Have You Heard of These Terms?
Funding your retirement will be up to you! That has become a harsh reality for those who planned to live on Social Security benefits alone in their retirement.
If you would like to accomplish items on your “bucket list”, you will need to build funds that can make that possible. You must pay for those items from funds outside your “fixed income” from Social Security.
Fortunately for you, Congress has tried to give us options for accumulating additional retirement savings, by making provisions in the Internal Revenue Tax Code. Some provisions allow for retirement contributions that reduce your tax obligations now but will require you to pay taxes on the principal and the earnings when you withdraw the funds. Other, more recent provisions allow you to make contributions after you pay current taxes in return for making withdrawals tax-free on the principal and earnings. Your choice!
The following are published terms for types of funds for your retirement savings:
- 401(k) Plan
- 403(b) Plan
- Traditional IRA
- Roth IRA
- SEP Plan
- SIMPLE IRA
- H.S.A.
- Annuity
I will mention some of the rules and contribution limits in my term explanations. This may not be a complete list so you should consult with your financial advisor for any recent changes in the Tax Code.
The 401(k) Plan
The 401(k) plans are set up by an employer to be offered as a benefit to their employees earning a taxable income. Contributions are tax-deferred, which means your current taxable income is reduced by your contribution amount. The principal and earnings are taxed upon withdrawal.
Employees can contribute up to $24,500 per year. There is a provision for Catch-up Contributions for those over 50 years old of $8,000 per year. Then, there is a special Super Catch-up allowance of $11,250 per year for those who are ages 60 to 63.
High wage earners have special limitations such as any catch-up contributions that must be a Roth contribution, after taxes are taken out.
Vesting rules may apply to the company match contributions, if the plan allows them.
Also, the Total Contributions per year is capped at $72,000 per year or 100% of compensation, whichever is less.
I suspect that most people reading this blog are still striving to reach those kinds of annual contribution limits!
The 403(b) Plan
These plans are like the 401(k) plans but are offered to employees of public schools, tax-exempt organizations, and certain ministers. Pre-tax contributions for tax-deferred earnings.
Traditional IRA
A traditional IRA is an Individual Retirement Arrangement. It is a tax-advantaged personal savings account designed to help individuals build wealth for retirement outside of a workplace-sponsored retirement plan, like a 401(k) plan. You can open an IRA through various financial institutions, such as a bank, mutual fund company, credit union, and a brokerage company.
Contributions may be tax-deductible, depending on your income, and your money grows tax deferred. You will pay taxes on your withdrawals during retirement.
The IRA offers more investment flexibility than a 401(k) account.
The contribution limit on an IRA is $7,500 per year. With a catch-up addition provision of $1,100 per year after age 50.
Roth IRA
A Roth IRA has similar limits to a traditional IRA, but contributions are made from after-tax funds. Therefore, you contribute from Net Pay.
Roth IRA contributions have a strict income phase out.
But the real benefit to the Roth IRA is that your withdrawals will be tax free, including earnings!
SEP Plan
The SEP Plan, Simplified Employee Pension Plan, is for self-employed individuals and small businesses. Employers can contribute toward employees’ or their own retirement savings.
Contribution limits are 25% of compensation up to $72,000. For self-employed individuals the limit is usually up to 20% of earnings.
SIMPLE IRA
A SIMPLE IRA, Savings Incentive Match Plan for Employees, is a tax-advantaged retirement plan for small businesses and self-employed individuals with 100 or fewer employees.
It allows employees to make pre-tax salary deferrals while requiring employers to make either matching (up to 3% of compensation) or non-elective contributions (2% of compensation).
A SIMPLE IRA is essentially a traditional IRA set up for each eligible employee. It is highly favored by small business owners because it avoids the costly administrative duties, annual IRS reporting, and discrimination testing associated with traditional 401(k) plans.
Contribution limits are $17,000, unless the company has 25 or less employees, then $18,000.
Caution: Withdrawals within the first two years in the plan made prior to reaching 59 and a half years are penalized at 25%, not 10% as those are in a 401(k) plan.
H. S. A.
The H. S. A., Health Savings Account, is a tax-advantaged personal savings account that you set aside with pre-tax money to pay for qualified medical expenses.
It is restricted to those who are enrolled in a High-Deductible Health Plan (HDHP).
I consider this one of the best things Congress did to help aging people deal with rising health insurance costs (high-deductible plans are cheaper) and offers help with the high-deductible exposure.
The best provision though is the fact that good health and low use of the funds will allow you to accumulate enough to be able to invest the unused balance above a certain level. Confer with an advisor for current contribution limits.
There are three tax advantages:
- Tax-deductible contributions, reducing current taxable income.
- Tax-free growth. No tax on interest or investment earnings.
- Tax-free withdrawals. No tax on withdrawals for eligible medical expenses.
You have portability which means you keep the funds, unlike the F. S. A., Flexible Spending Account.
Annuity
Annuity is a highly debated tool for investment. Read about the types and payout structures before choosing.
An annuity is a contract between you and an insurance company where you make a lump sum or series of payments. In exchange, the company provides you with regular income payments, either immediately or in the future. Primarily used as a retirement tool to guarantee life-long income and provide tax-deferred growth.
Risks and Advantages:
- High fees.
- Surrender charges when making withdrawals ahead of schedule.
- Tax Penalties on withdrawals before 59 and a half.
- Creditor dependency depends on the financial strength of the insurance company.
Terms of Retirement
Although Social Security benefits are a solid base for your retirement needs, they are limited and have potential to be scaled back in a few years. Therefore, you must be very familiar with your options to build retirement savings to supplement your Social Security benefits.
Taxes affect our financial decisions. So, Congress came up with plans to help us defer taxes or be able to get benefits tax free. They gave you options.
Make good choices. Decide what is best for your situation. But do calculate the cost effect on earnings if taxes are paid today versus later. The Roth IRA looks pretty good in that perspective!
Whatever options you choose, you must be committed to making consistent contributions to the plan and keep your personal finances stable with adequate savings to keep you out of your retirement funds until retirement!