Retirement plans are confusing financial accounts that many people don’t fully understand. Learning the ins and outs of each plan can help you maximize returns, save money, and set yourself up for the future.
This blog post will help:
- Individuals evaluating or choosing their retirement plan
- Businesses and self-employed individuals researching different retirement plan options
What is a retirement plan?
Retirement plans are financial plans set up by individuals, or businesses for their employees, that aid in the planning for living expenses during retirement.
Generally, individuals or companies make contributions into an account that is then placed in different investment vehicles, such as stocks, index funds, or bonds. Often, these contributions are entered into the account before taxes are withdrawn, allowing for more money to be invested and returns to be made.
These contributions must be made from some form of compensation, including:
- Wages, Salary, bonuses, etc.
- Commissions
- Self-Employment Income (including SE income from partnerships)
- Certain taxable alimony or separate maintenance payments
- Nontaxable Combat Pay
Compensation does not include:
- Income from investments, such as interest and dividends
- Pensions or annuities
- Social Security benefits
- Deferred compensation
- Partnership income that is not SE Income
- S Corp income from Schedule K-1
- Earnings from property (such as rent)
Once you reach a specified age (generally 59 ½), you can then withdraw money from the account. Theoretically, the amount of money in the account has risen exponentially as the economy, and the invested financial assets, have grown.
Types of retirement plans
There are two main types of retirement plans:
- Individual plans: Completely funded and supported by the individual. They are generally some sort of IRA, or individual retirement account. This means that employers are not matching or contributing any money to the account.
- Self-employed & employer plans: Employers contribute to an employee plan. Can also be utilized by self-employed individuals to leverage tax benefits. In this situation, the self-employed individual acts as both employer and employee.
Below, we’ve listed some of the most common types of retirement plans. We’ve also gone over key details of each, including:
- Contribution maximums and other details
- The tax deductibility of these contributions
- How and when you can withdraw from the accounts
Individual Plans
Traditional IRA
Traditional IRA retirement accounts are individual retirement plans that leverage untaxed income to grow investment accounts. While the money is not taxed prior to entering the account, the money is then taxed upon withdrawal.
Any individual below the age of 70 ½ can contribute untaxed income into a traditional IRA account.
Contributions
- The maximum contribution to a traditional IRA annually is $5,500 individually or $11,000 for married couples.
- The individual contribution increases to $6,500 once you are over the age of 50.
Tax Deductions
- The contributions are generally tax deductible unless a spouse is covered by an employer retirement plan.
- If you are offered a retirement plan at your place of employment and have a separate IRA account and make over $62,000 as a single adult or $99,000 as a married couple, you may receive only a partial, or even no deduction.
Distribution
- Once you are 59 ½ years of age, you can withdraw funds from the account, at which time the withdrawal will be taxed as earned income. If you decide to withdraw prior to that age, you will also incur a 10% penalty. The one exception to the 10% penalty is a one time withdrawal of $10,000 to go towards the purchase of a home.
- Once you reach age 70 ½, you must take a required minimum distribution each year. This is calculated based on your age and account balance.
Roth IRA
Roth IRA accounts are very similar to traditional IRA accounts, but instead of leveraging untaxed income you enter compensation funds into the account once taxes have been taken out. The advantage to Roth IRA accounts are that once you’d like to withdraw money, you are able to do so tax free.
Unlike traditional IRA accounts, individuals above the age of 70 ½ can continue to contribute to Roth IRA accounts.
Contributions
- The maximum contribution to a Roth IRA annually is $5,500 individually or $11,000 for married couples.
- The individual contribution increases to $6,500 once you are over the age of 50.
Tax Deductions
- ROTH IRA contributions are not tax deductible.
Distribution
- Withdrawals from Roth IRA accounts are untaxed and unpenalized, since the income entered into the account is after-tax income. The one exception is you may need to pay tax on any capital gains made on the funds
- There is no required minimum distribution amounts.
Self-Employed & Employer Plans
Simple IRA
SIMPLE IRAs, or savings incentive match plan for employees, is an employee-match retirement plan specially designed for small businesses under 100 employees. With a SIMPLE IRA, employers contribute untaxed funds to IRA accounts set up for each employee in one of two ways:
- Mandatory 2% retirement contribution: No matter the amount the employee contributes annually, the employer contributes 2% of the employee’s salary to the IRA.
- Matching contribution up to 3%: Employer matches the employee contribution up to 3% of the employee’s annual salary.
SIMPLE IRA’s are known for their ease of use, with minimal paperwork for startup and maintenance. Any employee, regardless of age of a participating organization, who has either made or is expected to make $5,000 in the previous or the current year must be allowed to participate.
Contributions
- Employees can contribute up to $12,500 annually to a SIMPLE IRA plan, with employees over 50 years old able to contribute an additional $3,000.
- Depending on the route the employer has decided to go, they will contribute either up to 3% or 2% regardless of your contribution amount.
Tax Deductions
- Employee contributions to SIMPLE IRA accounts are not tax deductible, but are tax deductible for the employer.
Distribution
- Once you are 59 ½ years of age, you can withdraw from the account, at which time the withdrawal will be taxed as earned income. If you decide to withdraw prior to that age, you will also incur a 10% penalty. An extra 25% penalty is assessed if the withdrawal is within 2 years of the first deposit into the IRA account. The one exception to the 10% penalty is a one time withdrawal of $10,000 to go towards the purchase of a home.
- Once you reach age 70 ½, you must take a required minimum distribution each year. This is calculated based on your age and account balance.
SEP IRA
SEP, or Simplified Employee Pensions, IRAs in many ways function similar to a traditional IRAs. In fact, the account that contributions will be going into is a traditional IRA.
For SEP IRAs, employers add funds to an employee’s IRA account on a discretionary basis. Employees can then add their own contributions as they would a traditional IRA account. Annual employer contributions may not exceed the lesser of 25% of an employees annual compensation or $55,000.
While any business can participate in a SEP IRA program, many small businesses choose this option as they can decide to not contribute in down years. It also has stringent eligibility requirements for contributors, such as:
- A minimum age of 21 years old
- Three years of employment
- Minimum annual compensation of $600
Contributions
- If an employee is eligible, employer contributes to an employee’s traditional IRA account on a discretionary basis.
- Employee can contribute as much or as little as they’d like to the associated IRA account.
Tax Deductions
- Contributions made by employers are tax deductible.
- Any independent contributions made by employees to the IRA account are tax deductible, just as they are in any traditional IRA contribution.
Distribution
- Same rules as traditional IRA withdrawals.
- Once you are 59 ½ years of age, you can withdraw funds from the account, at which time the withdrawal will be taxed as earned income. If you decide to withdraw prior to that age, you will also incur a 10% penalty. The one exception to the 10% penalty is a one time withdrawal of $10,000 to go towards the purchase of a home.
- Once you reach age 70 ½, you must take a required minimum distribution each year. This is calculated based on your age and account balance.
401(k) and 403(b) retirement plans
401(k) plans are employee-matched retirement savings account, and in many ways are similar to the earlier discussed SIMPLE IRA.
401(k) retirement plans can be set up by any business to assist their employees in saving for retirement. In addition to adding pre-tax contributions to the 401(k) account, employers can also set up profit sharing into the account. The maximum amount for total contributions into the plan are $54,000 for any employee under the age of 50 years old, and $59,000 for any employee older. Employees themselves can only contribute $18,000 (49 and under) or $24,000.
Contributions can happen pre-tax (traditional 401k) or post-tax (ROTH 401k).
403(b) plans operate similarly to 401(k) plans, except they are for certain employees of public school and tax-exempt organizations.
Contributions
- Contributions are made by either the employer or employee, though neither are required to make a contribution.
- Often times, employers will match an employees contribution on an annual basis.
Tax Deductions
- The tax deductibility of the contribution will depend of if it was a traditional 401k contribution or a ROTH 401k contribution.
- Traditional 401k: All contributions are tax deductible
- ROTH 401k: Not tax deductible on any level
Distribution
- Same rules as traditional IRA withdrawals.
- Once you are 59 ½ years of age, you can withdraw funds from the account, at which time the withdrawal will be taxed as earned income. If you decide to withdraw prior to that age, you will also incur a 10% penalty. The one exception to the 10% penalty is a one time withdrawal of $10,000 to go towards the purchase of a home.
- Once you reach age 70 ½, you must take a required minimum distribution each year. This is calculated based on your age and account balance.
Confused? Opsahl Dawson can help!
The Certified Public Accountants at Opsahl Dawson can help find the right retirement plan for you. Whether you are a business trying to decide between a retirement plans or an individual trying to develop a plan for your retirement, Opsahl Dawson can help you map out your future.
Contact us online with any questions on retirement plans and their tax implications.
