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Retirement Accounts Explained

William Freedman

Topics: Retirement, API, Trust Platform, Investment Advisors, Third Party Administrators

In the United States, as in other countries, public policy addressing how to fund post-work life continues to evolve. There is no perfect solution and, even if there were, it might not be ideal for the next generation of retirees. 

 

While an increasingly mobile population might -- or might not -- be a social and economic advancement, it leads to the kind of displacement which makes financial planning for retirement necessary. Multigenerational families have become increasingly rare, so matriarchs and patriarchs can no longer rely on their children and grandchildren to care for them. This has been true in the U.S. since at least the time of the Great Depression. 

 

In 1935, President Franklin Roosevelt signed off on the Old-Age, Survivors, and Disability Insurance program as part of the New Deal; it has since become known popularly as Social Security. While this tax-supported entitlement serves as a lifeline for many older Americans, it pays on average only $1,382 per month -- that was in 2019, not 1935. It is inadequate as a sole source of income for most. 

 

Then again, Social Security was never intended to be the sole source of income. People were expected to have saved on their own or, better yet, have worked for a company that offered a pension. 

 

“In 1875, the American Express Company established the first private pension plan in the United States, and, shortly thereafter, utilities, banking, and manufacturing companies also began to provide pensions," according to the Pension Benefit Guaranty Corp., the federally chartered pension insurer. "Most of the early pension plans were defined benefit plans that paid workers a specific monthly benefit at retirement, funded entirely by employers." 

 

The Employee Retirement Income Security Act allowed for accounts where the employee's monthly contribution was defined while the benefits floated with the market. In 1974, though, President Gerald Ford signed the law, which has led to a broad array of retirement plans in which benefits were not so clearly defined. Employers were no longer on the hook to guarantee these plans by locking up funds that could be used for operations or returned to shareholders. While that meant that the employee had to bear much more risk, ERISA provided tax benefits to save for retirement using one of these qualified plans. While government employees have held mainly on to defined-benefit plans since the advent of ERISA, almost all private-sector employers have shifted to these qualified defined-contribution plans. 

 

It is these tax-advantaged accounts, funded in large part or entirely by the individuals who hold them, that this article describes. There are essentially two broad categories: employer-sponsored plans and individual plans. Because paying for health care is also very much a part of paying for retirement, we will conclude with a discussion of medical savings plans operating under federal auspices. 

 

Required minimum distributions (RMDs)

Before we start parsing retirement plans, though, let us begin with the end in mind: withdrawing the money once retired. While a defined-benefit plan pays a fixed amount every month -- that is, after all, what makes it "defined-benefit" -- other ERISA-qualified plans operate under a different set of rules. 

 

There is very little in the way of legislation that keeps older Americans from simply withdrawing every penny all at once the day they retire. Few choose to do that, naturally, for apparent reasons. Public policy is more concerned with making sure that retirees do not keep postponing these withdrawals, and that is why there are required minimum distributions. Calculating RMDs is a bit of a convoluted process and generally in the purview of the plan administrator. Still, the IRS provides a worksheet that serves to simplify it in most cases. Of course, participants can always withdraw more than the RMD. 

 

Although you can begin to draw on qualified accounts at age 59½ -- otherwise, you would have to pay a 10% penalty -- you must start taking money out by the first April 1 after you reach age 72. This age limit is a recent development resulting from the Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed in 2019 by President Donald Trump. Until then, the age had been set at 70½. Anyone owning more than 5% of the business sponsoring the plan, by the way, must begin receiving distributions by that date even if they have not yet retired. 

 

More on the SECURE Act 

While the SECURE Act was not without controversy, it did receive bipartisan support because of the litany of benefits it afforded to participants in qualified retirement plans: 

 

  • Previously, non-spouse beneficiaries could spread disbursements from a qualified plan over their lifetime. HOWEVER, the SECURE Act requires disbursements to be collected and taxed within ten years of the original account holder's passing. Traditional IRA participants are also empowered to continue contributing even after turning 70.5, which had been the cutoff. 
  • Parents can withdraw up to $5,000 from retirement savings plans for each new child without incurring the 10% penalty for taking an early distribution.  
  • Employees who purchase an annuity in their 401(k) can move it to another 401(k) plan at a different employer or an IRA penalty-free. Other provisions make it easier for plan sponsors to offer annuities. 
  • Unrelated small businesses can establish a shared 401(k) plan, mitigating administrative costs.  

 

Employer-sponsored plans 

 

401(k)s  

The most ubiquitous type of employer-sponsored qualified plan stems from a reading of the Internal Revenue Code’s section 401(k). 

 

Under a 401(k) plan, an employee can choose to have the employer contribute a portion of the employee’s cash wages to the plan on a pre-tax basis. The annual limit on employee elective deferrals is $19,500 in 2021 for most employees. Those 50 or older can add another $6,500 in "catch-up" contributions. These figures tend to rise every year with the cost of living. We should clarify that these are the upward limits allowed by law; individual plans can set lower limits. 

 

The employer can match the employee's contribution up to 100%. However, the lifetime employee match cannot exceed $64,500, including catch-up contributions -- $58,000 otherwise. It is the rare, generous employer, though, who provides a 100% match. The company's tax benefit taps out at 25%. 

 

Contributing to a 401(k) does not necessarily mean you own 100% of it. 401(k) participants need to bear in mind that, similar to defined-benefit pensions, there is the question of vesting. The sponsor -- that is, the employer -- might set up a schedule requiring you to vest over a period of time. While this is not generally the case, it legally can be. 

 

An advantage that employer-sponsored plans have is that participants can use the funds vested in these as collateral for a loan, providing it is paid back within five years. The installments are made quarterly, if not more frequently. If there is a sudden crunch, the account holder can access cash without triggering the 10% penalty. Individual accounts, on the other hand, cannot serve as collateral. 

 

There's no legal mandate for a 401(k) administrator to offer loans, so rules will vary, and not all plans have them. Those that do could have restrictions on minimum amounts, maximum amounts (the IRS forbids borrowing more than 50% of the amount vested), spousal consent, or any number of other factors. 

 

Traditional 401(k) 

A traditional 401(k) plan allows eligible employees to make pre-tax elective deferrals through payroll deductions. Employers then have the option of making contributions on behalf of all participants, making matching contributions based on employees' elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee's right to employer contributions becomes nonforfeitable only after a period of time or be immediately vested. 

 

One-participant 401(k) 

Sometimes called a solo or self-directed 401(k), the one-participant version is a traditional 401(k) plan covering a business owner with no employees or that person and their spouse. These plans have the same rules and requirements as any other 401(k) plan. 

 

The significant distinction relates to contribution limits; the participant is, after all, both employee and employer and can put cash into the plan in both capacities. According to the IRS, the owner can defer up to 100% of earned income up to $19,500 or, if age 50 or over, $26,000 as of this writing. In addition, the owner can add up to 25% of compensation. So under the right circumstances, self-employed individuals could contribute up to 125% of their pay into a solo 401(k), providing they are willing to defer receiving it until they retire. 

 

“A business owner who is also employed by a second company and participating in its 401(k) plan should bear in mind that his limits on elective deferrals are by person, not by plan,” the IRS advises. “He must consider the limit for all elective deferrals he makes during a year.” 

 

In any event, total contributions to a participant’s account, not counting catch-up contributions for those age 50 and over, cannot exceed $58,000 as of this writing. The rate table and worksheets at the end of IRS Publication 560, Retirement Plans for Small Business, is probably the best source for figuring out just how much you can legally contribute. A solo 401(k) is generally required to file an annual report on Form 5500-EZ if it has $250,000 or more in assets at the end of the year. 

 

Small-business 401(k)s 

A safe harbor 401(k) plan is similar to a traditional 401(k) but must provide for employer contributions that are fully vested when made. The traditional and safe harbor plans are for employers of any size and can be combined with other retirement plans. 

 

The SIMPLE 401(k) plan was created so that businesses with fewer than 100 workers could have an effective, cost-efficient way to offer retirement benefits. As with a safe harbor 401(k) plan, the employer must make employer contributions that are fully vested. Participants may not receive any contributions or benefit accruals under any other plans offered by the employer. The 2021 limit on employee elective deferrals to a SIMPLE 401(k) plan is, at $13,500, lower than that for other 401(k)s, and the catch-up contribution for 50+ workers is only $3,000. 

 

The broad strokes of safe harbor and SIMPLE plans are covered in an IRS publication titled “401(k) Plans for Small Businesses”. 

 

Roth 401(k) 

One criticism that ERISA-qualified plans had at the outset regarded tax deferment. While most wages earn, highly successful people are often in a lower tax bracket at the beginning of their careers, when they first start contributing to these plans. It does them little good to deposit the money tax-free at, for example, a 15% marginal rate, then get taxed at 30% when they withdraw it. In 1997, that oversight was cleaned up by the Taxpayer Relief Act of 1997, signed by President Bill Clinton but championed on Capitol Hill by Senator William Roth (R-Del.) 

 

The Roth IRA reverses the polarity, allowing contributors to be fully taxed at the front end then withdraw funds tax-free at the back end. We will discuss this later under the Individual Retirement Account heading. For now, suffice to say that this treatment only extended to IRAs initially. It was not until President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 that 401(k) holders could share in that benefit. 

 

Other employer-sponsored plans 

A 403(b) plan is a tax-sheltered annuity that is in many ways indistinguishable from a 401(k). The real difference is that nonprofit organizations rather than for-profit companies sponsor it. If the employer is a school, church, or tax-exempt charity, it probably offers a 403(b). 

 

Similarly, state and local governments might offer a 457(b) plan in addition to or instead of a defined contribution pension. 

 

As with 401(k)s, participants can choose between traditional or Roth treatment. 

 

Individual plans   

 

Traditional  IRAs 

Traditional individual retirement accounts have been around since the mid-1970s. The money a participant contributes to a traditional IRA is pre-tax income, meaning no taxes are paid on it in the year contributed. Instead, the account holder will have to pay taxes on it when they withdraw as a retiree. 

 

This is a rational decision for many people, especially if most or all of their money is received through earned income; they tend to find themselves in a lower tax bracket after they retire than when they made their contributions. However, if your earnings are too high in the contribution year, you might find yourself partially or entirely phased out of the opportunity to take the deduction then. 

 

The maximum annual contribution for a traditional IRA is, as of this writing, $6,000, with an additional $1,000 catch-up contribution for account holders over age 50. 

 

Roth IRAs 

Still, what if you have a passive annual income that has grown through the years? You might be retired from your day job but are still collecting rents or benefiting from distributions of a business in which you are a silent partner. 

 

Rather than giving you a tax deduction at the front end when contributions are made, a Roth IRA allows you to withdraw money tax-free upon retirement.  Like traditional IRA deductibility, you can be phased out of eligibility to contribute directly to a Roth IRA, but there are currently no phaseout limits on Roth conversions. 

 

Converting traditional IRA funds to a Roth IRA is legally permissible. At that point, the funds become reportable on that year's tax return as taxable income. Anyone converting from traditional to Roth, though, needs to be sure that this move is in their best interest. Recent legislation has plugged the loophole that allows participants to toggle back and forth between the two. 

 

There are ways to blur the line using a "backdoor Roth" technique, but this tactic risks triggering a taxable event and a penalty charge. 

 

Still, traditional IRA holders continue to convert to Roths. Reasons include: 

  • Roths provide tax free-growth. 
  • By holding both Roth and non-Roth IRAs, you can diversify the tax nature of your retirement funds. 
  • Roths are unique among qualified plans in that they do not require withdrawals until after the owner's death; thus, participants can bequeath unused balances tax-free to their heirs. 
  • Because these are not taxed at the time of withdrawal, and knowledgeable retirees spend the most highly taxed funds first, Roths are the investments with the most extended time horizon; as such, they are likely to be the most suitable for aggressive growth strategies. 

The maximum annual contribution for a Roth IRA is the same as that for a traditional IRA as a default. Still, salary caps could reduce the allowable amount, as put forward in this IRS table. 

 

Self-directed IRAs 

The same 1997 law which inaugurated the Roth IRA also created the self-directed IRA – which can be structured as either a traditional or a Roth account. 

 

One problem remained -- not that it was a problem for most retirement savers. Those with a greater appetite for risk had a significant issue with a vital component of these vehicles: They were run by fiduciaries. There was no option to use them to invest in anything except stocks and bonds. It was just a matter of time before there was a legal challenge. 

 

A Florida couple, James and Josephine Swanson, turned their IRA into a blank-check company, then sold their S-corp family businesses to that shell, which also bought their old house in Illinois. The Internal Revenue Service refused to allow these entities to be taxed under the favorable ERISA rates, so the Swansons sued the IRS commissioner and won. 

 

Now, according to published reports, self-directed IRAs can be used to invest in: 

  • Cryptocurrency, 
  • Horses and livestock, 
  • Intellectual property, 
  • LLC membership interests, 
  • Mineral rights, 
  • Precious metals, 
  • Private equity, 
  • Promissory notes, 
  • Tax lien certificates and 
  • Water rights. 

The most popular investments in self-directed IRAs, though, are real estate and private mortgages. The few prohibited investments include collectibles and life insurance. 

 

There are limits on real estate, mostly on owner-occupied homes. Neither the account owner nor a close relative can own or control the property. 

 

Because of the high-flying nature of self-directed IRAs, tax reporting and recordkeeping are more complicated; many financial institutions avoid them and will not provide back-office functions as they would for other IRAs. 

 

For that reason, it is critical to find a custodian who specializes in self-directed IRAs to open one. 

 

Other IRAs 

Simplified employee pensions are IRAs into which business owners make retirement contributions for themselves and their employees. The key feature of the SEP-IRA is the high maximum annual contribution. Because employers make SEP-IRA contributions on behalf of their workers, they can put in up to 25% of employee compensation, up to $58,000 in 2021. In the case of a sole proprietorship or a family business, of course, the employer can also be an employee. 

 

A Savings Incentive Match Plan for Employees -- that is a SIMPLE -- plan allows employees and employers to contribute to traditional IRAs set up for employees. It is intended as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan.  

  

Rollovers 

Funds from one qualified retirement account can be deposited into another. This is how participants in an employer-sponsored plan can roll over their retirement funds into the plan sponsored by a new employer. It is also how people who have moved from being employed by an organization to being self-employed can move from a 401(k) or similar plan to an IRA. The reverse also applies; it is possible to roll over from an IRA to a 401(k). The only major prohibition is that no Roth account -- whether individual or employer-sponsored -- can be rolled over into a non-Roth account. The IRS provides this chart to illustrate all the possible permutations and which ones are permissible. 

 

One caveat is that the money has to land in the new account within 60 days of being withdrawn from the old one. Otherwise, the 10% penalty is triggered. It is best to have the old plan's administrator make the payment directly to the new plan to keep this from happening. Some people insist on holding the money for some or all of those 60 days, using proceeds to make a fast -- hopefully accretive -- transaction that requires immediate cash. While this is not technically illegal, it is very risky. 

 

An individual can only make one rollover between any two IRAs in 12 months. The one-per-year limit does not apply to converting from traditional IRAs to Roth IRAs. Further, if either the sending or receiving accounts are part of an employer-sponsored plan, there is no limit on the frequency. This rule is focused squarely on IRA-to-IRA movements. 

 

More broadly, account holders can roll over all or part of any distribution except: 

  • Required minimum distributions, 
  • Loans treated as a distribution, 
  • Hardship distributions, 
  • Distributions of excess contributions and related earnings and 
  • A few other particular circumstances. 

If the plan sponsor no longer employs you and your account is between $1,000 and $5,000, the administrator may deposit the money into an IRA in your name if you don't elect to receive the money or roll it over. If your plan account is $1,000 or less, the plan administrator may pay it to you, less, in most cases, 20% income tax withholding, without your consent. You can still roll over the distribution within 60 days. 

 

Non-retirement uses of qualified plans 

There are many ways someone can take cash out of an IRA, 401(k), or other qualified plans before retirement without triggering the 10% penalty. This is not to say you should, just that you could. 

The IRS allows emergency withdrawals based on an ill-defined "immediate and heavy financial need." "Consumer purchases (such as a boat or television)" are prohibited, but not much else. There need not be a natural disaster or a health scare involved. The need could be foreseeable or even voluntary. U.S. News & World Report offers these examples: 

  • Unreimbursed medical expenses exceeding 10% of adjusted gross income 
  • Paying for health insurance for a spouse or dependents, but only if you lose your job and collect unemployment compensation for 12 consecutive weeks 
  • Paying for college expenses 
  • Serving as a military reservist on active duty for more than 179 days 
  • Buying or building a first home; for this, though, there is a ceiling of $10,000 for an individual or $20,000 for a couple 
  • Being unable to keep working due to  severe physical and mental disabilities 

As stated previously, individual accounts cannot serve as loan collateral. IRA holders who need access to cash but cannot meet the "immediate and heavy" threshold would trigger a 10% penalty for withdrawal. 

 

Medical savings accounts (MSA) 

The difference between a medical savings account and a health savings account is more than semantic. All HSAs are MSAs, but not all MSAs are HSAs. “MSA” is a term describing any account into which income can be deposited, tax-deferred, to offset medical expenses. 

 

The U.S. version of the HSA was established by Bush's signature Medicare Prescription Drug, Improvement, and Modernization Act of 2003. In addition to establishing HSAs, it also approved employer participation. Before that, so-called MSAs were a privilege of the self-employed. 

 

HSAs enable qualified medical expenses -- deductibles and copayments to medical, dental, chiropractic, and mental health practices --  to be paid out of pre-tax income. They also cover anything requiring a prescription, such as medicine, hearing aids, eyeglasses, and travel to and from appointments. HSA funds can also be spent on home improvements, such as pools and medically necessary elevators. 

 

Health insurance premiums, non-injury-related cosmetic surgery, gym memberships, and over-the-counter drugs, health club membership, though, are excluded. 

 

HSAs are paired with High Deductible Health Plans, those that cover only preventive services before incurring a deductible set to a point where the consumer has to decide to pay for medical help consciously. 

 

For 2021, the annual minimum deductible for an HDHP is $1,400 for an individual or $2,800 for a family. HSA account holders can then contribute up to $3,600 for self-only coverage and up to $7,200 for family coverage in a year, plus another  $1,000 per year catch-up contribution limit for those over 55. 

 

CNBC reports that many of the 22 million HSAs are being used as a secondary retirement savings vehicle because HSA funds roll over year-to-year if they remain unspent and any interest earned is non-taxable. 

 

Other tax-advantaged MSAs exist, primarily for the benefit of top corporate executives. Flexible Spending Arrangements are employer-sponsored plans usually funded through pre-tax paycheck deductions.  Unlike with HSAs, there are no income tax reporting requirements for FSAs. Also, an FSA can pay qualified medical expenses even if the account holder has yet to place the funds in the account. 

 

Health Reimbursement Arrangements must be funded entirely by the employer, although many companies offer FSAs and HRAs in tandem. HRAs similarly have no tax reporting requirements and can have limits imposed on highly compensated participants. But the most attractive part of benefiting from an HRA is that there is no limit on the amount of money the employer can contribute, and any balance remaining at the end of the year can be carried over. 

Further, there are two new MSA flavors: the Qualified Small Employer HSA, established in 2016, and the Individual Coverage HRA, which was rolled out in 2020. 

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