17 Personal Finance Concepts – #3 Retirement Accounts

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Some of the Personal Finance content I will be writing about in this series of articles may be obvious or rudimentary to many of my readers but it also may be of great value to young people you may know. Please share this information with those you believe will best benefit from it.

There are numerous retirement plans available. This article will summarize the primary ones that most everyone uses.

401(k) Plans

401(k) Plans are retirement plans offered to employees working in the private sector (working for a company).

401(k) Plans are also known as “Deferred Contribution Plans” because they allow employees (aka Eligible Participants) to contribute part of their Gross Pay to the plan. The amount an employee contributes to the plan is not subject to Federal Income Tax. Most States follow (Called “Couple”) this Federal Tax Treatment of employee contributions. The amount the employee is permitted to contribute is capped each year. For example, in 2024, employees may contribute up to $23,000. If an employee is age 50 or older, the annual cap for 2024 is $30,500. That additional $7,500 employee contribution is known as a “Catch-Up” contribution. Most States couple (follow) with the Federal cap on Employee Contributions.

Most 401(k) Plans have something called an “Employer Match”. The Employer Match, for most plans, can be 0% (No Employer Match) up to a 100% Employer Match. Meaning, if an employee contribute $5,000 to the 401(k) Plan, the employer will match that employee contribution between 0% – 100%. If the employee does not make any contribution, the employer is not obligated to make any contribution, unless the employer makes an election to do so.

The employee and employer contributions are invested and grow Tax Deferred. Tax Deferred means there is no Federal of State income tax on the growth of an employee’s 401(k) Plan Account until that employee retires and begins withdrawing money from their 401(k) Plan. Those withdrawals are called Distributions. Distributions are taxed based upon an employee’s Federal and State Income Tax Brackets, at the time of the Distribution.

403(b) Plans

403(b) Plans are retirement plans offered to employees working for a non-profit, such as a school or charity. The 403(b) Plan rules are similar to 401(k) Plans.

457 Plans

457 Plans are retirement plans offered to employees working for a government entity. The 457 Plan rules are similar to 401(k) Plans.

A loophole allows individuals to contribute and participate in both 403(b) Plans and 457 Plans, essentially doubling an employee’s ability to build retirement plan assets.

Individual Retirement Accounts (IRAs)

There are four types of IRAs:

  1. Tax Deductible Traditional IRA
  2. Non-Tax Deductible Traditional IRA
  3. Roth IRA
  4. Rollover IRA

Traditional IRAs allow you to take an Income Tax Deduction for the amount you contribute each year. The amount you may contribute is capped each year. For example, in 2024 the cap is $7,000 if you are under age 50 and $8,000 if you are age 50 or older. This additional $1,000 is called a “Catch-Up” Contribution.

Most individuals are eligible to contribute to a Traditional IRA. Those who are ineligible include individuals who do not have any “Earned Income” (i.e. W-2 Income).

If you participate in an Employer Retirement Plan (401(k), 403(b) or 457 Plan) and make too much money, you will be ineligible to take a Tax Deduction for your IRA Contribution. In this case, the IRA is considered a “Non-Deductible Traditional IRA”. If you cannot make a Deductible IRA Contribution for a particular year, there is a loophole that allows you to convert that Non-Deductible IRA Contribution to a Roth IRA. This is called a “Back-Door Roth Contribution”.

Roth IRAs are different from Traditional IRAs in that you are not allowed to take a Tax Deduction for contributions you make to a Roth IRA. That’s the bad news. The good news is that when you retire, you are not taxed at all on Roth IRA Distributions. Contribution Rules for Roth IRAs are the same as the Rules for Traditional IRAs.

Rollover IRAs are simply Employer Retirement Plan assets that are Rolled Over into an IRA. This can be done in three instances:

  1. During Employment – Called an “In-Service Rollover”
  2. After Retirement or
  3. Change of Employment – When a participating employee in an employer 401(k) Plan leaves that employer, they may Roll Over their 401(k) Plan Assets into an IRA

Simple IRAs and SEP IRAs

Simple IRA Plans are available to small employers. The rules are similar to 401(k) Plan Rules, except the amounts that may be contributed by the employee and employer are much lower than 401(k) Plans.

SEP Plans are often used by Sole Proprietors. In a SEP, there is no Employee Contribution. The Employer is the only one who may contribute to a SEP. The employer is limited as to how much they may contribute to a SEP. The Sole Proprietor/Employer can only contribute a maximum of 20% of Net Profit to their own SEP Account. The Sole Proprietor/Employer may contribute as much as 25% to their Employee SEP Accounts. The employer percentage contribution to each employee must be the same percentage amount.

Annuities

Annuities are offered primarily by Insurance Companies. There are two types of Annuities – Fixed or Variable.

Fixed Annuities – You purchase a Fixed Annuity by giving an Insurance Company a Premium. In exchange for this Premium, the Insurance Company Guarantees you a Fixed Lifetime Income at some point in the future (i.e. age 65). When you purchase a Fixed Annuity, the Premium (Purchase Price) belongs to the Insurance Company. Meaning, if you purchase a $100,000 Fixed Annuity at age 50, to use when you retire at age 60, and then immediately die, you lose that $100,000.

That’s the downside.

The upside is that if you live to 100, the Insurance company is contractually obligated to continue paying you the Guaranteed Fixed Income until you die.

Variable Annuities – Unlike Fixed Annuities, the Premium you pay for a Variable Annuity is not lost to the Insurance Company. Rather, the Insurance Company invests that Premium, often based upon investment selections you are able to choose.

If the Investment Value of the Variable Annuity grows, you are entitled to the fair market value of that annuity, at some point. Often, a Variable Annuity will offer something called “Lifetime Income”. This Lifetime Income is typically a percentage of the value of the Variable Annuity at the time you begin to withdraw money from that Variable Annuity.

Variable Annuities may be Qualified or Non-Qualified.

A Qualified Variable Annuity means the money invested in the Variable Annuity is money that comes from a Retirement Plan that you rolled over into a Rollover IRA, and that Rolled Over “Pre-Tax” money (Money that has never been taxed) is then invested in a “Qualified” Variable Annuity.

Non-Qualified Variable Annuities are not funded by Retirement Assets but by money you have sitting in a bank account or brokerage account. This money is known as “After-Tax” money. When you start withdrawing funds from a Non-Qualified Variable Annuity, part of the Distribution will be considered a Tax-Free return of the After-Tax Contribution you previously made.

Cash Surrender Value

One type of Insurance Policy you can purchase is known as Permanent Life Insurance. This is Life Insurance that allows you to pay a fixed premium for many years. The premiums you make are then invested. After expenses, the Insurance Company will credit your Permanent Life Insurance Policy with something called “Cash Surrender Value” (CSV). There is a tax rule that allows you to borrow up to 90% of the CSV without any taxation. Many individuals who invest in a Permanent Life Insurance Policy will either borrow part of that CSV at retirement or allow the Insurance Company to use the CSV to pay for Premiums to keep the policy in force, so that you will receive a death benefit.

Pension

Pensions are Retirement Plans that are primarily funded by Employers for the benefit of their Employees. However, some Pensions do allow/require Employee Contributions. Pensions funded by Employers are the Gold Standard of Retirement Plans because it is a valuable benefit provided by the Employer. In exchange for working for a pre-determined length of time, a Pension guarantees each Employee a specific amount of retirement benefits each year, upon their retirement. Pension Plans are fading away, due to the high cost burden to Employers.

Tom Corley is an accountant, financial planner and author of “Rich Kids: How to Raise Our Children to Be Happy and Successful in Life”, Effort-Less Wealth, Change Your Habits Change Your Life, Rich Habits Poor Habits and “Rich Habits: The Daily Success Habits of Wealthy Individuals.”

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