Contemplating the future can be daunting – after all, it’s unpredictable. But if your future includes a secure retirement (and it should), one thing is very predictable: you will need money to maintain yourself and your loved ones. It’s always advisable to have a retirement plan – but which one? This is a choice only you can make, but it does not have to be daunting. With a guide, the right path can be easier to see.
Retirement plans are generally lumped into two types: defined benefit vs. defined contribution. Among the routes available is a traditional pension program, such as a defined benefit plans funded by employers (providing a guaranteed retirement income regardless of market conditions or the beneficiary’s longevity). Unless you are a public-sector and/or unionized worker, however, it’s unlikely that you have an option for this type of path. The percentage of all workers covered by such plans declined from 44% in 1990 to 23% in 2017, according to the Bureau of Labor Statistics, and the downward trend is likely to continue.
Keogh plans have been the traditional route for self-employed people, unincorporated businesses, and small “pass-through” entities that pay taxes on the individual-owner and not the corporate rate. A Keogh plan can be set up as either a defined benefit or defined contribution plan, although most plans are defined as contributions. But because Keogh plans require substantial paperwork to maintain, they are being largely replaced by the SEP (Simplified Employee Pension) IRA, which has similar contribution limits and less administrative demands, making it more attractive to freelancers and small businesses with one or two employees.
For most of those now in the workforce or just leaving it, retirement will be funded by a defined contribution plan, which is funded by both employers and employees. (In this plan, the market risk is borne by the beneficiary, with the benefits of market outperformance accruing to the participant). These are plans such as a 401(k) or IRA (Individual Retirement Account). 401(k) retirement plans are employer-sponsored savings plans that allow workers to contribute a tax-deferred portion of their paycheck (i.e., taxes are not taken out until the funds are withdrawn). Contributions are generally made by both the employer and the employee while the investments, though generally limited, are controlled by the employee.
There are several kinds of 401(k) plans, from a traditional 401(k) to Safe Harbor 401(k) to SIMPLE 401 (k), each with separate rules. These plans have several common traits: contribution limits for employees as of 2018 are $18,500 with an additional $6,000 for those age 50 or more for a total of $24,500. There is a combined maximum limit of $54,500 as of 2018 or 100% of salary (whichever is less) for both employers and employees. Contributions for a 401(k) must be made in the calendar year of the credited year. (i.e., to be credited for 2018, the contribution must be made by the last paycheck of 2018 or by December 31, 2018). A 401(k) employer can make an in-kind contribution to the 401(k) plan. This would allow a 401(k) plan to be funded by either cash or in-kind assets such as stocks, gold, or real estate. Employers can also deduct contributions made to employees’ 401(k) plans.
A Safe Harbor 401(k) requires an employer to make either an eligible matching or non-elective contribution to participants in a way that automatically passes the non-discrimination test or avoids it altogether. The SIMPLE 401(k) applies to businesses with less than 100 employees.
An IRA is a tax-deferred retirement account whereby contributions made may be fully or partially tax-deductible. Investment returns and return on invested capital are eventually taxed when the funds from the account are distributed. Anyone can contribute to a traditional IRA; however, IRA contributions are generally deductible until income hits the $62,000-to-$72,000 range (or $99,000 to $119,000 if married). If you have a spouse with a company plan, that income limit can be to $186,000 to $196,000. Contributions to an IRA account can be made even if your income exceeds the deductibility limits. These numbers are adjusted to rise with inflation. If you are eligible for a retirement plan from your employer, the traditional deduction is limited to significantly lower income levels. You can contribute up to $5,500 to a traditional IRA account and $6,500 if you are at least 50 years of age at the end of the calendar year. 2018 fiscal-year contributions to IRA accounts can be made until April 15, 2019.
There are minimum distribution requirements based upon the age of the owner of the account. Those minimum distribution requirements are accelerated when ownership of the account passes beyond the spouse of the owner. (Spouses can handle an inherited IRA as their own where as any other beneficiary will need to take accelerated distributions.) Currently, account owners have to stop contributing to IRA accounts at 70½ and begin minimum withdrawals.
A Roth IRA is a retirement account funded with after-tax income (no up-front deductions for contributions) which are invested tax-free and where future withdrawals that follow Roth IRA regulations are tax-free. There are income limitations restricting contributions to a Roth IRA account. Investors are allowed a full contribution if adjusted gross income is up to $118,000 of single/head of household and $186,000 if married and filing jointly. Partial contributions are allowed if income falls between $118,000 and $132,999 (if single) and $186,000 to $195,999 (if married). Contributions are not allowed if household income exceeds those limits (or, if married, filing separately).
Though there is no deductibility of contributions to a Roth IRA account, the contributions are after-tax and, like a traditional IRA account, investment returns accumulate tax-free. Contributions to a Roth IRA can be withdrawn at any time without penalty. There are currently no required minimum distribution requirements from a Roth IRA account.
The Roth IRA allows the owner to leave tax-free income to heirs, and is subject to minimum distribution requirements beginning on the year of demise. Though the heirs cannot allow the investments to accumulate tax-free indefinitely, it can be a good tool to use in estate planning to both pre-pay taxes and reduce the taxable size of your estate.
Both traditional IRA and Roth IRA contributions can be made at any time during the year and up until the tax filing deadline in the following year. In other words, you potentially have 15 months to fund your IRA and Roth IRA accounts beginning on January 1 of that tax year. In addition, contributions to Roth IRAs can be withdrawn at any time tax-free as long as the earnings from those contributions are left in the account. In order to withdraw earnings from a Roth IRA tax- and penalty-free, you must be 59½ years old and have had the Roth IRA for five years before you start withdrawing funds.
It’s important to note that beneficiaries specified in these different retirement plans can be critical and must be periodically updated. Like insurance contracts, most of these plans request you to name beneficiaries, usually when the accounts are created. The beneficiaries you name when you first started working may not be the same later on, as life events get in the way. These plans can pass to your heirs outside of the will as specified in the paperwork. In most plans, designated beneficiaries receive the assets upon your passing despite what the will may say. It is particularly important to be sure your intended beneficiaries are consistent with your desires and your will and are periodically reviewed.
Disclaimer
While this article may concern an area of investing or investment strategy in which we supply advice to clients, this document is not intended to constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. Any statements regarding market or other financial information is obtained from sources which we and/or our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.
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