Retirement plans are arrangements that individuals set up in order to provide them with an income after they retire. The most common types of private retirement plans are 401(k) and IRA plans.
One of the main reasons individuals have 401(k)s and IRAs is to reduce their tax liability and taxable income. This allows them to save more money in the long run.
Some large businesses provide their employees with pensions. After the employees retire, the business pays them a monthly amount depending on the length of their employment.
What are IRAs?
IRAs, or Individual Retirement Accounts may be provided by an individual’s employer or self-provided. They provide certain tax benefits. Transactions inside the account, which includes interest and capital gains, are not taxed.
Contributions are made to the account and the owner of the IRA may invest the money in most types of securities. The money is held by a custodian, which is typically a bank or brokerage firm. The custodian makes the actual investments based on directions from the owner of the IRA.
There are two main types of IRAs, a traditional IRA and a Roth IRA. A traditional IRA allows an individual to contribute a certain amount each year and invest those contributions without being taxed on the annual investment gains. This helps the account grow.
This tax break also provides an immediate advantage. However, it is only beneficial at retirement if the IRA holder is in a lower tax bracket.
An individual cannot withdraw funds from the account until the age of 59½ or a fee of 10% is charged. Once withdrawals begin, there is a minimum annual withdrawal.
In a Roth IRA, contributions are made after being taxed. However, withdrawals are free from income tax, which includes most earnings from the account. Additionally, there are fewer restrictions and requirements on withdrawals with this type of account.
What Are the Benefits of IRAs?
There are many benefits to an IRA. An IRA is essentially an investment account in which an individual can make contributions from their income without being taxed annually for their capital gains.
The benefits of a traditional IRA include:
- The contributions are tax-deductible;
- Earnings and gains are not taxed, which allows investments to grow;
- Any individual with an earned income can contribute to a IRA account; and
- An individual may use contributions on investment options such as:
- mutual funds;
- bonds; and
Another benefit of a traditional IRA is that contributions that are made to the account are tax deferred. The individual is not taxed and withdrawals that are made years later in the individual’s retirement reduce their tax liability. Since, in most cases, an individual’s income is lower during their retirement years, the funds withdrawn may be subject to a lower tax bracket.
What Is a 401(k)?
A 401(k) plan is a type of retirement plan that is sponsored by an employer. A portion of the employee’s wages are placed into the account. The employee chooses from a number of investment options.
Some companies match their employee’s contributions to a certain extent and pay extra money into their account. The contributions to the account are not taxed. Since gains from the investments in a 401(k) account are not taxable events, there are no capital gains or interest taxes applied.
When funds are withdrawn, they are taxed as income. However, similar to an IRA, funds withdrawn prior to the age of 59½ are subject to a 10% fee.
Both IRAs and 401(k) plans have specific requirements for eligibility and contribution limits. In addition, most plans permit early withdrawals without a penalty in certain situations that would be considered hardship.
What Are the Benefits of a 401(k)?
There are several benefits of a 401(k) plan. One of the benefits is that the plan allows an individual to save money towards their retirement on a tax-deferred basis.
This means that the individual does not have to pay federal or state income taxes on their savings or on the investment earnings until they withdraw funds at retirement.
Since an individual’s taxable income at retirement is much lower than when they were working, their tax liability is much lower. In addition, when money is deducted from the individual’s paycheck before taxes are withdrawn, it lowers their taxable income and, therefore, lowers their taxes.
What Is a Pension Plan?
Pension plans are plans in which an employer takes some of their own funds and invests them on the employee’s behalf. Upon their retirement, the employee is entitled to a specific amount of money, plus however much money the investment earned.
The specific amount of money and the investment income are called retirement income. Retirement income payments may be guaranteed until the end of an individual’s life.
How Does a Pension Plan Work?
When employers set up pension plans, they must contribute to a pool of money that is set aside for retirement income. This pool of money is invested by the employer. The employer may invest this money in various types of investments, including stocks and mutual funds.
Once the funds are invested, earnings on those investments accrue. These earnings are used to pay the employees part of their retirement income.
Some pension plans allow an employee to invest their own money in addition to that money that the employer invests. Other pension plans will match, up to a certain amount, of what the employee contributes each year.
What Does it Mean for a Retirement Plan to Vest?
When an employee’s retirement plan vests, they are able to receive their retirement benefits when they leave the company. If the retirement or pension plan has only partially vested, the employee is only eligible to receive the percentage of the plan that has vested.
What is ERISA?
Employers are not required to provide pension plans. However, if they choose to do so, then the Employee Retirement Income Security Act (ERISA) establishes rules that must be followed by a private employer.
ERISA regulates the vesting of an employee’s rights to their retirement benefits in all employer-sponsored plans. For example, ERISA provides standards as to:
- When an employee begins participating in the retirement plan;
- When an employee acquires non-forfeitable rights to their benefits; and
- When their benefits may be affected by events such as termination in employment.
What Rules Apply to Retirement Benefits Vesting?
The rules that apply to retirement benefits will often depend on the type of employer-sponsored retirement plan an individual has. However, some rules generally apply, including:
- Before an employee’s rights vest, they may lose some retirement benefits for leaving the company;
- After an employee’s rights vest, if they leave before their retirement, the receive all vested benefits, although the value of the vested benefits in a defined contribution plan may decline;
- A returning employee may count prior years of work towards their benefits vesting if the employee returns after less than five years;
- Military duty may be counted towards years of work that are necessary for vesting; and
- Different rules apply to an employee who left work prior to January 1, 1985.
Do I Need a Lawyer for my Retirement Plan?
It is important to have the assistance of an experienced tax attorney with your retirement plan needs. There are different retirement plans which may be complex and difficult to understand.
Your attorney can assist you in understanding the tax implications of each different type of retirement plan and help you determine which retirement plan is best for you. Your attorney can also advise you regarding your rights in a pension plan and assist you if any disputes arise.