Retirement Plans

Retirement plans allow employees and the self-employed to set aside money for retirement where earnings can accumulate tax-free. The contributions to a retirement plan must come from earned income, which is compensation for active work — the source of contributions cannot be from investments. Contributions can be made either with pretax dollars to tax-deferred accounts or with after-tax dollars to nontaxable accounts, such as a Roth IRA or a Roth 401(k). To achieve these tax savings, the retirement plans must satisfy tax rules, which is why they are called qualified retirement plans. Qualified retirement plans cannot discriminate in favor of owners or highly compensated employees and the amount that can be contributed annually is restricted, depending on the type of plan. The withdrawal of money from a retirement account is a distribution.

Qualified tax-deferred plans have several tax advantages:

Except for IRAs, qualified retirement plans are also protected from the claims of creditors. Although IRAs are not protected from the claims of creditors, up to $1 million held in IRAs is exempt under bankruptcy.

Retirement accounts can be classified as either defined contribution plans or defined benefit plans. The benefit of defined contribution (DC) plans depends on the amount contributed and the investment return of the contributions. This is the most common type of retirement plan offered by businesses because it is simpler than a defined benefit plan to set up and the cost to the business of the retirement benefit = the contributions.

Defined-benefit (DB) plans pay a specified amount during retirement that is usually based on a certain percentage × the number of years that the employee worked for the employer × average wages earned by the employee in the last 3 years. So if an employee earns an average of $100,000 during the last 3 years before retirement and worked for 30 years where the annual percentage is 2%, then at retirement, the employee will receive 30 × .02 × $100,000 = 60% × $100,000 = $60,000. Most employers, especially those without a unionized labor force, no longer offer DB plans, because the employers are obligated to fund the plan with a contribution large enough to pay the defined benefit, so they incur most of the risk of the plan, whereas with the DC plan, the employee bears the risk that the plan may be underfunded to satisfy the employee's retirement needs. Furthermore, DB plans are more complicated to set up because they depend on actuarial tables of the workers' life expectancies.

To fund tax-deferred plans, most employers set up a salary reduction plan, which is based on a salary reduction agreement that is signed by each employee who wishes to fund a retirement account for themselves, where the employer makes a contribution to the employee's account by the amount of the reduction in wages. The employer may also contribute an additional amount. The contribution is not subject to ordinary income tax, but is subject to Social Security and Medicare (FICA) taxes. Self-employed taxpayers simply deduct the contributions as an adjustment for gross income, which can be deducted whether the taxpayer itemizes or not. As for employees, the contributions are still subject to employment taxes.

Tax-deferred accounts and nontaxable accounts are best illustrated by the traditional IRA and the Roth IRA. If a taxpayer in the 25% tax bracket makes a $5000 contribution to a traditional IRA account, then he saves $1250 in taxes in the year of the contribution. But when the money is withdrawn during retirement, then both contributions and earnings will be subject to ordinary income tax. Another taxpayer in the same tax bracket that contributes the same amount to a Roth IRA saves nothing in taxes in the year of the contribution, but the contributions and the earnings can be withdrawn tax-free when the taxpayer retires.

Because contributions to retirement accounts do not save on FICA taxes, there is not much tax savings for low-income workers. To encourage low-income workers to save for retirement, the federal government offers the retirement savings contribution credit — often called the saver's credit — that matches up to $1000 of contributions for qualified taxpayers who contribute to their IRAs or 401(k)s.

The Secure Act 2.0, passed at the end of 2022, makes it easier for employers to help workers open emergency savings accounts, assist employees who are repaying student loan debt and allow part-time workers access to retirement plans in 2 years instead of 3. There are also new benefits to both Roth IRAs and Roth 401(k)s, including moving leftover money from a 529 college savings account to a Roth I.R.A. Certain rules must be followed to avoid taxes and penalties, and there are some income restrictions. However, some provisions start in different tax years.

Secure Act 2.0 changes for IRAs:

Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 (SECURE Act) has changed the law regarding qualified tax-deferred retirement accounts:

The Taxpayer Certainty and Disaster Tax Relief Act of 2019:

Maximum Contribution Limits

All qualified retirement plans have a maximum limit on annual contributions. One limit that applies to all retirement accounts is that the contribution cannot exceed the participant's compensation, which, for defined contribution plans, is the compensation received during the tax year, while the limit for defined benefit plans is the highest average compensation for 3 consecutive calendar years. If not limited by compensation, then the following limits, not including any allowable catch-up contributions, apply:

Catch-up contributions allow taxpayers at least 50 years old to contribute up to $1,000 more annually.

Excess Contributions

For most taxpayers, contributions are made throughout the year, so some taxpayers may end up contributing more than is allowed. Furthermore, because contributions are limited by the employee's income or by the business income of the employer, the amount that can actually be contributed may not be known until the end of the year. Excess contributions must be withdrawn by a certain time, usually by the due date of the return for the tax year, including extensions; otherwise, they may be subject to a tax penalty, such as the 6% excise tax that is assessed on excess contributions to IRAs.

Tax Warning! — Excess Contributions to Self-Directed IRAs in the Form of Paid Expenses

Self-directed IRAs allow the account owner to invest in riskier investments, such as rental properties. Although this can be advantageous, only money in the IRA can be used to cover potential expenses related to the properties. Expenses paid directly by the taxpayer will be considered an IRA contribution.

Adjusted Gross Income Limits

There are also some income limits for contributing to certain retirement plans, which vary according to the type of plan and by the year of contribution. Moreover, there are special rules regarding highly compensated and key employees, defined as employees with at least the following inflation-adjusted minimum incomes (COLA Increases for Dollar Limitations on Benefits and Contributions | Internal Revenue Service):

Required Minimum Distributions

Because the government wants to get its money eventually, there are required minimum distributions (RMDs) from any tax-deferred accounts, such as the traditional IRA. Note that RMDs are reported as ordinary income in the Income section on Form 1040, so the marginal tax rate on ordinary income applies. There is no preferred tax treatment for long-term capital gains and qualified dividends. There is an exception for some retirement account owners who hold appreciated stock of the employer in an employer-provided retirement plan. Any net unrealized appreciation (NUA) on such stock is taxed at the long-term capital gains rate. In contrast to tax-deferred retirement accounts, there are no distribution requirements for Roth IRAs, because they are funded with after-tax dollars. In other words, the contributions to these accounts have already been taxed.

However, RMDs do apply to Roth 401(k)s, even though they are funded with after-tax dollars. The RMD rules are the same as for regular 401(k) accounts.

RMDs must begin by April 1 of the following year when the taxpayer becomes 72. Each subsequent distribution must be made by December 31, including the year of the 1st distribution. Otherwise, a hefty 50% tax penalty will be assessed on an amount equal to the required distribution minus the amount actually distributed. The RMD is calculated by dividing the total amount in the tax-deferred accounts on December 31 of the previous year by the distribution period, which can be found in tables published by the IRS. The distribution periods are based on the current age and life expectancy of the taxpayer and may also be based on a presumed beneficiary. For instance, the tables used for IRA owners presumes that the owner has a beneficiary who is 10 years younger. So if the taxpayer is 84 and has $100,000 in tax-deferred accounts, then the distribution period = 15.5, so the RMD for the year = $100,000/15.5 = $6451.61

Generally, distributions from different traditional IRA accounts can be combined to determine if the required minimum distribution has been received. However, there is an RMD for each 401(k) account, so they cannot be combined, either with other 401(k) accounts or traditional IRA accounts, to determine if an RMD has been received.

Retirement Account Beneficiaries

Most retirement accounts allow account holders to designate their beneficiaries, which cannot be altered through a will. Therefore, any change of beneficiaries must be changed in the appropriate documents provided by the retirement accounts. If more than 1 beneficiary is designated for a particular account, and the beneficiary dies before the account holder and before any changes are made to the beneficiary designations, then how the deceased's portion is distributed depends on state law. If state law stipulates a per capita distribution, then the portion allocated to the deceased beneficiary will be allocated in equal proportions to the remaining beneficiaries of the account. So if there were 3 beneficiaries, and one dies, then each of the surviving beneficiaries will receive 50% of the portion allocated to the deceased. Under a per stirpes distribution, if the deceased beneficiary had descendants, then an equal allocation of the benefit will pass to the descendants of the deceased beneficiary. So if the deceased had 2 children, then 50% of the deceased's benefit will go to each child.

Tax Penalties for Early Withdrawals

To prevent abuses and to fulfill the objective of retirement plans, there are penalties for taking distributions if the taxpayer is younger than the IRS-defined retirement age of 59½, although there are some exceptions. Unless an exception applies, early withdrawals from tax-deferred accounts are not only subject to ordinary income taxes, but they are also subject to a 10% tax penalty. So if a taxpayer in the 25% tax bracket receives an unqualified distribution of $1000, then there will be an assessment of $250 of ordinary income tax + a $100 tax penalty on the distribution. However, if the retirement plan allows it, the taxpayer may receive part of the fund as a loan without penalty. The general exceptions that allow for a penalty-free distribution include the following:

Additionally, some distributions from a traditional IRA may be penalty free if used to pay for:

However, the employment termination exception that generally applies to qualified retirement accounts does not apply to traditional IRAs. Also, for a SIMPLE IRA plan, the early withdrawal penalty is 25% during the 1st 2 years after the account is established.

Tax Tip: Remember that taking a distribution from a retirement account will increase your adjusted gross income (AGI), which may incur additional taxes, such as the net investment income tax or the Additional Medicare Tax imposed on higher income taxpayers, or the distribution may reduce deductions and tax credits. For instance, if you receive a subsidy for insurance premiums under the Affordable Care Act (aka Obamacare), then a distribution may lower, or even eliminate, that subsidy.

Nonqualified Retirement Plans

Because qualified retirement plans do not allow discrimination in favor of owners or highly compensated employees and because of the contribution limits of qualified retirement plans, some employers set up nonqualified retirement plans as part of a compensation package for key employees. A major employer benefit of nonqualified retirement plans is that they do not have to be funded, since they are only a promise by the employer to pay the employee at some future date. However, the major drawback to nonqualified plans is that they are not deductible by the employer until the employee receives the payment. Moreover, the employee bears the risk that the employer may renege on the promise or may not be able to pay the deferred compensation if the employer becomes insolvent or declares bankruptcy, or if the company is subject to a hostile takeover.

To mitigate this risk, an employer can set up a so-called rabbi trust — so-called because a synagogue 1st used this method of deferred compensation — by paying the deferred compensation to an irrevocable trust. The Rabbi trust must be domestic; otherwise, IRC §409A provides for the immediate taxation of the employee for payments to an offshore Rabbi trust, along with the imposition of tax penalties. Contributions to the trust are not taxed until the employee receives the compensation if the arrangement satisfies tax rules, including that the assets of the trust must be subject to the employer's creditors and neither the employees nor their beneficiaries can have preferred claims on the trust's assets. Hence, the rabbi trust simply makes it more difficult for an employer or a successor to renege on its promise of payment, but offers no protection against insolvency or bankruptcy. If the employee dies, then payments to beneficiaries are taxed as income in respect of a decedent.

To reduce the risk inherent in nonqualified retirement plans for the plans' participants, especially with a change in control or a deterioration of the financial condition of the company, many nonqualified retirement plans have benefit triggers, causing the immediate payment of benefits to the plan participant based on some event. Historically, benefit triggers could be based on changes in financial ratios, or a change in the net worth of the company. However, §409A allows only benefit triggers based on the company's financial stress or a change in control of the business.

Historical Notes

Covid-19 Distributions

Section 2202 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act treats Covid-19 as a qualified natural disaster, so it provides that the 10% early withdrawal penalty does not apply to a distribution of up to $100,000 made during 2020 to a qualified individual because of Covid-19. A qualified individual is an individual, spouse, or dependent diagnosed with Covid-19 or who has suffered financially, because of reduced or eliminated work hours or because childcare is unavailable, due to Covid-19.

These Covid-19 distributions may be recontributed to the tax-advantaged retirement plan during the 3-year period starting the day after the withdrawal. Recontributed amounts are treated as if the plan beneficiary received an eligible rollover contribution and, within 60 days, transferred the amount to a qualified retirement plan as a direct trustee-to-trustee transfer. Any distribution not recontributed is included as taxable income, but ratably over the 3-year period after the withdrawal or the taxpayer can elect to pay tax on the entire distribution by the filing date for tax year 2020.

Maximum Contribution Limits

All qualified retirement plans have a maximum limit on annual contributions. One limit that applies to all retirement accounts is that the contribution cannot exceed the participant's compensation, which, for defined contribution plans, is the compensation received during the tax year, while the limit for defined benefit plans is the highest average compensation for 3 consecutive calendar years. If not limited by compensation, then the following limits, not including any allowable catch-up contributions, apply:

Catch-up contributions allow taxpayers at least 50 years old to contribute up to $1,000 more annually.

Adjusted Gross Income Limits