Surveying the different types of accounts you can choose from
Taking care of your 401(k) balances
Naming beneficiaries for your retirement accounts
Becoming familiar with RMDs
One of the virtues and drawbacks of living in the United States is that you have plenty of choices — sometimes too many. And that’s certainly the case with the numerous types of retirement accounts and variety of investments; far more options exist here than in just about any other country in the world.
With so many choices, you may be confused about which option is best for you. Selecting the best is important because you can end up saving yourself more tax dollars and making more after-tax money in the long run. And whether you’re entering retirement or are still a decade (or more) away, you need to understand the nuances and rules of each type of account so you not only make good decisions but also comply with the myriad tax rules.
This chapter discusses the common types of retirement accounts to which you may contribute. It also discusses early withdrawal penalties, beneficiary decisions, transfer and rollover rules, and borrowing from or against retirement accounts.
Eyeing the Characteristics of Retirement Accounts
Before you can use retirement accounts to your benefit, you first need to know the 4-1-1 on these accounts, including the advantages to using them and the potential drawbacks. The following sections lay out these pros and cons. Keep this important information in mind as you consider the different types of retirement accounts available.
Focusing on the tax benefits
The main attraction of any retirement account is the tax savings it provides. You generally receive upfront tax breaks on your contributions up to a certain limit. For example, suppose that you’re able to contribute $1,000 per month ($12,000 per year) into a tax-deductible retirement savings plan. Assuming that, between federal and state taxes, you’re paying about 35 percent in taxes on your last dollars of income, you should see your federal and state tax bills decrease by about $4,200 ($12,000 × 0.35). This immediate savings is usually enough of an incentive to encourage folks to build wealth by funding retirement accounts.
Because the money contributed to the retirement account isn’t taxed at the federal or the state level in the year in which a contribution is made, your take-home pay shrinks by much less than the $1,000-per-month contribution. Unfortunately, directing money into retirement accounts doesn’t allow you to avoid current Social Security and Medicare taxes on wages you earn during the year.
These upfront tax breaks are just part of the value derived from using retirement accounts. You also can reap these other tax-related benefits when you invest in a retirement plan:
Your investment returns accumulate without taxation. After you contribute money into a retirement account, any accumulated investment returns aren’t taxed in the year earned. So, in addition to reducing your taxes when you make your contribution, you save from this tax-deferred compounding of your investment over time. In other words, all the taxes you would have owed over the years compound in your account and make your money grow faster. You pay tax on this retirement account money only when you make withdrawals.
When you invest, Uncle Sam ends up with less of your money. If you don’t invest money in a retirement account, you start with less dinero in your pocket because Uncle Sam and your state’s government immediately siphon off some taxes. The longer the money is invested, the more you profit by investing inside a retirement account.
Some people are concerned that if their tax rate in retirement is high, then funding retirement accounts could lead to higher taxes. Although this scenario is possible, it’s unlikely. Because of the tax-deferred compounding, you should come out ahead by funding your retirement accounts. In fact, your retirement tax rate could increase and you’d still come out ahead.
Income tax rates need to rise significantly from current levels to eliminate the tax-deferral benefits. Even though income tax rates for some individuals may rise in the future, the benefits of tax-deferred contributions and investment income should outweigh the increased tax burden you may face when these funds are withdrawn. For example, say that your tax rate at the time of contribution is 35 percent. Table 7-1 shows how high your tax rate would need to increase to wipe out all your tax-deferral benefits over the years.
TABLE 7-1 Retirement Tax Rates That Would Negate Tax-Deferral Benefits
Number of Years Contribution Compounds
Tax Rate That Eliminates Benefits
10
50 percent
15
56 percent
20
61 percent
25
66 percent
30
70 percent
35
74 percent
40
77 percent
As you can see from the table, the longer your money is invested, the higher your tax rate would have to rise to wipe out the tax-deferred compounding benefits. After the money is in the account for 30 years, your tax rate would have to double (from 35 percent to 70 percent) to eliminate the tax-deferred compounding benefits.
If your employer matches your contributions or contributes additional money to your account, such as with a company-sponsored 401(k) plan, you’ll be even better off. Free employer money further enhances the upfront tax benefits by giving you more money working for you that is not subject to tax in the year the contributions are made. Even if you unexpectedly need to withdraw your contribution, you should still come out ahead — the penalties for early withdrawal are only 10 percent and whatever penalty, if any, your state charges. You’ll also owe regular federal and state income tax on withdrawals.
Being aware of restrictions and penalties
Some people contribute little or no money to retirement accounts because of worries about having access to their funds. Although investing your money in a retirement account may limit your access to the money in the short term, overall the investment is a smart move for your retirement in the long run.
If you do have to withdraw your money from a retirement account prior to reaching 59½, you may incur a tax penalty. The penalty is 10 percent in federal taxes plus whatever penalty your state assesses. This penalty tax is in addition to the regular income tax that’s due in the year you make the early withdrawal.
Some exceptions (called IRS Rule 72(t) exceptions) do allow you to withdraw retirement account money before age 59½ without penalty, though you’ll still owe income taxes. (All the exceptions are explained in detail in the free IRS Publication 590-B, “Distributions from Individual Retirement Arrangements”.) The most commonly used exceptions are these:
Five years of withdrawals: You may withdraw retirement account money early as long as you make withdrawals for at least five consecutive years or until age 59½, whichever is later. The withdrawals must be substantially equal each year and be based on your life expectancy according to Internal Revenue Service (IRS) assumptions and reasonable interest rates. IRS rulings provide details for computing the annual distributions.
Health problems: If you suffer a disability or incur significant medical expenses, you may be allowed to withdraw money early from your retirement account without penalty. See IRS publication 590 for more information.
Borrowing: Your employer’s retirement plan may allow you to borrow from your plan without incurring a penalty. This is generally not a great idea, especially if you seek the money for current spending, such as buying furniture, taking a vacation, and so on. It can make sense, for example, if you need some down payment money to buy a home. But be sure that you understand the repayment rules and terms, because if you’re unable to repay the loan, the unpaid money is treated as a retirement account withdrawal and subject to current federal and state income taxes as well as penalties unless you withdrew the money after age 59½.
The best solution for short-term money needs is to ensure that you maintain an emergency reserve of money (three to six months’ worth of living expenses) outside your retirement account. If you don’t have an emergency reserve account, you may be able to borrow money from other sources, such as a family member or through a line of credit or lower-interest credit card.
Identifying the Different Types of Retirement Accounts
Different employers and employment situations present unique retirement account options. This section explains the common retirement accounts you’ll confront and how they work.
Employer-sponsored retirement accounts
When you work for a company or organization, you may have access to an employer-sponsored retirement savings plan. In this case, the company provides access to an investment firm through which you can contribute money via payroll deductions. Plans have rules specifying, for example, how long after becoming an employee you must wait to begin participating in the plan, company matching contributions, and the overall limits of how much you may contribute to your account.
The good news with this type of plan is that your employer has done the legwork and maintenance for the plan. The potential bad news is that you’re at their mercy if they don’t have a good plan.
For-profit companies may offer 401(k) plans. Nonprofit organizations can offer 403(b) plans. Government employees may have their own plans such as a 457 plan for state and local government workers and the Thrift Savings Plan for federal government employees. These plans are similar in that contributions into them from your employment earnings aren’t taxed at either the federal or state level.
For tax year 2017, the annual contribution limits for these retirement accounts are the lesser of 20 percent of an employee’s salary to a maximum of $18,000. If you’re 50 or older, your contribution limit is $24,000.
Self-employed retirement savings plans
Another type of retirement plan is the self-employed retirement savings plan. One of the biggest benefits of earning self-employment income is the ability to establish a tax-sheltered retirement savings plan. These plans not only allow you to contribute more than you likely would be saving on a tax-deferred basis for an employer, but they also can be tailored to meet your specific needs.
As with other retirement savings plans, your contributions to self-employed savings plans are excluded from your reported income and are thus exempt from current federal and state income taxes. The earnings that accumulate on your savings over time also are exempt from current income taxes. You pay taxes on your contributions and earnings when you withdraw them, presumably in retirement, which is when you’re likely in a lower tax bracket.
A couple of different versions of self-employed retirement plans are available. The following list explains which plan may be right for you:
Keogh plan: This type of retirement plan is of potential interest to business owners who have employees that are covered by a plan, because you may be able to contribute more to your account relative to contributions for your employees’ accounts. Speak with a tax adviser or an investment management company for more information.
You must establish a Keogh plan by the end of the tax year (usually December 31), but you have until the filing of your federal tax return to make your actual contribution to the plan.
The drawback to a Keogh plan is that it requires slightly more paperwork than a SEP-IRA plan to set up and administer. However, the no-load mutual fund “prototype” plans simplify the administrative burden by providing fill-in-the-blank forms.
A Simplified Employee Pension Plan, Individual Retirement Account (SEP-IRA): This type of plan cuts through much of a Keogh plan’s red tape and is somewhat easier to set up and administer.
As with a Keogh plan, when you as the employer establish a SEP, you must offer this as a benefit to employees if you have them.
With both of these plans, you may contribute up to the lesser of 25 percent of your self-employment income to a maximum of $54,000 for tax year 2017 ($55,000 for 2018). To determine the exact maximum amount that you may contribute from self-employed income, you need to have your completed Schedule C tax form so you know your business’s net income for the year. To find out more about setting up these types of accounts, see the nearby sidebar “Establishing and transferring retirement accounts.”
Individual Retirement Accounts (IRAs)
What if you work for an employer that doesn’t offer a retirement savings plan? You can certainly lobby your employer to offer a plan, especially if it’s a nonprofit, because little cost is involved. Absent that, you can consider contributing to an Individual Retirement Account, or IRA. You may contribute up to $5,500 in 2017 as long as you have at least this much employment (or alimony) income. Those folks who are age 50 and older may contribute up to $6,500 in 2017. The limits are adjusted for inflation annually (or not).
Whether you can deduct your IRA contribution from your annual taxes depends on whether you participate in another plan through your employer. Check with your employer about this.
If you can’t take the tax deduction for a regular IRA, consider the newer Roth IRAs, which allow for tax-free withdrawal of investment earnings in your later years. For tax year 2017, you may contribute up to maximum limits, which are the same as on a regular IRA, as long as your modified adjusted gross income doesn’t exceed $118,000 if you’re a single taxpayer or $186,000 for married couples filing jointly.
Rolling Over Retirement Balances
One of the most important decisions you’ll make with your retirement accounts is what to do with your money in your accounts when you retire. Make the right choice and do the transaction properly, and your after-tax retirement income will be greatly increased. Make a mistake, and you’ll pay far more taxes than you need to.
The most common rollover is from a 401(k) plan to an IRA. There are other types of rollovers, however. Money can be moved from one 401(k) to another, from one IRA to another, and from a defined benefit pension plan to an IRA, to give three common examples. But the 401(k)-to-IRA rollover is the most common and probably the most important. This section, as an example, focuses on the important (and common) decision of how to handle a 401(k) account balance when leaving an employer.
Deciding what road to take
You should begin planning what to do with your 401(k) account balance well before you leave the sponsoring employer to ensure that you have sufficient time to research and get comfortable with what you’re going to do with your money. Too many people make their plans for travel and other activities for the first six months of retirement, but then they give no thought to what to do with their 401(k) balances until presented with their options as they’re leaving the job.
Most 401(k) plans offer several options for handling an account balance when you leave your employer. Here are those options and the issues to consider for each one:
Leave the balance in the plan until distributions begin. This option can be a good idea when you like the plan because of its investment options, low costs, or other features. The plan also may allow you to take loans from the account, which could make the plan a source of emergency cash.
However, depending on your circumstances, you may not want to leave your money in the plan for several reasons. For example, you will have more investment options by rolling the balance into an IRA. In addition, the employer could increase fees and change plan offerings between the time you quit and the day you begin receiving distributions. As a former employee, you’ll be out of the information loop and may learn about important changes long after current employees. Due to rules and restrictions, most 401(k) plans also are less flexible about post-retirement distributions than IRAs.
Look into annuity options. The plan may offer an annuity option, making fixed, guaranteed payments to you for life or for a period of years, which can be attractive. Look at all your options, though; you may find higher payments available through commercial annuities purchased through an IRA. (For more on annuities, check out Book 4, Chapter 3.)
When your employer offers an attractive annuity but you don’t want the entire account turned into an annuity, you can purchase the annuity with part of the account. The annuity portion can be distributed directly to you, and then taxes are paid only as annuity payments are received. The rest of the account can be rolled over to an IRA.
Take the account balance in a lump-sum payment. The entire lump sum would be included in gross income, but the tax law provides a special ten-year income averaging treatment that reduces the tax — but only for those born before 1936, so few people taking lump sums now qualify. You may choose this option when you need or anticipate needing the cash to pay expenses within a few years. Otherwise, you probably should take advantage of tax deferral by leaving the balance in the 401(k) plan or rolling it over to an IRA.
Roll over the balance to an IRA. A rollover basically is taking the money from the 401(k) account and moving it to an IRA. The rollover transfers the account to the broker or mutual fund company of your choice for the best combination of fees, investment choices, and other services.
Choosing a custodian and rolling over your balance to an IRA
After deciding that you want to roll over your 401(k) balance to an IRA, determine who will be the IRA custodian. The custodian is a broker, mutual fund firm, bank, insurance company, or other financial services company that offers IRAs. When considering which custodian to choose, consider the following:
Research the fees, services, and investment options. Look for an IRA custodian that has the features and services you desire. You should have an idea of how the account will be invested initially and which types of investments are most important to you.
Decide how you will transact most of your business. Do you prefer talking on the telephone? Doing transactions in person? Mailing information? Or using the web? Most large custodians offer all these options, but smaller ones may not.
After you select your custodian, you basically have two ways to rollover a retirement account balance:
Option 1: The trustee for your employer’s plan can issue a check to you or make a direct deposit into your bank account. You have 60 days to deposit the check (or an equivalent amount) into an IRA or other qualified retirement plan. If you fail to make the transfer within 60 days, you’ll owe income taxes; and if you’re under age 59½, you may owe a 10 percent early distribution penalty. In 2014, the IRS revised the rules so that a taxpayer is allowed to do only one of these rollovers per tax year.
This type of rollover has a trick. When the check is made out to you, the trustee must withhold 20 percent of the account balance for income taxes. The taxes will be refunded to you after you file your tax return and show that you rolled over the account balance within 60 days. But you must deposit in the IRA the entire 401(k) account balance, not only the amount distributed to you. As a result, you must come up with an amount equal to the 20 percent that was withheld and roll that into the IRA along with the amount that was distributed.
Option 2: The other form of rollover is the trustee-to-trustee transfer. The 20 percent withholding isn’t required when the distribution check is made payable to a specific IRA custodian instead of to you.
Here’s how this easy transaction works:
You open an IRA with the custodian of your choice.
You complete a rollover form giving the details of the account you want the balance rolled over from.
The IRA custodian contacts the trustee of your 401(k) plan and ensures that the 401(k) trustee transfers your account balance to the custodian.
This method is the easier and safer way to roll over your IRA, because it avoids the possibility of missing the 60-day deadline of the other method and can be done an unlimited number of times. All you have to do is be sure the 401(k) balance is transferred to your IRA. Sometimes a mistake is made, and the transfer is made to a taxable account instead of an IRA. If this isn’t corrected promptly, you will owe income tax on the entire amount.
Why would anyone choose Option 1 when you can avoid the hassle of rounding up the extra cash by choosing Option 2? Some employees choose inferior Option 1 because they don’t know better and their employers don’t warn them before issuing the check. You’ve now been informed and won’t make that mistake!
No matter which of the preceding options you choose, to be tax-free, a rollover must qualify as a lump sum, which means that the entire account must be distributed within the same calendar year. Sometimes a rollover doesn’t qualify as a lump sum because some late dividends or other distributions aren’t distributed until after December 31. In addition, the employee must be either separated from service of the employer (in other words, no longer working for the employer) or over age 59½.
If your 401(k) account contains employer stock, don’t transfer the entire account to an IRA. Doing so causes you to lose a valuable tax benefit. When the employer stock is distributed to a taxable account, taxes are generally deferred on it until the stock is sold from that account. In this situation, you maximize tax benefits by splitting off the employer stock from the retirement account. Have the employer stock distributed to a taxable (nonretirement) account and the rest of the account rolled over to an IRA.
Choosing Beneficiaries for Your Retirement Accounts
When you create a retirement account, you need to make sure you select the beneficiaries who receive the proceeds. Your will doesn’t determine who inherits your IRA and other qualified retirement plans. The account is inherited by whoever is named beneficiary on the beneficiary designation form on file with the plan custodian or trustee.
When choosing your beneficiary, take the time to select the person (or persons) you want to receive your money. Often people don’t give much thought to this important designation. Most folks simply write down an obvious beneficiary when they open the account and don’t give much thought to it again. In the meantime, they may have been married or divorced, or had children or grandchildren. The account probably has grown into a significant asset over time, yet the beneficiary choice hasn’t been reconsidered through all these changes.
You need to give some thought to your beneficiary choice as part of your overall estate plan, and you must review that choice every couple of years. Here are some guidelines to follow:
Take care of your spouse first. Retirement accounts are a significant part of most estates. Married people whose priorities are taking care of their spouses name their spouses as the primary or sole beneficiaries of their accounts. Of course, you also should name contingent beneficiaries (those who get the account if the primary beneficiary has passed away) in case your spouse doesn’t survive you or passes away while assets are still in the IRA. For most people, the contingent beneficiaries are their children in equal shares. But you can name other contingent beneficiaries, such as other relatives or friends.
Be careful about naming a trust. A trust is an arrangement in which a trustee manages property for the benefit of someone else. You may want to name a trust as beneficiary to ensure that, for example, your sibling who knows something about investing manages the IRA until your teenagers are older. A trustee also can control how much is distributed. A trust also allows you to control who receives the amount left after the initial beneficiary passes away. However, you have the potential of losing the tax deferral for the IRA if the beneficiary isn’t a natural person. Certain types of trusts carry a limited exception to this rule about natural persons. In this case, however, the trust must be carefully written by an experienced estate planner to avoid losing the tax deferral.
Consider splitting your IRA. When you have children but no surviving spouse (or your spouse will have significant non-IRA assets), your children likely will be named equal beneficiaries of your IRA. When children inherit IRA funds, annual distributions are required based on the life expectancy of the oldest beneficiary. The children also must agree on investments and distributions that exceed the minimum required distributions.
Your children have the right to split the IRA into separate IRAs for each of them. You may want to split the IRA now instead of waiting for the kids to work things out. This split gives you more control over the amount of assets each child inherits. It also allows you to name different contingent beneficiaries for each IRA. If you want a trust to control the inheritance of only one beneficiary, splitting the IRA makes this easier. Otherwise, the other beneficiaries have to coordinate their management of the IRA with the trustee.
Make charitable gifts with the IRA. All your beneficiaries could receive more after-tax wealth when charitable gifts are made with the IRA and other heirs inherit other assets.
Don’t name your estate as a beneficiary. A natural person must be beneficiary for the IRA to retain its tax deferral. Name your estate as beneficiary, and the IRA must be distributed on an accelerated schedule. Also, don’t fail to name a beneficiary; otherwise, your estate will be considered the beneficiary.
Taking Required Minimum Distributions, or RMDs
The main purpose of investing in an IRA or other qualified retirement plan is to help you financially during your retirement years. As a result (and because he wants to collect taxes), Uncle Sam requires that you start taking distributions at a certain age. You must begin annual required minimum distributions (RMDs) from IRAs and other qualified retirement plans by April 1 of the year after you turn age 70½.
The following sections help you calculate your RMD with an IRA and with other types of retirement accounts.
The RMD is a floor, not a ceiling. You’re free to withdraw as much in excess of the RMD as you want. An excess distribution doesn’t result in any credit the following year. The adjustment is automatic because the next year’s RMD is computed using the account balance as of the end of the current year.
Calculating your RMD for an IRA
To calculate your RMD, you can do the following:
Start with your IRA balance as of December 31 of the year before you turn 70½.
Divide this amount by your life expectancy.
The result of dividing your IRA balance by your life expectancy is your RMD for the year. The good news is you don’t have to do the math regarding your life expectancy. Instead you must consult the life expectancy tables in IRS Publication 590-B (available for free at www.irs.gov). Most people use the “Uniform Lifetime Table.”
You use a different life expectancy table, the “Joint Life and Last Survivor Expectancy Table,” if you’re a married IRA owner whose spouse is the primary beneficiary of the IRA and is more than ten years younger.
Repeat the calculation each year.
For the first RMD, use the IRA balance as of December 31 of the year before you turned 70½, not the year before the April 1 deadline. The first RMD, though delayed until April 1 of the year after turning 70½, really is the RMD for the previous year. If you wait until April 1 to take the distribution, you’ll have to take two distributions in that year: the previous year’s distribution, and the current year’s distribution that’s due by December 31. Taking two distributions in one year could push you into a higher tax bracket. Overall taxes may be lower if the first distribution is taken by December 31 of the year you turn age 70½.
So, for example, if Rick turned 70½ in January 2017 and Corrine turned 70½ in December 2017, each must take his or her first RMD by April 1, 2018. Subsequent RMDs must be taken by December 31 of each year. If you fail to take an RMD, the penalty is 50 percent of the distribution that should have been taken. Ouch!
When you own more than one IRA, add all the balances together as one to compute the RMD. You can withdraw that amount from the IRAs in any combination you want. Take it all from one account, equally from the different accounts, or in any other way you want. Just be sure that by December 31 your distributions equal (or exceed) the RMD.
If a traditional IRA is converted into a Roth IRA, a new RMD is required for the year of the conversion, using the traditional IRA balance as of December 31 of the preceding year. A new RMD also is required for the year of the IRA owner’s death, no matter when during the year that occurred. Roth IRAs are discussed in the section “Individual Retirement Accounts (IRAs),” earlier in this chapter.
Computing the RMD for other retirement plans
All qualified retirement plans — profit-sharing, 401(k), and pension plans — must make RMDs. The basic calculation is the same as for IRAs, but employer plans have some important differences.
For employer-sponsored plans (but not for IRAs, SEP-IRAs, and SIMPLE IRAs), the required beginning date is delayed when you’re still working for the employer and don’t own more than 5 percent of the employer’s stock. The first RMD is delayed until April 1 of the year after the year in which you retire. Also, for money contributed to a 403(b) plan before 1987, RMDs may be delayed until age 75.
The calculations for employer plans can be a bit different from IRA calculations. For instance, when you have multiple employer plans, such as a profit-sharing plan and a 401(k) plan, you compute the RMDs separately for each plan instead of totaling them. Check IRS Publication 590 for details (see www.irs.gov).
An employer-sponsored plan can impose stricter rules than the IRS imposes. For example, some employer plans require retired employees to withdraw or roll over their account balances within five years. They may have other stringent restrictions as well. These rules are in the documents describing the employer plan. You’re supposed to receive these periodically and can request them at any time from your employer or plan trustee.
Reviewing the features of retirement accounts
These upfront tax breaks are just part of the value derived from using retirement accounts. You also can reap these other tax-related benefits when you invest in a retirement plan: 
If your employer matches your contributions or contributes additional money to your account, such as with a company-sponsored 401(k) plan, you’ll be even better off. Free employer money further enhances the upfront tax benefits by giving you more money working for you that is not subject to tax in the year the contributions are made. Even if you unexpectedly need to withdraw your contribution, you should still come out ahead — the penalties for early withdrawal are only 10 percent and whatever penalty, if any, your state charges. You’ll also owe regular federal and state income tax on withdrawals.
If you do have to withdraw your money from a retirement account prior to reaching 59½, you may incur a tax penalty. The penalty is 10 percent in federal taxes plus whatever penalty your state assesses. This penalty tax is in addition to the regular income tax that’s due in the year you make the early withdrawal.