To provide a source of retirement income you can draw on after you stop working, you have to invest for retirement while you’re still on the job. To take advantage of the opportunity to accumulate tax-deferred earnings and in some cases defer taxes on your contributions as well, you can participate in employer-sponsored retirement plans and invest in individual retirement accounts (IRAs) that you set up on your own. In fact, you can do both at the same time.
TYPES OF PLANS
You may participate in an employer-funded retirement plan, better known as a pension, or in an employer plan to which you make contributions by deferring a portion of your salary. Both types offer tax advantages. The major difference is the source of the money that’s invested — in the case of a pension your employer puts it in, over and above your salary, and a salary deferred plan it is a portion of what you earn that may or may not be matched by a contribution from your employer. You may participate in several different employer plans, either at the same time or at different points in your working life.
Profit-sharing and money purchase plans are funded by your employer with money that’s separate from your salary. Your employer gets to deduct the contribution from corporate income tax. In some cases, if you own a small business, you may set up such a plan even if you have just one or two employees.
Retirement savings plans are funded with a portion of your earnings. In a traditional tax-deferred plan, the amount of your contribution is subtracted from your gross income before your income is reported to the IRS, reducing the amount on which you owe current taxes. If your employers also contributes to your retirement savings plan, it’s typically a percentage of your contribution up to a fixed cap, such as 5% or 6%.
If your employer offers a Roth 401(k), Roth 403(b), or Roth 457 alternative in addition to a traditional 401(k), 403(b), or 457, and you choose to participate, your contribution is made with after-tax income. Both types of accounts accumulate tax-deferred earnings, but when you withdraw from a Roth account, the amount is exempt from federal income tax provided you are at least 59½ and your account has been open at least five years. If your employer contributes, that money goes into a separate traditional tax-deferred account.
In all cases, your account value and the retirement income it provides will depend on the amount that is invested, how it is invested, and how well those investments perform over time. Since investment returns aren’t fixed and will fluctuate, you may have gains in some periods but losses in others. This means it is impossible to predict the value of your account at the time you retire or the specific income it will provide.
THE PLAN RULES
There are many types of employer sponsored plans, and, in general, they work like this: In return for postponing taxes on your earnings until you start receiving your retirement income, you give up access to the money that’s invested. There is an emergency exception, which allows you to withdraw early to meet certain financial needs.
When an employer sponsors a retirement plan, the employer is responsible for making sure the plan meets the legal requirements for the type of plan it is:
ELIGIBILITY
A plan must offer the same options to everyone who is eligible to participate, and the eligibility rules must be applied consistently.
ANNUAL CONTRIBUTIONS
There are specific limits on the amount you can contribute each year to employer sponsored retirement savings plans and limits on the combined contributions that you and your employer make in your name.
PAYOUT REGULATIONS
In most cases, you must have left your job and be at least 59½ before you start to take income from a retirement plan without penalty. You must also begin taking required minimum distributions (RMDs) when you reach 70½, with some exceptions if you’re still on the job. With a tax-deferred plan, you owe income tax on the withdrawals at your regular rate. No tax is due on RMDs from a Roth 401(k), 403(b), or 457 if you follow the rules that apply.
A QUALIFIED ADVANTAGE
When you contribute pretax income to a retirement plan, you postpone or defer paying taxes on your contributions and on any investment earnings until you begin to withdraw the money. When you invest through a taxable account, earnings are taxed at the rate that applies to dividends, interest, and capital gains even if you reinvest those earnings. Remember that earnings are not guaranteed in either type of account.
WHAT’S TAX DEFERRED?
While you’ll hear a lot of discussion about tax-deferred investments as a way to save for retirement, it’s actually the accounts or plans you use to save, not the specific investments you hold in those accounts or plans, that are tax deferred. Any earnings you accumulate on money in those accounts or plans are also tax-deferred. That’s why an investment, such as a mutual fund, produces tax-deferred earnings if you purchase shares with money you put in an IRA but taxable earnings if you hold that mutual fund in a taxable account.
DOES TAX DEFERRAL PAY?
You pay income tax on the money you withdraw from your traditional tax-deferred account at whatever your tax rate is for the year you withdraw the money. For example, if your taxable income, including the amounts you withdraw, puts you in the 28% federal tax bracket, that’s the top rate at which you pay tax and the rate that will apply to your withdrawal amount.
You may wonder if you’ll end up owing more tax on the money you eventually take out of your tax-deferred account than you would have paid at the time you actually earned the money. Realistically, there is no way to tell for sure. Tax rates change over time, depending on a number of factors. What you earn changes as well.
But because you owe no tax during the years your account accumulates earnings, tax-deferred accounts have the potential to grow larger than a comparable taxable account, especially if you have to withdraw from the taxable account to pay the taxes that are due on the earnings.
You may have an alternative, though, if you can contribute to a Roth 401(k), Roth 403(b), Roth 457, or Roth IRA. Then you pay taxes on the money you contribute but will be eligible for tax-free withdrawals when you retire. Using a combination of traditional and Roth accounts lets you take advantage of both approaches.