The Internal Revenue Service (IRS) offers taxpayers a variety of tax-advantageous savings vehicles to incentivize retirement savings. The following list is an overview of some of these savings vehicles and their tax effects.
A traditional individual retirement account (IRA) can be used by anyone under the age of 70½ who earns income or is the spouse of someone who earns income. The income from the investments will grow tax free but are taxed at withdrawal. Individuals can contribute up to $6,000, and an additional annual catch-up contribution of $1,000 at age 50 and older.
A Roth IRA is like a traditional IRA but differs in its tax effects. Individuals who earn under a set amount can contribute the same amount as a traditional IRA. The contributions are after-tax dollars, but the contributions grow tax-free and the withdrawal of the gains and contributions are tax-free as well. The cap for 2019 is $6,000 combined for traditional and Roth IRAs.
The employer’s status determines the type of plan offered to employees. Employees can choose whether to contribute to the employer-sponsored plan.
401(k). Contributions into a traditional employer sponsored 401(k) have an annual limit of $19,000 (for 2019). The contribution is made with pre-tax dollars, but the contributions and earnings on those contributions will be taxed at withdrawal. Generally, employers can allow for contributions to be made into a Roth 401(k) as well. The contributions into a Roth 401(k) will be after-tax dollars, but the contributions and earnings will not be taxed upon withdrawal. Individuals of age 50 and older can make an annual catch-up contribution, which amounts to an additional $6,000 for the 2019 tax year.
403(b). A 403(b) plan is like a 401(k) but used by nonprofits, governments, school districts, and religious groups. These plans are exempt from the administrative costs that 401(k)’s carry, which usually results in lower administrative fees for the user. The contribution limit is $19,000 annually (for 2019) and the contributions are made with pre-tax dollars. The contributions and earnings, like a traditional 401(k), are taxed at withdrawal. A Roth version of the 403(b) plan is also available and offers the same tax treatment as the 401(k)—after-tax dollar contributions and not taxed upon withdrawal.
SIMPLE IRA and SIMPLE 401(k). Savings Incentive Match Plan for Employees (SIMPLE) IRAs and 401(k)s are traditionally associated with small businesses—100 employees or less. Individuals use pre-tax dollars to contribute to both plans and the contributions and earnings are taxed at withdrawal. The annual limitation for a SIMPLE plan is $13,000 for 2019. An annual catch-up contribution of $3,000 is allowed for individuals age 50 and older. Unlike the traditional employer-sponsored plans, employers are required to match up to 3 percent of the employee’s compensation or a 2 percent nonelective contribution for each eligible employee.
SEP. A Simplified Employee Plan (SEP) is a plan available to businesses of any size, including self-employed. Employers can contribute up to 25 percent of each employee’s pay annually, capped at $56,000 for 2019.
Required Minimum Distributions
The IRS generally requires that individuals take withdrawals once they reach the age of 70½ (there is an exception for Roth IRAs, which require distributions after the owner’s death). Individuals can take more than the minimum distribution. The minimum amount required is dependent on the individual’s age, marital status, and value of retirement accounts.
For IRAs, individuals must take withdrawals April 1st of the year following the calendar year in which the individual turns 70½. For 401(k)s and other defined contribution plans, the individual must take withdrawals April 1st of the year following the calendar year in which the individual turns 70½ or retires—whichever is later.
Just as the IRS mandates how long an individual can leave savings in his account, the IRS has rules for how early is too early to withdraw. Generally, an individual will be penalized if he takes a withdrawal before the age of 59½. Taxpayers will be hit with a 10 percent penalty (25 percent in some cases) for early withdrawal amounts and possibly the tax owed for the withdrawal from a pretax contribution savings vehicle.
Luckily, there are exceptions to the early withdrawal rules. Contributions to a Roth IRA are fully vested, meaning individuals can withdraw the contribution (not the earnings) at any time. The IRS allows for early withdrawal on traditional, Roth earnings, and SIMPLE IRAs, and SEPs under the following circumstances: disability, qualified higher education expenses, qualified first-time homebuyers, and medical expenses. The exemptions for early withdrawals from a 401(k) or 401(b) are more limited and exclude withdrawals for qualified higher education expenses and qualified first-time homebuyers.
Knowing the tax effects of the various retirement savings accounts can have a significant impact on your financial decisions. The IRS offers these accounts to incentivize saving so it’s not a bad idea to take advantage!