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Introduction

Formulate a Financial Plan

Know Your Net Worth

Manage & Minimize Debt

Accumulate Assets

Budget to Live Within Your Means

Understand Investing Basics

Plan for Retirement

Insure People & Property

Deal with Financial Advisors

Review Your Employment Contract

Make Plans for Your Estate

Make Good Decisions

Conclusion

Qualified retirement accounts are distinguished by their tax-related characteristics. Your guiding principles as a passive investor are to invest with a long-term mindset, achieve broad diversification, and minimize fees.

Eligibility, contribution limits, required withdrawals, and tax implications for these accounts can get confusing. Consult a licensed accountant to ensure the best decisions are made.

 

401(k) and 403(b)

Qualified retirement plans are sponsored by an employer and include 401(k) and 403(b) plans. 401(k) accounts are offered by for-profit organizations while 403(b) accounts are typically offered by tax-exempt organizations.

The plans become qualified by meeting IRS guidelines, which allows them to provide tax advantages to the sponsor (employer) and the employee. Typically, employees can choose, subject to some limits, what percentage of their salary they wish to contribute annually to their accounts. Employers may offer to match employee contributions up to a certain limit, for example, 6% of their salary.[1]

Employees contribute to these plans with pre-tax dollars, reducing their taxable income for that year. Gains within the plans are tax-deferred—no taxes are due until the employee begins to receive withdrawals (known as distributions) from the account.

The value proposition for qualified accounts is that distributions will be received, and taxes will be payable, when the account holder is retired, at which time her tax rate will be lower than when she was employed. There is, however, no guarantee that this will be the case in future.

Technically, you can withdraw as much as you want from these accounts once you are over 59.5 years of age, but these distributions will be subject to income tax at your marginal (highest) tax rate. If you withdraw a very large amount out of the account in a given year, the distributed income may push you into a higher tax bracket, resulting in a larger tax bill.

There are rules governing how much can be contributed per year, when distributions must be taken from such accounts and how much must be taken each year. Once you reach age 72 you generally must begin taking distributions from your account. By imposing this requirement the government forces you to pay taxes on money you’ve shielded from taxation. The amounts you must withdraw each year are known as required minimum distributions (RMD). Your RMDs depend on your account balance and life expectancy.

In response to the COVID-19 outbreak, Congress suspended RMDs for the year 2020. This allows taxpayers to avoid selling investments at depressed prices. Instead, those investments may recover some lost ground as markets bounce back.

Taking distributions prior to age 59½ may trigger a 10% penalty on top of the taxes payable on the amount withdrawn. The 2019 limit on annual 401(k) or 403(b) tax-deferred contributions is $19,000 (The 2020 limit is $19,500). The IRS refers to this as your Elective Deferral amount. If you’re over the age of 50, you’re allowed an extra $6,000, known as a catch-up contribution ($6,500 in 2020). The total Defined Contribution Limit for 2019 (the combined amount you and your employer can contribute) is $56,000 (The 2020 limit is $57,000). These limits usually grow every year or two. I suggest you check the IRS website for the latest updates (www.irs.gov).

The money contributed by both employee and employer into these plans is typically invested in mutual funds. Management of qualified accounts is undertaken by a financial institution. It may offer its own mutual funds or allow you to choose funds offered by other companies. There may be a limited choice of funds in 401(k) and 403(b) plans. This could be bad for you if it limits your ability to diversify or to identify low-fee funds.

Often, employees accept the default settings on these accounts. Default settings may direct your contributions to mutual funds with unnecessarily high fees. Look closely at the available choices and ensure your contributions go to the most advantageous investments, which means those with good diversification and low fees. You and your colleagues can and should push your employer’s human resources department to switch to the most advantageous qualified plan around. Don’t accept a plan that isn’t optimized to your needs.

 

Related Links:

IRS 401(k) Contribution Limits

IRS 403(b) Contribution Limits

Strata Trust – Increasing Life Expectancies and RMDs

Schwab RMD Calculator

Fidelity Required Minimum Distribution Calculator

Fidelity Inherited IRA RMD Calculator

 

Vesting

When an employer contributes matching funds to your retirement account, those funds may not automatically become your property. The employer may impose a vesting schedule, which specifies when each amount contributed by the employer legally becomes yours. Any amount that has been vested is yours. When you leave that firm you can take any vested amounts with you, usually by rolling funds over into an Individual Retirement Account (IRA accounts are discussed in a later section). Any amounts which have not yet vested when you leave an employer revert back to the employer.

Vesting schedules vary. Some examples are: (1) Vesting occurs after three years (each contribution made by the employer vests only after three full years have passed and the employee is still working at the company), or (2) 25% of each employer contribution vests each year, so each matching amount becomes fully vested after a total of four years, again assuming you’re still an employee.

Your own contributions and any gains on your contributions are always immediately fully vested to you.

 

Related Links:

Women’s Institute for a Secure Retirement: Improving the long-term financial security of all women through education and advocacy.

What are the Differences Between 401(k) and 403(b) Plans

Schwab RMD calculator

 

457(b) Account

Technically, a 457(b) account is not qualified by the IRS but I include it in this category because it is most similar to 401(k) and 403(b) retirement accounts. 457(b) plans are typically offered by state and local government employers to their employees and also to certain nonprofits such as hospitals.

As with 401(k) and 403(b) accounts, in 457(b) accounts employees contribute with pre-tax dollars, reducing their taxable income for that year. Gains within the plans are tax-deferred, so no taxes are due until the employee begins to receive distributions from the account. The 457(b) elective deferral contribution limit for 2019 is $19,000 ($19,500 for 2020). In 2019, an additional annual catch-up contribution of $6,000 is permitted for those above age 50 ($6,500 in 2020).

Because 457 plan accounts are not qualified, when you resign or retire from your job you may withdraw early from the account without the 10% early withdrawal penalty. Furthermore, 457(b) workers who are within three years of normal retirement age as specified in the plan can make special catch-up contributions equivalent to twice the regular limit. For 2019 the total they can contribute is $38,000 ($39,000 in 2020).

 

Related Links:

IRS 457(b) Contribution Limits

 

Roth 401(k)/403(b)

In 2006, a new retirement plan was approved. Similar to a Roth IRA, the Roth 401(k) is funded with after-tax dollars and no tax deduction is available in the year a contribution is made. No taxes are paid when qualified distributions are taken. Unlike the Roth IRA, there are no income limitations for participation in Roth 401(k)/403(b) plans. The usual 401(k)/403(b) maximum contribution limits apply. Note that employer matching contributions must go into regular 401(k)/403(b) accounts. They are not treated as Roth assets, and funds in Roth 401(k) may be subject to required minimum distributions, even if they are not taxed.

 


[1] Employers can deduct their contributions from corporate earnings, leading to tax savings for the corporation.


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