of this post).  Tax advantaged means there are tax benefits to contributing to these plans.  Employer sponsored means the plan must be administered by an employer, as opposed to an IRA which you can open as an individual.  Finally, a defined contribution plan means the amount you contribute is defined (rather than the benefit as in a defined benefit or pension plan) and there is no guaranteed benefit (the benefit is based on market performance).
• Most employers offer a matching contribution, usually 50 cents to $1 for every dollar you contribute up to a percentage of your salary, typically 3-6%.  There may be a vesting schedule for your employers matching contributions.  
• 401(k)s are traditionally considered pre-tax accounts, but more and more plans now allow the option for Roth contributions.  Pre-tax contributions grow tax deferred, which means taxes are due when money is distributed.  Earnings on Roth contributions, however, grow tax free since they are made with post-tax dollars.  

What are the contribution rules?

• Your employer must offer a 401(k) plan and you must be enrolled in it to be eligible to contribute.  
• In 2019 the maximum contribution to a 401(k) plan is $19,000.  Employees over age 50 can make an additional catch-up contribution of $6,000, for a total of $25,000.  
• Traditional contributions are made with pre-tax dollars and are tax deductible, regardless of your income (unlike a traditional IRA where the deduction is phased out as modified AGI increases).  The contributions then grow tax-deferred.  
• Some plans allow Roth contributions with post-tax dollars, so taxes are paid up front and the money then grows tax free.

What are the distribution rules?

• A triggering event must occur in order to receive distributions form a 401(k) and these include retirement, death, disability, separation from service from employer, termination of the plan, or financial hardship as defined by the IRS and governing plan document.  
• Distributions of traditional contributions and their earnings are taxed as ordinary income and are assessed an additional 10% penalty if withdrawn before age 59 1/2 (with some unique exceptions per IRS rules).  
• Distributions of Roth contributions are tax free (you’ve already paid the taxes on this).  Qualified distributions of earnings on Roth contributions are tax free if made after age 59 1/2 and 5 years after your first designated Roth contribution.  If you don’t meet one or both criteria, then there will be income tax due on the earnings plus a 10% penalty tax if under age 59 1/2.  
• 401(k)s are subject to RMDs beginning at age 70 1/2 unless the participant is still employed, in which case RMDs can be deferred until retirement.  Unlike a Roth IRA, Roth contributions to a 401(k) are still subject to RMDs.  
• Most individuals rollover their 401(k) account to a traditional IRA (which is not a taxable event if done correctly) when they change employers or retire.  This is done for two primary reasons.  First, their money is now under their individual account and control and no longer linked to their employer.  Second, IRA accounts offer many more investment options and lower fees than most 401(k) plans.

What are the pros and cons?

• Pros 
  • Employer match is free money! Take advantage of it.
  • Traditional 401(k) contributions are tax deductible regardless of total income you earn
  • Higher annual contribution limits than IRAs
• Cons 
  • Your 401(k) plan may have limited investment choices and/or associated plan fees
  • Subject to RMDs at age 70 1/2 (including Roth contributions and earnings)

Who is this account good for?

• If your employer offers a 401(k) or 403(b) plan with a matching contribution program, contributing enough to get the full match should be one of your highest financial priorities since it is a 100% guaranteed return on your money, and it will continue to grow as it is invested.  Contributing to your 401(k) is an excellent way to reduce your current tax burden and save for retirement.  If able, and other financial affairs are in order, I recommend contributing the maximum amount to this type of plan each year.  

Spousal IRA

What type of account is this?

• The IRS rules state you must have earned income to contribute to an IRA.  However, for married taxpayers there is an exception to this rule.  If one of the two isn’t working outside the home earning income, you can still both contribute to an IRA.  This can be a traditional or a Roth IRA, and the term spousal IRA is just to designate that the working spouse can contribute to the IRA under the non-working spouse’s name.  

What are the contribution rules?

• The tax filing status of the couple must be married, filing jointly to contribute to a spousal IRA.  
• The spousal IRA must be opened under the name and social security number of the spouse that is not working.  
• The non-working spouse must be under age 70 1/2 if it is a traditional IRA (no age limit if Roth IRA).
• The maximum contribution to the spousal IRA is the same as for the working spouse ($6,000 in 2019, $7,000 if over age 50).
• The sum contributed to both the spousal IRA and the working spouse’s IRA must not exceed the lesser of their total joint earned income or double the annual contribution limit ($12,000 in 2019, $14,000 if over age 50).
• The same rules for traditional IRAs and Roth IRAs apply.  This means if the working spouse has an employer sponsored retirement plan, tax deductions for contributions to a traditional IRA phase out as income increases (no deductions if modified AGI is over $123,000 in 2019).  Likewise, there are income limits restricting eligibility to contribute to a Roth IRA (modified AGI over $203,000 in 2019).  However, it is still possible to do a spousal backdoor Roth IRA contribution (I also do this every year).  

What are the distribution rules?

• The same rules for distributions apply based on whether the spousal IRA is a traditional IRA or Roth IRA.
  • Traditional IRAs are tax-deferred accounts, so distributions are taxed as ordinary income.  They are also subject to RMDs.  Please see details above.  
  • Roth IRAs are post-tax accounts, so distributions of original contributions are always tax free.  Distributions of earnings are also tax free so long as you are over age 59 1/2 and account has been open for more than 5 years.  Roth IRAs are not subject to RMDs.  Please see details above.

What are the pros and cons?

• Pros  
  • The spousal IRA allows a spouse without earned income to build his/her own nest egg
  • Excellent way to boost overall household savings for retirement
  • Because an IRA is an individualaccount, if the couple gets divorced, the spousal IRA remains the property of the person under whose name it was filed.
• Cons 
  • This is a great way to get around the earned income requirement for IRAs, I can’t really think of any cons.  

Who is this account good for?

• This account is good for anyone who has both earned income and has a spouse that doesn’t work outside the home.  If you are able to contribute to a spousal IRA, I highly recommend you do so.  

SEP IRA

What type of account is this?

• SEP stands for simplified employee pension and is an account type typically used by small business owners and self-employed individuals.  A SEP IRA is a type of traditional IRA that is set up for employees by an employer who then receives subsequent tax benefits.  Thus, It is essentially a hybrid of an employer sponsored retirement plan and an individual retirement account; an employer sponsors the plan and makes contributions on behalf of the employee as part of their compensation, while the investments, distribution, and rollover rules are that of a traditional IRA.  Like a traditional IRA, this also means that contributions are tax deductible, grow tax deferred, and are then taxed as ordinary income when distributed.  
• An employer that sets up a SEP IRA for their business must contribute on behalf of eligible participants an equal percentage of compensation as their own.  The IRS considers eligible participants those that are age 21 or older, have worked for the employer for 3 of the last 5 years, and made at least $600 from the employer last year.  For example, if you want to save 20% of your compensation in the plan as an employer, you must also contribute 20% of compensation for each eligible participant employee as well.  That is why this works best for small business owners with few or no employees or self-employed individuals.  

What are the contribution rules?

• The contribution limits are what really distinguish a SEP IRA from a traditional IRA.  Nearly 10 times the limit of a traditional IRA can be contributed to a SEP IRA.  In 2019, annual contribution limits cannot exceed the lesser of:
  • 25% of compensation (compensation calculations capped at $280,000 in 2019)
  • $56,000 maximum for 2019
• Employers must contribute the same percentage of compensation to employees as to their own SEP IRA.
• There is no fixed amount an employer is required to contribute to the plan each year.  Thus, this allows for some flexibility based on cash flow of the business, which tends to be more important and variable for small businesses and self-employed individuals.
• There are no catch up contributions after age 50.

What are the distribution rules?

• Distributions are taxed as ordinary income.  Distributions taken before age 59 1/2 also subject to 10% penalty unless certain hardship criteria can be met.  
• SEP IRAs are subject to RMDs at age 70 1/2

What are the pros and cons?

• Pros 
  • Higher annual contribution limits than many other tax advantaged accounts (but less than solo 401(k))
  • Employers can vary contributions year to year based on cash flow
• Cons
  • No provision for catch up contributions after age 50
  • No Roth version, so distributions will always be taxed as income
  • Subject to RMDs

Who is this account good for?

• SEP IRAs are a great option for self-employed individuals or small business owners with few employees.  
• If you are planning on backdoor Roth IRA contributions, any IRA balances under your name in traditional, SEP, or SIMPLE IRAs will make you subject to taxes in those accounts based on the pro rata rule (beyond scope of this post).  So the bottom line is if you want to do a backdoor Roth, this account type is not a good idea for you.  

SIMPLE IRA

What type of account is this?

• SIMPLE stands for Savings Incentive Match Plan for Employees.  A SIMPLE IRA is an employer sponsored tax advantaged retirement savings plan that can be used by smaller businesses with 100 or fewer employees.  Compared to more conventional employer sponsored plans, like 401(k)s, SIMPLE IRAs require less paperwork and have lower start-up and operating costs.  As a result, this type of plan appeals to smaller businesses.  
• For SIMPLE IRAs the employer is required to either make a nonelective mandatory 2% contribution for each eligible employee or an optional matching contribution up to 3% of employee compensation.  This contribution is tax deductible for the employer.   Employer contributions are always 100% vested in SIMPLE IRAs.
• Employees may elect to contribute to this plan and can make their own investment choices.  Like most other employer sponsored retirement plans, employee contributions are tax deductible and grow tax deferred.  Distributions are taxed as ordinary income.  

What are the contribution rules?

• In order for employees to be eligible for the plan they must have earned at least $5,000 each of the previous 2 years and be expected to earn at least $5,000 during the current year.  Employers are able to exercise some flexibility in these requirements in the original plan document if they so choose.
• In 2019, the employee contribution limit is $13,000 if under age 50.  After age 50 there is provision for an additional $3,000 catch up contribution, making the total $16,000.  

What are the distribution rules?

• Distributions are taxed as ordinary income, and like most retirement plans there is a 10% penalty if distributions are taken before age 59 1/2.  There is one extra kicker for SIMPLE IRAs: if you begin taking distributions within 2 years of opening the account, the 10% penalty is increased to 25% in addition to the income tax, so don’t do that.  
• SIMPLE IRAs can be rolled over to traditional IRA two years after original contributions to the account.
• SIMPLE IRAs are subject to RMDs at age 70 1/2.

What are the pros and cons?

• Pros 
  • Easy and inexpensive for small businesses and self-employed individuals to set up and operate
  • Employer match is free money, take advantage of it!
  • Employer contributions are always 100% vested (as opposed to vesting schedule sometimes seen with 401(k)s)
  • Catch up contributions allowed after age 50
• Cons 
  • Less flexible contribution requirements for employer, compared to SEP IRA or 401(k)
  • Harsh penalties for withdrawals within 2 years of opening account
  • Subject to RMDs

Who is this account good for?

• SIMPLE IRAs are a good solution for small business owners and self employed individuals seeking a less expensive and easier to operate plan than a 401(k).  
• If you are planning on backdoor Roth IRA contributions, any IRA balances under your name in traditional, SEP, or SIMPLE IRAs will make you subject to taxes in those accounts based on the pro rata rule (beyond scope of this post).  So the bottom line is if you want to do a backdoor Roth, this account type is not a good idea for you.  

Solo 401(k)

What type of account is this?

• A solo 401(k), also known as a one participant 401(k) by the IRS, is a tax advantaged retirement savings plan for self-employed individuals.  It has many similar features to a regular 401(k) account, but for solo 401(k)s you are acting as both the employer and the employee.   
• There is no age or income limit for opening a 401(k), but you must be a business owner with NO employees.  The one exception to this is your spouse if he or she is also employed by the business.  

What are the contribution rules?

• The best way to understand contribution limits to a solo 401(k) is to understand that you are acting as both the employer and the employee
  • As the employee, your annual contribution limit in 2019 is $19,000, just like a regular employer sponsored 401(k).  After age 50 you can contribute an additional $6,000, for a total of $25,000.
  • As the employer, you can contribute up to 25% of compensation or net self-employment income (your net profit minus half your self-employment tax plus your contributions as an employee).  In 2019 the upper limit for compensation in this calculation is $280,000.
• In 2019 the total contribution limit for a solo 401(k) is $56,000, not including after age 50 catch up contributions.  
• Contributions to a solo 401(k) can be made as either traditional pre-tax contributions or post-tax Roth contributions.  
• If your spouse is employed by the business, he or she can also have a solo 401(k) account with same contribution limits, effectively doubling your joint contributions if your income will allow it.  

What are the distribution rules?

• Qualified traditional pre-tax contributions and their earnings will be taxed as ordinary income when distributed after age 59 1/2, with standard 10% penalty if taken before this age.
• Qualified post-tax Roth contributions and their earnings are distributed tax free.
• Solo 401(k)s are subject to RMDs at age 70 1/2.

What are the pros and cons?

• Pros 
  • Higher contributions limits than SEP IRA for self-employed individuals
  • Traditional and Roth options for contributions
  • Allowance for catch up contributions
• Cons 
  • Must annually file report with IRS if account balance greater than $250,000
• Subject to RMDs (including Roth contributions)

Who is this account good for?

• A solo 401(k) is an excellent option for self-employed individuals without any employees (except for spouse) who want to save the maximum amount in a tax advantaged retirement account.  The plan starts to look even better when your spouse is employed by the business, as this can ultimately double the annual limit you contribute together.  

Governmental 457(b)

What type of account is this?

• 457(b) plans fall under the umbrella of defined contribution plans.  They are non-qualifiedemployer sponsored tax-advantaged deferred compensation plans.  Let’s break that down one term at a time.  Non-qualified means they are not governed by the rules of the Employee Retirement Income Security Act of 1974 (ERISA), while other plans like 401(k)s and 403(b)s are.  This allows you to contribute to both a qualified and non-qualified plan up to their respective maximum in the same year if your employer offers both (e.g. $19,000 to a 401(k)/403(b) and $19,000 to a 457(b) in 2019).  Employer sponsored means these plans must come through an employer.  Tax advantaged means there are tax benefits.  Deferred compensation means you are putting off part of your paycheck now to save for retirement.
• These plans come in two varieties: governmental and non-governmental.  Governmental 457(b) accounts are available to the employees of state or local governments (the federal government retirement plan is the Thrift Savings Plan or TSP).   
• Like a 401(k)/403(b), this is generally a pre-tax account, so contributions are tax-deductible and then grow on a tax deferred basis.  However, some plans also offer options for Roth contributions.  
• Assets are held in trust (assets are immediately your property but held by your employer until distribution) and have rollover privileges similar to a 401(k)/403(b).  

What are the contribution rules?

• Employees of state or local governments can contribute to a governmental 457(b) plan.  
• In 2019 the contribution limit is $19,000.  After age 50 the limit is increased by $6,000, so up to a total of $25,000 in 2019.  
• In the final 3 years before normal retirement age (the reason this non-specific term is used is because retirement age for a fireman is different than for an office worker) a plan participant can contribute the lesser of 2 x the current limit ($38,000 in 2019) or applicable dollar limits plus the sum of unused deferrals in prior years.

What are the distribution rules?

• One way non-qualified 457(b) plans greatly differ from other qualified retirement plans is that you can take distributions before age 59 1/2 without a 10% penalty.  This is only permissible, however, if there has been severance from the employer that sponsored the plan (retired or fired), plan termination, or some other more obscure criteria beyond scope of this post.  Unless contributions were Roth contributions, taxes will be due at the time of distribution.  
• Hardship distributions are permitted if you meet certain criteria.
• Governmental plans are subject to RMDs beginning at age 70 1/2.  
• Governmental 457(b) plans can be rolled over to eligible retirement plans which include 401(k), 403(b), other governmental 457(b), and IRA plans/accounts

What are the pros and cons?

• Pros 
  • Both tax deferred and Roth options for many plans
  • Distributions before age 59 1/2 not subject to 10% penalty if no longer employed
  • Better contribution catch up limit last 3 years before normal retirement age compared to other plans
• Cons 
  • May have limited investment choices
  • Subject to RMDs at age 70 1/2

Who is this account good for?

• If you are a state or local governmental employee, then I would recommend contributing to your 457(b) plan.  You get almost all the upside of a 401(k)/403(b) plan, plus you can begin taking distributions before age 59 1/2 without 10% penalty so long as you leave your employer.  That’s a winning combination.  

Non-governmental 457(b)

What type of account is this?

• This is the other flavor of non-qualified employer sponsored tax-advantaged deferred compensation plan, often referred to as simply non-qualified deferred compensation plans (NDCPs).  It may be offered if your employer is a 501(c) tax-exempt non-profit institution.  While it may not have quite as many of the perks of a the governmental 457(b) plan, there are still a lot of advantages to it, especially if you are looking to invest more pre-tax money and your employer offers this plan in addition to a qualified plan such as a 401(k) or 403(b). 
• On the surface non-governmental 457(b) plans appear very similar to a 401(k)/403(b) plans because you contribute pre-tax money that grows in a tax-deferred manner.  However, there are three key differences to keep in mind. 
  • Your assets in a non-governmental 457(b) plan are not held in trust, meaning they remain the property of the employer until distributed.  This is different than other employer sponsored retirement plans where the assets are immediately your property but held in trust by the employer.  Because the assets remain the property of the employer, they are subject to insolvency risk, which means the funds are available to creditors in the event of a lawsuit or bankruptcy.  This could be a big deal if your employer is not a very large and stable company.
  • The distribution rules vary widely.  If you leave your employer, you may not have the option to leave the assets in the plan and must immediately begin taking distributions, which are taxable events.  You may even be forced to take a one-time lump sum payment.  If the assets are substantial, this could push you into the highest tax brackets, causing you to lose a large sum of money to taxes.  Other plan options for distribution may include taking out divided payments over the course of 5 years, 10 years, or some other interval.
  • Rollovers from nongovernmental 457(b) plans to other eligible retirement plans are not an option.

What are the contribution rules?

• Unlike the governmental option that is available to all employees of that given institution, a non-governmental 457(b) plan is only available to “highly compensated employees” of the tax-exempt non-profit organization that offers it.
• In 2019 the contribution limit is $19,000.  There is no standard catch up contribution after age 50.  However, similar to the governmental 457(b), in the final 3 years before normal retirement age a plan participant can contribute the lesser of 2 x the current limit ($38,000 in 2019) or applicable dollar limits plus the sum of unused deferrals in prior years.
• No Roth option for contributions.

What are the distribution rules?

• This can greatly vary from plan to plan (see above).  If you are going to invest in a non-governmental 457(b) plan, make sure you know the rules first and have an exit strategy.
• Since this is a non-qualified plan, if distributions are taken before age 59 1/2, there is no 10% penalty so long as there has been severance from the employer that sponsored the plan (retired or fired) or plan termination.
• Taxes are due at the time of distribution.

What are the pros and cons?

• Pros  
  • Reduces your taxable income
  • Investments grow tax deferred
  • If offered, you can contribute to both a 401(k)/403(b) and a 457(b)
• Cons 
  • Contributions are not held in trust, so your money could be subject to your employer’s creditors if employer is financially unstable
  • Distribution options vary by plan, make sure you understand your options
  • Standard catch up contributions after age 50 are not permitted

Who is this account good for?

• This is a plan type to consider if you are looking to save as much of your money on a tax deferred basis as possible.  However, I would only consider this option if you have a stable employer (not likely to go bankrupt) and if there are good distribution options.  Adding a 457(b) plan to your retirement assets is a great strategy if you are considering retirement before age 59 1/2 since there is no 10% penalty for withdrawal, so long as you have left that employer.

Self-directed IRA

What type of account is this?

• A self-directed IRA is a special type of traditional or Roth IRA.  The distinguishing characteristic is the flexibility of asset types that can be held within the account.  While investments in a regular IRA typically consists of stocks, bonds, and mutual funds, a self-directed IRA can hold many other types of investments such as real estate, privately owned businesses, and other alternative assets. 
• All IRA accounts require a custodian to govern the contributions, distributions, and holdings of the account per IRS regulations.  The IRA custodian is allowed to determine the types of assets they will handle within the account under current tax rules.  For regular IRAs, the custodian is usually a large investment firm or bank you are likely already familiar with, like Fidelity, Vanguard, Charles Schwab, etc. and they typically only allow highly liquid investments such as stocks, bonds, mutual funds, and exchange traded funds (ETFs).  For self-directed IRAs, however, custodians are willing to administer accounts with alternative investments in more varied asset classes.  These custodians are usually smaller banks or trust companies.  
• Custodians vary in the types of investments each will allow in the self-directed IRA, as well as the fees they charge, so it’s important to do your research.  Furthermore, they will not provide financial advice on the asset you are investing in, so it is imperative you do your own due diligence.  
• As you might expect, the increased flexibility in these accounts are accompanied by a complex set of rules that if violated, result in significant penalties that may negate any tax benefit you get from the account.  

What are the contribution rules?

• Because a self-directed IRA is a type of traditional or Roth IRA, it has the same IRA eligibility and contribution rules as the parent account.  Please see above for those specifics.  
• Contributions within the standard limit (up to $6,000 annually in 2019, $7,000 if over age 50) are given to the custodian and invested in the chosen alternative asset.  This could be applied to a payment for real estate, ownership in a non-publicly traded company, or hard asset like gold.  It is the responsibility of the investor to comply with all IRS regulations.  
• Despite the flexibility a self-directed IRA offers, the IRS still forbids some types of investments be held within them, such as collectibles (artwork, stamps, coins, baseball cards, etc.) and life insurance.  

What are the distribution rules?

• As with contributions, the same IRS rules apply for distributions based on whether it is a traditional self-directed IRA or Roth self-directed IRA.  
• If IRS rules governing an asset within a self-directed IRA are violated, the IRS may consider this the same as distributing the asset and taxes and penalties may be due.  A common example of this is violating the “no self-dealing” rule.  For example, if you own a rental property within your self-directed IRA and a repair is needed, you may decide to try to save some money and do it yourself.  This is considered “self dealing” because you are “furnishing services” to the IRA.  As a result the IRS will consider the entire account distributed, for which you will owe taxes and a penalty.  
• Oftentimes investments within a self-directed IRA are illiquid, which can make distributions more complicated.  For example, if it is a traditional self-directed IRA you will have to begin receiving RMDs at age 70 1/2.  This may require you sell the investment to liquidate it, distribute the cash, and of course . . . pay the taxes.  

What are the pros and cons?

• Pros 
  • Allows for investments in other asset classes in a tax advantaged account
  • Greater diversification of investments beyond paper assets
  • Possible higher returns and ability to leverage investments
• Cons 
  • Requires greater investor initiative and due diligence when selecting investments
  • May be high fees associated with the investment or custodian
  • Violation of the complex rules and regulations could negate any benefit of the account

Who is this account good for?

• If you are an experienced investor and want more diversification in your investment portfolio in a tax advantaged account, a self-directed IRA might be right for you.  But you must be aware of and abide by the more complex rules and regulations, or you may be subject to heavy penalties, losing any tax benefits or worse.  For most people, regular traditional and Roth IRAs may be a better choice.  

Conclusion

Congratulations if you read this entire blog post.  I know this stuff can be tough to get through.  I envisioned this as more of a point of reference for people rather than a read it all the way through type of post.  There is so much to know and understand when it comes to retirement plans and accounts.  

Hopefully this series of posts has increased your financial literacy on this topic, which will help you take control of your financial situation on the path to FI.  If you have anything to add, please do so in the comments section below.