Financial Fingerprint: How to Approach Your Retirement Questions presented by William D. Connor, Financial Advisor at Meld Financial.
DEFENSE WINS RETIREMENT™: How to Shift Your Strategy From Growth to Income presented by Kyle Whittington, CFP®, President at Meld Financial. The webinar will be held on August 24th at 3:00 PM Central Time. There is no cost to attend, but you must register in advance.
The multitude of options available for retirement and investing accounts makes planning for retirement even more difficult. That’s because deciding which plan is best for you involves an understanding of plan eligibility, benefits and tax scenarios.
Investors who know which type of retirement account is best for their situation and choose accordingly will have better chances of meeting their goals. To make sure you are well informed, it’s critical to understand the details surrounding each type of account.
What is special about retirement accounts and what are the different types?
Retirement accounts are special because they are intended to provide individuals with a tax-advantaged way to save for retirement. Because of these tax benefits, those who take advantage of retirement accounts correctly can save huge sums of tax money over the life of their investments.
Again, there are many different types of retirement accounts, but they can be broken into two main categories: Defined Benefit Plans and Defined Contribution Plans. The benefits and eligibility for each type of account can vary, so it’s important to know the details to ensure you are selecting the best account for your situation.
Defined Benefit Plans
Defined Benefit Plans are employer sponsored retirement plans that provide a benefit for the employee at retirement. The benefit is most commonly a fixed dollar amount paid monthly during retirement, and it can vary based on many factors like length of employment and salary.
Defined Benefit Plans are managed by your employer – or the Federal Government in the case of Social Security – and retirement income from these plans is guaranteed regardless of the economy or investment returns. Early withdrawals are usually not allowed but loans are sometimes permitted, depending on the plan. There are two key types of defined benefit plans that you should understand:
1. Pension Plans
A Traditional Pension plan has historically been the most common type of Defined Benefit Plan provided by employers, but their popularity has waned in recent decades. A Pension involves an employer making contributions to an account for employees’ future gain. The funds are deposited and invested by the employer to provide predictable income for employees during retirement.
Pensions are available to employees of companies offering this retirement benefit, based on company-specific criteria. The criteria for eligibility are often based on the employee’s salary, length of employment and age at retirement.
Benefits & Limitations
Enrollment into a pension plan often occurs after an initial period of employment is completed, usually after the first year of employment. A pension will provide a set income amount at retirement, which helps you budget current and future spending. Benefits will remain stable in a changing economy. Pension plans allow employers to deposit and deduct higher annual amounts than other types of plans. This can allow for substantial retirement savings to be accumulated in a short period of time. “Vesting” can be immediate or spread out up to seven years.
With pension plans, you have no control over your employer’s investment decisions. Investment decisions are made by the company with the intention to meet the needs of the entire plan, rather than each individual employee. Pensions do not allow for withdrawals before the age of 59 1/2, although some pension programs do offer loan options. Pensions require significant oversight and maintenance, and they are considered the most expensive form of employer sponsored retirement plan.
Pension contributions are typically made by the employer and do not provide tax benefits to the employee when they are made. Payments are taxable to the employee when received during retirement.
2. Social Security
Social Security is not technically a defined benefit plan, but it shares some similarities. Social Security is a government-administered retirement system that seeks to replace a portion of income for retirees. Most people have one or more additional retirement savings plans to supplement the income received from Social Security.
Social Security was introduced during the Great Depression to ensure that retirees continue to have income once they are no longer working. Benefits are generated from workers’ contributions to the program, most commonly through payroll withholding, along with employer’s match on their contribution. Social Security is part of the retirement plan for almost all working Americans.
Employees who have paid into the Social Security system for 10 or more years and are at least 62 years old are eligible to receive Social Security retirement benefits. Spouses and former spouses are also potentially eligible for Social Security benefits, depending on earnings history.
Benefits & Limitations
The Social Security benefit replaces a portion of your pre-retirement income, based on your lifetime earnings, specifically the highest 35 years of earnings. The income amount can vary, depending on how much is earned during employment and when you choose to start receiving benefits. Social Security beneficiaries generally receive approximately 40% of their pre-retirement income from Social Security.
Some individuals will pay federal income taxes on Social Security benefits. This is common if you have income in addition to your benefits, such as employment wages, self-employment income, interest, dividends, or other taxable income.
One important advantage of Social Security is the program allows you some control over when you begin receiving benefits. Those who choose to delay receiving benefits until their full retirement age, 67 for those born after 1959, or until the latest age of 70, will receive higher monthly payments. The program also allows eligible non-working spouses to receive benefits.
On the other hand, there are some drawbacks to Social Security. For example, some people are not eligible for the benefit, and funds for the program are dwindling nationally, which could result in higher taxes, lower benefits, or a federal deficit for the program.
Defined Contribution Plans
Defined contribution plans allow employees to invest money for their retirement and choose which products they invest in. There is no guarantee of income in retirement, but these plans give you the flexibility to choose investments that match your risk tolerance. There are many different types of Defined Contribution Accounts:
A 401(k) is a retirement plan offered by some employers. There are Traditional 401(k) plans, Roth 401(k) plans, as well as Solo 401(k) plans, with each being unique to a person’s situation. Contributions that you make as an employee always belong to you, but contributions and matching contributions made by your employer could be subject to a vesting schedule.
With a traditional 401(k) plan, employees can contribute pre-tax money though automatic payroll deduction, and employers may match all or a portion of the contributions made by employees. Employers also have the option to make non-matching contributions to your 401(k), but this is less common.
401(k) plans are company-sponsored, meaning that eligibility to this type of account will be based on what your employer offers.
Benefits & Limitations
A Traditional 401(k) is a pre-taxed plan. Contributions are tax deductible in the year that they are made, and you pay income tax when you receive income from the account. This means that neither the employee’s investment nor the gains are taxed as income until such time as they are withdrawn.
The amount that can be invested each year into a traditional 401(k) is limited. For 2021, employees can contribute up to $19,500. Your employer can contribute to the account up to a combined maximum of employee and employer contributions of $58,000. Employees over the age of 50 can contribute an additional $6500 annually.
With all plans there are some limitations and the same is true for a 401(k). You will be restricted to the investment options that your employer offers. The most common investment vehicle for 401(k)s is the mutual fund, but your employer may also make company stock, individual stocks, bonds, ETFs, and variable annuities available for you to choose from. Some 401(k) plans require maintenance or other fees, so you should be aware of those. Withdrawals while you are working are accompanied by a stiff penalty, so many who need cash will opt to borrow against their savings – rather than making an early withdrawal, if loans are available within the plan.
If you change jobs, you can choose to withdraw the funds, roll them over to an IRA, or roll them over into your new employers 401(k). If you choose to withdraw the funds prior to retirement, you will be taxed for the full withdrawal amount and, if you do not meet the age requirement, you will also find a 10% early distribution penalty. In many cases, you can roll the contributions into another eligible retirement account to avoid immediate taxes and early withdrawal penalties, and keep the tax-advantaged status. At age 72, individuals are required to take out a portion of the account as a Required Minimum Distribution [RMD].
A Roth 401(k) is like a traditional 401(k) in some ways, but unlike the Traditional 401(k), Roth 401(k) is a post-tax plan. This means contributions are made after taxes are paid.
Like a Traditional 401(k), eligibility for a Roth 401(k) depends on whether your employer offers that type of plan. Some employers offer both Roth and Traditional 401(k) options. If your employer offers both, it is possible that you will be able to split your contributions between the Traditional and Roth options.
Benefits & Limitations
Since contributions to a Roth 401(k) are made after your income is taxed, you will not be taxed for withdrawals you make from the account upon retirement. This means the money you invest and the associated gains can be withdrawn tax-free at retirement. There are certain requirements that you may have to meet to ensure your withdrawals are penalty free, such as being at least 59½ years of age, and the account being open for a minimum of five years. In addition, withdrawals before age 59 ½ could be subject to a 10% penalty on earnings.
Contribution limits are the same for both Traditional and Roth 401(k) plans, and if you have both plans, your combined contributions are subject to those same limitations. For 2021, the limits are $58,000 total, with a maximum of $19,500 of employee contributions, and those over the age of 50 can contribute an additional $6,500 annually. Unlike Roth IRAs, Roth 401(k) contributions are not subject to income limits.
If you leave your job, you can withdraw contributions made to a Roth 401(k), without any tax or penalty. However, any earnings will be taxed, and a 10% penalty could be applied if you are under the age of 59½. You can also roll over your Roth 401(k) into a Roth IRA or into a new employer’s Roth 401(k) plan.
The Solo 401(k) is a variation of the Traditional and Roth plans, and it is also known as the one-person 401(k) plan. It is also sometimes called an i401(k) or Uni-k. The major difference is this plan is not provided by a 3rd party employer.
The Solo 401(k) is for individuals who are self-employed or business owners with no employees.
Benefits & Limitations
Solo 401(k) plans are available as Traditional 401(k)s or Roth 401(k)s.
If your business has any employees, you would be ineligible for a Solo 401(k). However, you are allowed to hire your spouse and he or she can contribute to the plan.
In 2021, you can contribute 100% of your earned income up to $19,500 to a solo 401(k). You can also make employer contributions from your business up to 25% of your compensation. Total Employer and Employee contributions cannot exceed $58,000. For those over age 50, you are allowed to contribute an additional $6,500 annually. For a traditional Solo 401(k), you are required to take RMDs beginning at age 72.
Individual Retirement Arrangements [IRAs] are plans that are managed by you and not your employer. You as the policy holder must open and fully fund the account. There are several types of IRAs, including Roth IRA, Traditional IRA, SEP IRA, and Simple IRA. IRAs can typically be established with a bank, insurance company, brokerage firm or other financial institution. Each type will have its own rules regarding eligibility, withdrawals, and taxation.
Roth IRAs are one type of individual retirement account, and contributions you make to a Roth IRA are made post-tax. When the funds are withdrawn, they are tax-free as long as certain conditions are met.
To be eligible for a Roth IRA, you must have an earned income. Roth IRAs are beneficial for people who are looking for the flexibility to withdraw funds from a retirement account without paying taxes. They are also popular if you are currently in a lower income tax bracket but expect to be in a higher tax bracket at some point in your future.
Benefits & Limitations
Your Roth IRA contributions will not be taxed upon withdrawal, as they were made on a post-tax basis. You also do not face any taxes on investment gains with this type of retirement plan if you wait until after age 59 ½ and at least five years from the year your account was established to withdraw any earnings.
There are no age-based restrictions on how long you can make contributions to a Roth IRA. In fact, you can contribute to a Roth IRA while you have eligible income. However, there are income-based contribution restrictions. Your eligibility to contribute will begin to phase-out when your income reaches $125,000 (or $198,000 as a married couple filing jointly). The maximum contribution amount for 2021 is $6,000, or $7,000 for those over age 50.
Traditional IRAs, unlike Roth IRAs, may allow you to deduct some or all of your contributions from your income in the year you make the contributions. This type of account is best for those individuals with earned income who are looking to reduce their tax bill while saving for retirement.
Almost anyone can contribute to a Traditional IRA, provided they have some taxable income. However, these accounts are best for people with earned income who are looking to lower their tax bill. Additionally, these plans can be beneficial for those who make too much money to contribute to a Roth IRA.
Benefits & Limitations
The major benefits of a Traditional IRA come in the form of tax benefits. Contributions reduce your taxable income in the year you make them, so you can expect to pay the standard income tax rate when it is time to begin withdrawing funds from the account. Those who expect to have lower taxable income at the time they make their withdrawals can benefit greatly from these accounts. In addition, these funds will grow on a tax-deferred basis, which can provide significant benefits over time.
There are limits to the amounts invested in a Traditional IRA, and those limits are based on income. Also, if you or your spouse are covered by an employer’s retirement plan, you may not be eligible to deduct your IRA contributions from your taxable income. Individuals can contribute up to $6,000 for 2021, and for those ages 50 and older, the limit is $7,000 annually for catch-up contributions.
As with a Roth IRA, you can now contribute to a Traditional IRA at any age, given the requirement to have earned income. Unlike a 401(k), you can withdraw funds at any time, even if you are still employed. If you withdraw funds before age 59½, you will be required to pay tax on the distribution plus you may be required to pay a 10% penalty. At age of 72, you will be required to take out a portion of the account as a required minimum distribution.
A Simplified Employment Pension [SEP] is an IRA retirement plan that is intended for small business owners and those who are self-employed. These plans do not have the start-up and operating costs of a conventional retirement plan.
Individuals who are self-employed or small business owners are eligible to set up an SEP IRA. Business owners who open a SEP IRA are required to establish an account for eligible employees if they have any.
Benefits & Limitations
Contributions to a SEP IRA are made by an employer and are tax deductible by the business. Employees cannot make contributions to a SEP IRA, but they can contribute to a Traditional or Roth IRA as an individual, even if they also participate in a SEP IRA.
For the SEP IRA, the contribution limit is higher than with the Traditional or Roth IRA options. The limitations are either $58,000 or 25% of your earned income (20% of your net income if self-employed) – whichever is less. SEP IRAs are easy to set up and maintain and often have lower cost than other retirement plan options. Employees can invest in mutual funds, stocks, bonds, annuities, and other investment options.
Withdrawals are allowed for any reason, even if you are still employed. However, they are subject to tax and may be subject to an additional 10% penalty if you are under age 59 ½. During retirement, withdrawals are taxed as income and subject to RMDs at age 72. There are no loan options for a SEP IRA. Finally, SEP IRA contributions are immediately 100% vested.
The Savings Incentive Match Plan for Employees, also known as the SIMPLE IRA, is a plan that is established by the employer. The employer is required to contribute to the accounts of participating employees.
SIMPLE IRAs are intended for small businesses and self-employed persons. Employers with fewer than 100 employees are allowed to participate in these retirement plans.
Benefits & Limitations
Unlike SEP IRAs, employees are eligible to make contributions to a SIMPLE IRA account. Employee contributions are made on a pre-tax basis. In addition, funds that you invest will grow tax-deferred – meaning they are taxed when you take a distribution from the account.
SIMPLE IRA accounts are immediately 100% vested and the owner of the account can take a distribution at any time. However, if you take a distribution before age 59 ½, you may face a penalty of up to 25%. The penalty is reduced to 10% if your account has been active for two years prior to the distribution.
Employers who establish SIMPLE IRAs for their employees must contribute to their eligible employee’s accounts. The employer can choose to contribute a flat rate of 2% for all employees, regardless of whether the employee also contributes to the account, or more commonly, employers can match 100% of employees’ contributions up to 3% of their compensation.
As with most retirement plans, there are contribution limits and guidelines. Employee contribution limits for 2021 are $13,500, with those ages 50 and older being eligible to make catch up contributions of $3,000. Employer contributions are not included in the $13,500 limit.
A 403(b) plan is similar to a 401(k) plan but is intended for employees of tax-exempt organizations. A 403(b) is also called a tax-sheltered annuity [TSA] plan. Employees with these plans can save for retirement through contributions to their individual accounts and through employer matching if offered.
Employees of tax-exempt organizations like public schools, non-profit agencies and churches can be eligible for 403(b) plans if their employer sponsors the plan.
Benefits & Limitations
Employers might offer 403(b) plans as part of a benefits package and may match your contributions as an employee. You will have a choice of investments when you defer earnings to a 403(b) plan. Your employer will choose which investments are available for you, and the options can include annuities, mutual funds, or a retirement income account. One major limitation to these plans is individual stocks, bonds, and ETFs are not available as investments.
In a Traditional 403(b) plan, contributions are made on a pre-tax basis, and these contributions, along with their earnings are not taxed until you withdraw funds during retirement. In a Roth 403(b) plan, contributions are made with after tax money and distributions are not taxed when taken after age 59 ½. For 2021, the contribution limits are $58,000 total, with a maximum of $19,500 of employee contributions. Those over the age of 50 or with over 15 years of service may qualify to make additional “catch-up” contributions over the normal limits.
Any contributions that you made as an employee to a 403(b) can be taken with you if you change jobs. If you are vested prior to your job change, you will maintain all your employer-made contributions, however, if not vested, you may will lose all or some of those contributions made by your employer.
Funds withdrawn from a 403(b) prior to the age of 59½ may be subject to a 10% tax penalty. Early withdrawals are generally not allowed but account holders can usually take out loans against the plan if they need emergency cash. At age of 72, you will be required to take out a portion of the account as a required minimum distribution.
A 457(b) plan is a deferred compensation plan offered through government or other special types of employers. Contributions are taken from your paycheck on a pre-tax basis, lowering your taxable income, and remain untaxed until the funds are withdrawn. Some plans offer a Roth option, where contributions can be made after taxes are paid. In this case, funds would be withdrawn tax-free, assuming any specific qualifying conditions are met.
Those eligible for 457(b) plans typically include state and local government employees, such as police officers, firefighters, and government officers. Public school teachers are also commonly eligible for this type of plan. There are some employees at nonprofit agencies such as hospitals, charities, and unions who are also able to use 457(b) plans.
Benefits & Limitations
457(b) plans generally offer two types of investments: annuities or mutual funds. These types of investments are not taxed until funds are withdrawn in retirement. 457(b) plans work well with other plans, such as 403(b), making them a desirable retirement plan option for some.
The contribution limit for 457(b) plans in 2021 is $19,500, which includes employee deferrals and any contributions made by the employer. Those age 50 and older may be eligible to make catch-up contributions three years before reaching retirement age. This additional amount can allow you to contribute up to twice the maximum annual contribution. Eligibility will be based on the details of your plan.
With 457(b) plans, there is no tax penalty for early withdrawals – if the withdrawal is for a qualifying hardship or you have separated from your participating employer. A downside to 457(b) plans is that not everyone will qualify since the plans target a specific audience for eligibility. Also, these plans do not have the same type of employer match as found with a 403(b). In addition, be careful because some 457 plans do not allow rollovers into an IRA if you change jobs.
There are some other types of accounts and plans that aren’t designed specifically for retirement but can allow certain individuals added benefits when saving for retirement. One of the lesser known, but most important is the Health Savings Account [HSA].
Health Savings Accounts [HSAs] are like personal savings or investing accounts, but they can only be used for qualified healthcare expenses, as identified in your plan. HSAs allow you to set aside pre-tax funds to be used for those qualified expenses. These funds can grow in the account, tax-free until they are used for a qualified expense. However, what many people don’t realize is that funds that remain in an HSA after retirement can be withdrawn without penalty.
To be eligible for an HSA, you must be enrolled in a High-Deductible Health Plan [HDHP]. HDHPs typically covers preventive services before the deductible, and eligible health plans will typically identify themselves as HSA-eligible.
Benefits & Limitations
Funds for HSA are deposited before taxes and may lower your taxable income. As you pay for qualified medical expenses, withdrawals from the HSA are not taxed. Funds in the account can be invested in mutual funds, stocks, ETFs, and other investment vehicles defined by the HSA provider. Unused funds at the end of the year roll over to the next year.
A drawback to the HSA is the required HDHP. The current deductible minimum for a qualifying health plan is $1,400 for individuals and $2,800 for families. These plans are not suited for every situation, particularly if you expect to have a significant amount of healthcare related expenses.
If you have an eligible HDHP, you can contribute up to $3,600 to an HSA in 2021 as an individual, and families can save up to $7,200. Individuals age 55 and over can contribute an additional $1,000 per year as a catch-up contribution. Those who have any form of Medicare are ineligible to contribute to an HSA. Withdrawals are tax-free within the allowable parameters, but if you withdraw funds prior to age 65 that are not for qualified expenses, you will owe income tax on the withdrawn amount, plus a penalty of 20%.
HSAs can be set up through your employer, or individually. If you set up your HSA through your employer and then leave the company, you keep the money that you have invested. In some cases, HSAs may charge a monthly fee, but this is specific to each institution.
Get Your Financial Fingerprint™ at Meld Financial
As you navigate the process of retirement planning, having a team of professionals at your side can give you confidence in your future. Contact the team at Meld Financial, where we can leverage our vast experience, in conjunction with a team of financial and legal professionals, to help you develop your Financial Fingerprint™.
Your Financial Fingerprint™ is a unique financial planning process developed at Meld through several decades of managing our clients’ wealth. In short, your FINANCIAL FINGERPRINT™ is a plan that is quick to assemble, easy to understand and simple to modify as your circumstances change. If you’re ready to talk, click the “Get Started” button on our home page to schedule a meeting with a member of our team.