Individual Retirement Account (IRA)
An IRA is a personal savings account into which an individual makes limited contributions yearly. The contributions are tax deductible and grow tax deferred until withdrawn at retirement.
Contribution maximums for IRAs are $5,500 per year, or if you are 50 and over, $6,500 per year. If withdrawals take place prior to the owner being 59 1/2 years old, the owner pays a 10% penalty plus taxes on the withdrawal. The owner of an IRA must begin to take minimum distributions at 70½ years old; otherwise, the owner will be penalized 50% by the IRS. There are multiple types of IRAs, such as a Roth IRA, traditional IRA, SEP IRA, and SIMPLE IRA. Traditional and Roth IRAs are customarily set up by a singular taxpayer who can add 100% of his/her compensation to the account up to a maximum yearly sum. SEP and SIMPLE IRAs on the other hand are established by employers for their employees.
A Roth IRA is an individual retirement plan in which an eligible individual can make contributions on an after tax basis (not tax deductible). The benefit of a Roth IRA is that qualified distributions are on tax-free and minimum distribution requirements do not apply.
In order for a distribution to be qualified, it must fall under one of the following rules: It takes place 5 years or more after the taxpayer creates his/her first Roth IRA, or the taxpayer becomes disabled, is 59 1/2 years of age or older, passes away, or is using the withdrawal to purchase his/her first home, in which case there is a limit of $10,000. The contributor’s age, income, and tax filing status all determine how much he/she can deposit into the Roth IRA account.
Short for Simplified Employee Pension IRA, a SEP IRA is a retirement plan designed for self-employed people and other small business owners. The employer is allowed a tax deduction for contributions made to an employee’s SEP IRA account.
A SEP IRA is available to self-employed/sole proprietors, partners in a partnership, or owners of corporate businesses, and their employees. Contributions are pre-tax and the account growth is tax-deferred until funds are withdrawn at retirement age. Eligible employees are those that are at least age 21, earned at least $550 in a given year, and have worked for the business for at least 2 of the previous 5 years.
SIMPLE stands for Savings Incentive Match Plan for Employees. It is a retirement plan that may be established by employers. The employer is allowed a tax deduction for contributions made to the SIMPLE IRA. The employer usually makes a limited matching contribution to employee’s SIMPLE IRA when employees make salary deferral contributions into their account.
Employers with less than 100 employees earning at least $5,000 per year who do not offer other retirement plans can offer SIMPLE IRA. Self-employed workers are also eligible. Employees can contribute up to $12,000 per year into the account, with the exception that employees who are at least 50 years old can contribute up to $14,500.
A 401(k) is a retirement plan offered by a business organization that allows employees to begin saving pretax income. Contributions are made from the employees’ salary and are often matched to some extent by employers. Maximum salary deferrals are $17,500 per year unless 50 years of age or older which can defer $23,000 per year.
A 401(k) plan (a type of defined contribution plan) takes its name from subsection 401(k) of the Internal Revenue Code. This retirement plan permits employees to set aside a portion of their pretax income. Depending on what the plan allows, employees can also contribute to the 401(k) on a post-tax basis (Roth 401k). Regardless, earnings from investments within the 401(k) account are tax-deferred. Employers offering a 401(k) plan may make equivalent contributions to the plan on behalf of eligible employees. A major benefit of a 401(k) is the tax deferral (postponement) of taxation and possible employer match. For pre-tax contributions, the employee does not pay federal income tax on the sum of income that he/she defers to a 401(k) account. The employee eventually pays taxes (unless it’s a Roth 401k) on the money as he/she extracts the funds, customarily during retirement. Restrictions are placed on the availability of assets after being placed in a 401(k) account to the participating employee. If an employee chooses to withdraw from the 401(k) plan while under the age or 59 ½, penalties may occur. Most plans provide a core group of investment products from which participants can choose.
A 403(b) is a retirement plan offered by nonprofit organizations. Employees contribute a percentage of their salary into a 403(b) account. These contributions grow until withdrawal, at which point the money is taxed as regular income.
Typically, under a customary 403(b) plan, an employee permits a percentage of his/her pre-tax income to be invested by placing it into a 403(b) account. Taxation is delayed until removal from the account. Usually this occurs after retirement. In order to take advantage of a 403(b) plan, workers must have a sponsoring employer such as a school, governmental agency, charity or a foundation. This plan is considered a nonprofit worker’s equivalent of a 401(k). These plans typically offer TSAs or tax sheltered annuities.
Defined Contribution Plans
The most common type of defined contribution plans are profit sharing, 401(k), and money purchase plans. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts (through employer contributions and, if applicable, employee contributions), plus any investment earnings on the money in the account. With defined contribution plans, future benefits are based on future contribution levels and investment earnings. With a 401(k) plan provisions can be established that allow employees to contribute, pretax, up to a predetermined portion of his or her earnings, part of which is usually matched by the employer. Money purchase plans are funded entirely by employer contributions.
Defined Benefit Plans
A defined benefit pension plan is a pension plan in which an employer promises a specified monthly benefit at retirement that is predetermined by a formula based on the employee's earnings history, tenure of service and age, rather than depending directly on individual investment returns and contributions made. It is 'defined' in the sense that the benefit formula is defined and the benefits are known in advance.
These types of plans are generally not tax deductible, grow tax deferred, and may or may not be taxable upon distribution. Examples of these type plans are deferred compensation plans, supplemental life insurance plans, and other private banking strategies. These plans may be discriminatory, allowing employers to pick and choose who will be covered, and are more flexible then qualified plans as to the level of annual contributions that can be made. Individuals can also establish private non-qualified plans, providing liquidity, use and control of their money, security and stability, and access to money on a tax free basis.