Frequently Asked Questions

It is generally preferable to save as much as possible for retirement, but you should do so within your means. The Internal Revenue Service (IRS) sets limits on how much you can contribute to a retirement plan. This maximum contribution amount generally increases to keep pace with inflation, so it is a good idea to check this annually. If possible, you should try to maximize your 401(k) contributions each year. While there is a maximum amount you can contribute per year, don’t contribute so much that you aren’t able to pay your bills.

For this reason, it may be wise to save some of your money in other investment accounts just in case you have unexpected costs that arise before retirement. This is because there could be restrictions and penalties for accessing the money you have put away in your 401(k).

There are two types of 401(k)s: traditional and Roth. The main difference between the two types is the way taxes are handled. Contributions to a traditional 401(k) are made pre-tax—that is, taken from your paycheck before income or other taxes are assessed. You are then taxed on withdrawals from the account when you take them. Contributions to a Roth 401(k) are made after-taxes are assessed on your income, meaning later withdrawals from the account are not taxed again.

Traditional 401(k)

Traditional 401(k) contributions and earnings are not taxed until the money is withdrawn. This means a larger amount of money (remember, no taxes were taken out) can grow and compound over time. Because taxes are deferred, your reportable earned income is less for the year you make a contribution, which could mean you potentially have a lower tax bill in that contribution year.

When you contribute to a traditional 401(k), the amount contributed, the realized capital gains, and income earned in the account are tax-deferred as long as you don’t remove them from the account. However, you have to pay taxes when you withdraw funds. You can generally withdraw your money without penalties after age 59 ½, at which time withdrawals are taxed at your ordinary income tax rate. Depending on your tax bracket at that time, your effective tax rate may be higher or lower than the rate you paid when you were contributing.

Roth 401(k)

With a Roth 401(k), you pay ordinary income tax on the contribution before you put the money in. Then, withdrawals are tax-free.  You can begin withdrawing from a Roth 401(k) at age 59 ½.

Required minimum distributions, or RMDs, are government-mandated withdrawals that begin to affect 401(k) and IRA owners and their beneficiaries when they reach a specific age or at death. Those that inherit a 401(k) or an IRA from a deceased party may also be subject to RMDs depending on the type of account they inherit, the age of the decedent and whether RMDS have already been taken. This is a highly complex subject and should be discussed with a qualified tax professional before beginning to take withdrawals.

The amount you have to withdraw varies. You should contact your custodian or a qualified tax adviser to calculate your required minimum distribution (RMD) amount.

A 401(k) plan is an employer-sponsored retirement savings vehicle. It is set up by the employer and gives employees the option to contribute a percentage of their salary or certain dollar amount. 401(k) plans give employees the option of investing their money in various types of securities. The number and type of investments varies from plan to plan.

401(k) plans offer potential tax benefits which can vary depending on the type of 401(k) your employer makes available to you and what plan type you elect. For example, if you are making pre-tax contributions to a traditional 401(k), your contributions are deducted from your paycheck and could lower your current income taxes. The contributed amount grows on a tax-deferred basis, meaning you will be taxed when the money is withdrawn.

Some employers match employee contributions up to a certain percentage. That means your investment returns could get an extra boost if you contribute at least up to that company match.

There are two types of 401(k)s: traditional and Roth. You can have and contribute to both types of plans. An incentive to have both is tax diversification in the event of regulatory changes. If your plan offers both types of 401(k), you can split your yearly maximum contribution between the two account types.

An individual retirement account (IRA) is a tax-advantaged investment vehicle set up at a financial institution that allows you to make investments to help save for retirement.

Even though IRAs are a common type of investment account, it’s important to be aware of how they work, understand the available investment choices and know the different types of IRAs that exist. Whether or not an IRA is a good option for you depends primarily on the type you choose and your personal financial situation.

Like 401(k)s, there are different types of IRAs. These include traditional, Roth, SEP and SIMPLE IRAs.

Traditional IRA. A traditional IRA (also known as contributory or pre-tax IRA) allows most people to contribute up to $7,000 per year in 2022.^[i] If you are 50 or older, a “catch-up” provision allows you to contribute another $1,000 for a total of $8,000 per year. You may also be able to roll over assets from your pre-tax 401(k) account into an IRA after leaving your employer. This should be discussed with a tax adviser and plan administrator before completing such a transaction.

Some or all of traditional IRA contributions could be fully tax deductible depending on your income, tax-filing status and whether you have a retirement plan through your employer. Further, there are no income limits to contributing to a traditional IRA, even if you don’t qualify for a deduction. A tax adviser can offer clarity on your particular situation and eligibility.

Roth IRA. A Roth IRA has the same annual contribution limits as a traditional IRA; the main difference is when you pay taxes. With Roth IRAs, you don’t get an up-front tax break on your contributions, but you also don’t have to pay tax on withdrawals during retirement—the opposite of a traditional IRA. A Roth IRA can also serve as the recipient account of a roll-over from a Roth 401(k) account or other Roth defined contribution plan after leaving your employer. It may be best to speak with a tax adviser if you have any questions pertaining to your unique situation.

SEP and SIMPLE IRAs. Both SEP (Simplified Employee Pension) and SIMPLE (Savings Incentive Match Plan for Employees) IRAs are designed for self-employed individuals, small-business owners and their employees. Both are similar to a traditional IRA. They allow for contributions to grow tax-free until withdrawn. Also, funds cannot be distributed penalty-free until age 59½. They differ from traditional IRAs over contribution limits and who makes the contributions.

With a SIMPLE IRA, the employee makes the majority of contributions, with a small contribution required by the employer. Employees can contribute up to $16,500 annually in 2022—with a $3,500 per year “catch-up” contribution if over age 50. Employers can match that up to 3% of the employee contribution. Like in a traditional IRA, employees can take a tax deduction for their contributions to a SIMPLE IRA plan.

With a SEP IRA, the employer makes all of the contributions, which cannot exceed the lesser of 25% of the employee’s compensation or $70,000.^[ii] Employees can take a tax deduction on contributions by their employer, up to a maximum of 25% of their annual compensation. Consult a tax adviser if you have any questions.

After leaving an employer, you can typically consolidate SEP or SIMPLE IRAs with other traditional IRAs you may have.

IRA Investment Choices

Individual retirement accounts can generally hold a wide variety of securities including but not limited to:

• Cash
• Certificates of deposit (CDs)
• Bonds, notes and other fixed income securities
• Common stocks
• Mutual funds
• Exchange-traded funds (ETFs)

Distributions. With traditional, SEP and SIMPLE IRA investments, you will likely incur a penalty (10% in many cases)—as well as pay taxes—on distributions taken before age 59½.

A Roth IRA gives you a bit more flexibility than a pre-tax IRA. You can withdraw contributions at any time, for any reason, penalty-free after 5 years—although you will be penalized if you withdraw any Roth IRA investment earnings before age 59½. Additional requirements for Roth IRAs may apply and you should consult a tax adviser if you have any questions.^[iii]

Additionally, pre-tax IRAs are subject to required minimum distributions (RMDs) starting at age 73 that increase as a percentage of your IRA as you get older. Roth IRAs also allow you to leave your money untouched as long as you like while you are alive. If you have inherited any IRA, you may want to consult a tax adviser to determine what withdrawals are required and when.^[iv]

[i] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits

[ii] https://www.irs.gov/retirement-plans/plan-sponsor/simplified-employee-pension-plan-sep

[iii] https://www.irs.gov/publications/p590b

[iv] https://www.irs.gov/retirement-plans/required-minimum-distributions-for-ira-beneficiaries

Source: https://www.irs.gov/publications/p590b

Source: https://www.irs.gov/retirement-plans/required-minimum-distributions-for-ira-beneficiaries

Many people may elect to roll over a 401(k) when they retire or leave their employer. You can contribute to a new 401(k) plan at a new employer and have multiple tax-deferred or tax-exempt accounts (i.e., you can have 401(k)s and IRAs simultaneously).

If a 401(k) plan allows participants to invest in whatever they like, there is usually less of a hurry to roll over (unless fees are a consideration). Plan participants may also want to consider rolling assets into an IRA for reasons such as to work with a different custodian (keeper of their assets) than the one their employer uses or maybe to entrust those assets to an active manager.

Depending on the type, IRAs can have similar tax-deferred or tax-exempt benefits to 401(k)s, but they are set up by individuals. One downside to IRAs is they have lower contribution limits than 401(k)s. That’s not much of a hurdle, though if a new employer offers a 401(k) program because the employee participant can open an IRA account and reap the benefits of both.

There are two methods for rolling 401(k)s into an IRA if the plan permits it. Employee plan participants should check with their personal tax adviser and 401(k) plan administrator before initiating a rollover.

Option One: A 401(k) plan administrator directly transfers the money to another retirement plan or to an IRA.

Option Two: If the 401(k) plan administrator issues a distribution in the form of a check, recipients will have 60 days to deposit the check into a new retirement account. If they don’t deposit it in the new retirement plan account or IRA within 60 days, the full distribution amount may be subject to ordinary income tax and potentially a 10% early-withdrawal penalty if they are under age 59 ½.

Importantly, if the check is made payable directly to the employee, it will be subject to a mandatory 20% tax withholding, even if to the intent is to roll it over. However, this mandatory withholding can be avoided by having the check made payable directly to the receiving plan or IRA account.

For many, the goal of building a retirement portfolio is to provide income when you stop working. Some investors may not need income from their portfolio until well into their retirement and others may need it right away. It is prudent to discuss any IRA withdrawal strategy with a tax adviser beforehand, since individual circumstances can vary.