Long-Term Financial Planning
Qualified Plans
Long-Term Financial Planning
Qualified Plans
Defined contribution (DC) retirement plans allow employees to invest pre-tax dollars in the capital markets where they can grow tax-deferred until retirement. 401(K) and 403(B) are two popular Defined-Contribution plans commonly used by companies and organizations to encourage their employees to save for retirement.
What Is a 401(k) Plan?
A 401(k) plan is a retirement savings plan offered by many American employers that has tax advantages to the saver. It is named after a section of the U.S. Internal Revenue Code.
The employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution. The employee gets to choose among a number of investment options, usually mutual funds.
How 401(k) Plans Work
The 401(k) plan was designed by the United States Congress to encourage Americans to save for retirement. Among the benefits they offer is tax savings.
There are two main options, each with distinct tax advantages.
However, not all employers offer the option of a Roth account. If the Roth is offered, the employee can pick one or the other or a mix of both, up to annual limits on their tax-deductible contributions.We will discuss Roth 401(K) in the next chapter.
Traditional 401(k)
With a traditional 401(k), employee contributions are deducted from gross income, meaning the money comes from the employee's payroll before income taxes have been deducted. As a result, the employee's taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on the money contributed or the earnings until the employee withdraws the money, usually in retirement.
Contributing to a 401(k) Plan
A 401(k) is a defined contribution plan. The employee and employer can make contributions to the account up to the dollar limits set by the Internal Revenue Service (IRS).
A defined contribution plan is an alternative to the traditional pension, known in IRS lingo as a defined-benefit plan. With a pension, the employer is committed to providing a specific amount of money to the employee for life during retirement.
In recent decades, 401(k) plans have become more common, and traditional pensions have become rare as employers shifted the responsibility and risk of saving for retirement to their employees.
Employees also are responsible for choosing the specific investments within their 401(k) accounts from a selection their employer offers. Those offerings typically include an assortment of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as the employee approaches retirement.
They may also include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer's own stock.
Contribution Limits
The maximum amount that an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation, which is a metric that measures rising prices in an economy.
For 2021, the annual limit on employee contributions is $19,500 per year for workers under age 50, and for 2022, the limit is $20,500 per year. However, those aged 50 and over can make a $6,500 catch-up contribution in 2021 and 2022.
If the employer also contributes, or if the employee elects to make additional, non-deductible after-tax contributions to their traditional 401(k) account, there is a total employee-and-employer contribution amount for the year.
2021
- For workers under 50 years old, the total employee-and-employer contribution amount is capped at $58,000, or 100% of employee compensation, whichever is lower.
- If we include the catch-up contribution for those 50 and over, the limit is $64,500.
- For workers under 50 years old, the total employee-employer contributions cannot exceed $61,000 per year.
- Including the catch-up contribution for those 50 and over, the limit is $67,500.
Once money goes into a 401(k), it is difficult to withdraw it without paying taxes on the withdrawal amounts.
"Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement," "Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary."
The earnings in a 401(k) account are tax-deferred in the case of traditional 401(k)s and tax-free in the case of Roths. When the traditional 401(k) owner makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners have already paid income tax on the money they contributed to the plan and will owe no tax on their withdrawals as long as they satisfy certain requirements.
Both traditional and Roth 401(k) owners must be at least age 591/2—or meet other criteria spelled out by the IRS, such as being totally and permanently disabled—when they start to make withdrawals.
Otherwise, they usually will face an additional 10% early-distribution penalty tax on top of any other tax they owe.
Some employers allow employees to take out a loan against their contributions to a 401(k) plan. The employee is essentially borrowing from themselves. If you take out a 401(k) loan, please consider that if you leave the job before the loan is repaid, you'll have to repay it in a lump sum or face the 10% penalty for an early withdrawal.
Defined contribution (DC) retirement plans allow employees to invest pre-tax dollars in the capital markets where they can grow tax-deferred until retirement. 401(K) and 403(B) are two popular Defined-Contribution plans commonly used by companies and organizations to encourage their employees to save for retirement.
What Is a 403(b) Plan?
The term 403(b) plan refers to a retirement account designed for certain employees of public schools and other tax-exempt organizations. Participants may include teachers, school administrators, professors, government employees, nurses, doctors, and librarians.
The 403(b) plan, which is closely related to the better-known 401(k) plan, allows participants to save money for retirement through payroll deductions while enjoying certain tax benefits. There's also an option for the employer to match part of the employee's contribution.
How 403(b) Plans Work
As noted above, individuals employed by schools and other tax-exempt organizations can save for retirement by contributing to a 403(b) plan through payroll deductions. The plan is akin to the 401(k) plan used by private-sector employees. Participants can include:
- Employees of public schools, state colleges, and universities
- Public school employees of Indian tribal governments
- Church employees
- Employees of tax-exempt 501(c)(3) organizations
- Ministers and clergy members
Contribution Limits
The 403(b) plan has the same caps on yearly contributions that come with 401(k) plans. The maximum contributions allowed are $19,500 and $20,500 for the 2021 and 2022 tax years. The plan also offers $6,500 catch-up contributions for those age 50 and older.
If the employer also contributes, or if the employee elects to make additional, non-deductible after-tax contributions to their traditional 401(k) account, there is a total employee-and-employer contribution amount for the year.
The 403(b) plan has the same caps on yearly contributions that come with 401(k) plans. The maximum contributions allowed are $19,500 and $20,500 for the 2021 and 2022 tax years. The plan also offers $6,500 catch-up contributions for those age 50 and older.
If the employer also contributes, or if the employee elects to make additional, non-deductible after-tax contributions to their traditional 401(k) account, there is a total employee-and-employer contribution amount for the year.
2021
- For workers under 50 years old, the total employee-and-employer contribution amount is capped at $58,000, or 100% of employee compensation, whichever is lower.
- If we include the catch-up contribution for those 50 and over, the limit is $64,500.
- For workers under 50 years old, the total employee-employer contributions cannot exceed $61,000 per year.
- Including the catch-up contribution for those 50 and over, the limit is $67,500.
There are generally two broad types of 403(b) plan—the traditional and the Roth. Not all employers allow employees access to the Roth version. We will discuss Roth version in next chapter.
A traditional 403(b) plan allows the employee to have pretax money automatically deducted from each paycheck and paid into a personal retirement account. The employee has put away some money for the future and at the same time reduced his or her gross income (and income taxes owed for the year). The taxes will be due on that money only when the employee withdraws it.
Once money goes into a 403(b), it is difficult to withdraw it without paying taxes on the withdrawal amounts.
The earnings in a 403(b) account are tax-deferred in the case of traditional 403(b)s and tax-free in the case of Roth. When the traditional 403(b) owner makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners have already paid income tax on the money they contributed to the plan and will owe no tax on their withdrawals as long as they satisfy certain requirements.
Both traditional and Roth 403(b) owners must be at least age 591/2—or meet other criteria spelled out by the IRS, such as being totally and permanently disabled—when they start to make withdrawals.
Otherwise, they usually will face an additional 10% early-distribution penalty tax on top of any other tax they owe.
Some employers allow employees to take out a loan against their contributions to a 403(b) plan. The employee is essentially borrowing from themselves. If you take out a 403(b) loan, please consider that if you leave the job before the loan is repaid, you'll have to repay it in a lump sum or face the 10% penalty for an early withdrawal.
Advantages
Earnings and returns on amounts in a regular 403(b) plan are tax-deferred until they are withdrawn. Earnings and returns on amounts in a Roth 403(b) are tax-free if the withdrawals are qualified distributions.
Many 403(b) plans vest funds over a shorter period than 401(k)s, and some even allow immediate vesting of funds, which 401(k)s rarely do.
If an employee has 15 or more years of service with certain nonprofits or government agencies, they may be able to make additional catch-up contributions to a 403(b) plan. Under this provision, you can contribute an additional $3,000 a year, up to a lifetime limit of $15,000. And unlike the usual retirement plan catch-up provisions, you don't have to be 50 or older to take advantage of this as long as you worked for the same eligible employer for the whole 15 years.
The earnings in a 403(b) account are tax-deferred in the case of traditional 403(b)s and tax-free in the case of Roth. When the traditional 403(b) owner makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners have already paid income tax on the money they contributed to the plan and will owe no tax on their withdrawals as long as they satisfy certain requirements.
Both traditional and Roth 403(b) owners must be at least age 591/2—or meet other criteria spelled out by the IRS, such as being totally and permanently disabled—when they start to make withdrawals.
Otherwise, they usually will face an additional 10% early-distribution penalty tax on top of any other tax they owe.
Some employers allow employees to take out a loan against their contributions to a 403(b) plan. The employee is essentially borrowing from themselves. If you take out a 403(b) loan, please consider that if you leave the job before the loan is repaid, you'll have to repay it in a lump sum or face the 10% penalty for an early withdrawal.
Advantages
Earnings and returns on amounts in a regular 403(b) plan are tax-deferred until they are withdrawn. Earnings and returns on amounts in a Roth 403(b) are tax-free if the withdrawals are qualified distributions.
Many 403(b) plans vest funds over a shorter period than 401(k)s, and some even allow immediate vesting of funds, which 401(k)s rarely do.
If an employee has 15 or more years of service with certain nonprofits or government agencies, they may be able to make additional catch-up contributions to a 403(b) plan. Under this provision, you can contribute an additional $3,000 a year, up to a lifetime limit of $15,000. And unlike the usual retirement plan catch-up provisions, you don't have to be 50 or older to take advantage of this as long as you worked for the same eligible employer for the whole 15 years.
What Is Qualified Distribution
The term qualified distribution refers to a withdrawal from a qualified retirement plan. These distributions are both tax- and penalty-free. Eligible plans from which a qualified distribution can be made include 401(k)s and 403(b)s. Qualified distributions can't be used at an investor's discretion. Instead, they come with certain conditions and restrictions set by the Internal Revenue Service (IRS), so they aren't abused.
How Qualified Distributions Work
What Is Qualified Distribution
The term qualified distribution refers to a withdrawal from a qualified retirement plan. These distributions are both tax- and penalty-free. Eligible plans from which a qualified distribution can be made include 401(k)s and 403(b)s. Qualified distributions can't be used at an investor's discretion. Instead, they come with certain conditions and restrictions set by the Internal Revenue Service (IRS), so they aren't abused.
How Qualified Distributions Work
The government wants to encourage people to save for their later years and offers substantial tax benefits to those who save in qualified retirement accounts. As such, many people pay into qualified plans in order to save for retirement. These plans include individual retirement accounts (IRAs), 401(k)s, and 403(b)s.
To make sure people don't abuse these accounts and use them to avoid paying taxes, the IRS imposes additional taxes and penalties on withdrawals that don't meet the qualified distribution criteria. This means that if you withdraw money and the withdrawal does not meet the criteria for the account, you will be taxed.
However, if you meet the conditions, you can make what's called a qualified distribution without having to pay taxes or penalties. The rules vary based on the type of account for what constitutes a qualified distribution, so it's important to know what they are before you consider making a withdrawal.
Tax-Deferred Accounts
Tax-deferred retirement plans require that the account holder be at least 59½ years of age at the time the withdrawal is made in order for it to be considered a qualified distribution. Tax-deferred plans include traditional IRAs, SEP IRAs, SIMPL IRAs, traditional 401(k)s, and traditional 403(b)s. Although the account owner will have to pay some income tax on a tax-deferred plan distribution, there will not be any early withdrawal penalties as long as the person is at 59½ years of age.
Disadvantages
Funds withdrawn from a 403(b) plan before age 59½ are subject to a 10% tax penalty, although you may avoid the penalty under certain circumstances, such as separating from an employer at age 55 or older, needing to pay a qualified medical expense, or becoming disabled.
A 403(b) may offer a narrower choice of investments than other plans. Although these plans now offer mutual fund options inside variable annuity contracts. you can only choose between fixed and variable contracts, and mutual funds inside these plans—other securities, such as stocks and real estate investment trusts (REITs), are prohibited.
The presence of an investment option that 403(b)s favor is, at best, a mixed blessing. When the 403(b) was invented in 1958, it was known as a tax-sheltered annuity. While times have changed, and 403(b) plans can now offer mutual funds, as noted, many still emphasize annuities.
Financial advisors often recommend against investing in annuities within a 403(b) and other tax-deferred investment plans. Accounts may lack the same level of protection from creditors as plans that require ERISA compliance. If you are at risk of creditors pursuing you, speak to a local attorney who understands the nuances of your state as the laws can be complex.
Funds withdrawn from a 403(b) plan before age 59½ are subject to a 10% tax penalty, although you may avoid the penalty under certain circumstances, such as separating from an employer at age 55 or older, needing to pay a qualified medical expense, or becoming disabled.
A 403(b) may offer a narrower choice of investments than other plans. Although these plans now offer mutual fund options inside variable annuity contracts. you can only choose between fixed and variable contracts, and mutual funds inside these plans—other securities, such as stocks and real estate investment trusts (REITs), are prohibited.
The presence of an investment option that 403(b)s favor is, at best, a mixed blessing. When the 403(b) was invented in 1958, it was known as a tax-sheltered annuity. While times have changed, and 403(b) plans can now offer mutual funds, as noted, many still emphasize annuities.
Financial advisors often recommend against investing in annuities within a 403(b) and other tax-deferred investment plans. Accounts may lack the same level of protection from creditors as plans that require ERISA compliance. If you are at risk of creditors pursuing you, speak to a local attorney who understands the nuances of your state as the laws can be complex.
Traditional Pension Plan also known as Defined-Benefit plan provides a specified payment amount in retirement. A defined-contribution plan allows employees and employers (if they choose) to contribute and invest in funds over time to save for retirement.
What Is a Pension Plan?
A pension plan is an employee benefit that commits the employer to make regular contributions to a pool of money that is set aside in order to fund payments made to eligible employees after they retire.
Traditional pension plans have become increasingly rare in the U.S. private section. They have been largely replaced by retirement benefits that are less costly to employers, such as the 401(k) retirement savings plan.
Still, about 83% of public employees and roughly 15% of private employees in the U.S., are covered by a defined-benefit plan today according to the Bureau of Labor Statistics.
How Pension Plan Works
Traditional pension plans have become increasingly rare in the U.S. private section. They have been largely replaced by retirement benefits that are less costly to employers, such as the 401(k) retirement savings plan.
Still, about 83% of public employees and roughly 15% of private employees in the U.S., are covered by a defined-benefit plan today according to the Bureau of Labor Statistics.
How Pension Plan Works
A pension plan requires contributions by the employer and may allow additional contributions by the employee. The employee contributions are deducted from wages. The employer may also match a portion of the worker’s annual contributions up to a specific percentage or dollar amount.
There are two main types of pension plans the Defined-Benefit and the Defined-Contribution plans.
A Defined-Benefit Plan
In a defined-benefit plan, the employer guarantees that the employee will receive a specific monthly payment after retiring and for life, regardless of the performance of the underlying investment pool.
The employer is thus liable for a specific flow of pension payments to the retiree, in a dollar amount that is typically determined by a formula based on earnings and years of service.
If the assets in the pension plan account are not sufficient to pay all of the benefits that are due, the company is liable for the remainder of the payment.
Defined-benefit employer-sponsored pension plans date from the 1870s. The American Express Company established the first pension plan in 1875. At their height in the 1980s, they covered 38% of all private-sector workers.
A Defined-Contribution Plan
In a defined-contribution plan, the employer commits to making a specific contribution for each worker who is covered by the plan. This may be matched by contributions made by the employees.
The final benefit received by the employee depends on the plan's investment performance. The company’s liability ends when the total contributions are expended.
The 401(k) plan is, in fact, a type of defined-contribution pension plan, although the term "pension plan" is commonly used to refer to the traditional defined-benefit plan.
The defined contribution plan is much less expensive for a company to sponsor, and the long-term costs are difficult to estimate accurately. They also put the company on the hook for making up any shortfalls in the fund.
That's why a growing number of private companies are moving to the defined contribution plan. The best-known defined contribution plans are the 401(k), and its equivalent for non-profit employees, the 403(b).
A pension plan requires contributions by the employer and may allow additional contributions by the employee. The employee contributions are deducted from wages. The employer may also match a portion of the worker’s annual contributions up to a specific percentage or dollar amount.
There are two main types of pension plans the Defined-Benefit and the Defined-Contribution plans.
A Defined-Benefit Plan
In a defined-benefit plan, the employer guarantees that the employee will receive a specific monthly payment after retiring and for life, regardless of the performance of the underlying investment pool.
The employer is thus liable for a specific flow of pension payments to the retiree, in a dollar amount that is typically determined by a formula based on earnings and years of service.
If the assets in the pension plan account are not sufficient to pay all of the benefits that are due, the company is liable for the remainder of the payment.
Defined-benefit employer-sponsored pension plans date from the 1870s. The American Express Company established the first pension plan in 1875. At their height in the 1980s, they covered 38% of all private-sector workers.
A Defined-Contribution Plan
In a defined-contribution plan, the employer commits to making a specific contribution for each worker who is covered by the plan. This may be matched by contributions made by the employees.
The final benefit received by the employee depends on the plan's investment performance. The company’s liability ends when the total contributions are expended.
The 401(k) plan is, in fact, a type of defined-contribution pension plan, although the term "pension plan" is commonly used to refer to the traditional defined-benefit plan.
The defined contribution plan is much less expensive for a company to sponsor, and the long-term costs are difficult to estimate accurately. They also put the company on the hook for making up any shortfalls in the fund.
That's why a growing number of private companies are moving to the defined contribution plan. The best-known defined contribution plans are the 401(k), and its equivalent for non-profit employees, the 403(b).
A 529 college savings plan is a state-sponsored investment plan that enables you to save money for a beneficiary and pay for education expenses. You can withdraw funds tax-free to cover nearly any type of college expense. 529 plans may offer additional state or federal tax benefits.
A 529 plan allows you to save for college or higher education while receiving some type of tax benefit. Earnings from 529 plans are not subject to federal tax and generally not subject to state tax when used for qualified education expenses such as tuition, fees, books, as well as room and board. The contributions made to the 529 plan, however, are not deductible.
What Is a 529 Plan?
A 529 plan is a tax-advantaged savings plan designed to help pay for education. Originally limited to post-secondary education costs, it was expanded to cover K-12 education in 2017 and apprenticeship programs in 2019. The two major types of 529 plans are savings plans and prepaid tuition plans.
Savings plans grow tax-deferred, and withdrawals are tax-free if they're used for qualified education expenses. Prepaid tuition plans allow the account owner to pay in advance for tuition at designated colleges and universities, locking in the cost at today's rates. 529 plans are also referred to as qualified tuition programs and Section 529 plans.
How 529 plan Works
Although 529 plans take their name from Section 529 of the federal tax code, the plans themselves are administered by the 50 states and the District of Columbia. Anyone can open a 529 account, but they are typically established by parents or grandparents on behalf of a child or grandchild, who is the account's beneficiary. In some states, the person who funds the account may be eligible for a state tax deduction for their contributions.
Withdrawals from 529 Plans
The money in the account grows on a tax-deferred basis until it is withdrawn. As long as the money is used for qualified education expenses, as defined by the IRS, those withdrawals aren't subject to either state or federal taxes. In the case of K-12 students, tax-free withdrawals are limited to $10,000 per year.
529 Plan Contributions
There are no limits on how much you can contribute to a 529 account each year, but many states put a cap on how much you can contribute to it in total. Those limits recently ranged from $235,000 to over $525,000.
529 contributions are not tax deductible on the federal level. However, some states may consider 529 contributions tax deductible. Check with your 529 plan or your state to find out if you’re eligible.
Types of 529 Plans
How 529 plan Works
Although 529 plans take their name from Section 529 of the federal tax code, the plans themselves are administered by the 50 states and the District of Columbia. Anyone can open a 529 account, but they are typically established by parents or grandparents on behalf of a child or grandchild, who is the account's beneficiary. In some states, the person who funds the account may be eligible for a state tax deduction for their contributions.
Withdrawals from 529 Plans
The money in the account grows on a tax-deferred basis until it is withdrawn. As long as the money is used for qualified education expenses, as defined by the IRS, those withdrawals aren't subject to either state or federal taxes. In the case of K-12 students, tax-free withdrawals are limited to $10,000 per year.
529 Plan Contributions
There are no limits on how much you can contribute to a 529 account each year, but many states put a cap on how much you can contribute to it in total. Those limits recently ranged from $235,000 to over $525,000.
529 contributions are not tax deductible on the federal level. However, some states may consider 529 contributions tax deductible. Check with your 529 plan or your state to find out if you’re eligible.
Types of 529 Plans
The two main types of 529 plans—college savings plans and prepaid tuition plans—have some significant differences.
The two main types of 529 plans—college savings plans and prepaid tuition plans—have some significant differences.
Savings Plans
Savings plans are the more common type. The account holder contributes money to the plan, which is typically invested in a selection of mutual funds. Account-holders can choose the funds they want to invest in, and how those funds perform will determine how the account grows (or, worst-case scenario, shrinks) over time. Many 529 plans also offer target-date funds, which adjust their holdings as the years go by, becoming more conservative as the beneficiary gets closer to college age.
Taking Withdrawals From 529 Savings Plan
Savings plans are the more common type. The account holder contributes money to the plan, which is typically invested in a selection of mutual funds. Account-holders can choose the funds they want to invest in, and how those funds perform will determine how the account grows (or, worst-case scenario, shrinks) over time. Many 529 plans also offer target-date funds, which adjust their holdings as the years go by, becoming more conservative as the beneficiary gets closer to college age.
Taking Withdrawals From 529 Savings Plan
Withdrawals from a 529 savings plan can be used for both college and K-12 expenses. In the case of a 529 savings plan, qualified expenses include
- Tuition
- Fees
- Room and board
- Related costs.
A 2019 federal law, the SECURE Act, expanded tax-free 529 withdrawals to include registered apprenticeship program expenses and up to $10,000 in student loan debt repayment for both account beneficiaries and their siblings.
Withdrawals from a 529 savings plan can be used for both college and K-12 expenses. In the case of a 529 savings plan, qualified expenses include
- Tuition
- Fees
- Room and board
- Related costs.
A 2019 federal law, the SECURE Act, expanded tax-free 529 withdrawals to include registered apprenticeship program expenses and up to $10,000 in student loan debt repayment for both account beneficiaries and their siblings.
Prepaid Tuition Plans
Prepaid tuition plans are offered by a limited number of states and some higher education institutions. They vary in their specifics, but the general principle is that they allow you to lock in tuition at current rates for a student who may not be attending college for years to come. (Prepaid plans are not available for K-12 education.)
As with 529 savings plans, prepaid tuition plans grow in value over time, and the money that eventually comes out of the account to pay tuition is not taxable. Unlike savings plans, prepaid tuition plans do not cover room and board.
Prepaid tuition plans may have other restrictions, such as which particular colleges they may be used for. The money in a savings plan, by contrast, can be used at just about any eligible institution.
IMPORTANT: You aren't restricted to investing in your own state's 529 plan, but doing so may get you a tax break, so check out that plan first.
Tax Advantages of 529 Plans
Prepaid tuition plans are offered by a limited number of states and some higher education institutions. They vary in their specifics, but the general principle is that they allow you to lock in tuition at current rates for a student who may not be attending college for years to come. (Prepaid plans are not available for K-12 education.)
As with 529 savings plans, prepaid tuition plans grow in value over time, and the money that eventually comes out of the account to pay tuition is not taxable. Unlike savings plans, prepaid tuition plans do not cover room and board.
Prepaid tuition plans may have other restrictions, such as which particular colleges they may be used for. The money in a savings plan, by contrast, can be used at just about any eligible institution.
IMPORTANT: You aren't restricted to investing in your own state's 529 plan, but doing so may get you a tax break, so check out that plan first.
Tax Advantages of 529 Plans
The earnings in a 529 plan are exempt from federal and state income taxes, provided the money is used for qualified educational expenses. Any other withdrawals are subject to taxes plus a 10% penalty, with exceptions for certain circumstances, such as death or disability.
The money you contribute to a 529 plan isn't tax-deductible for federal income tax purposes. However, more than 30 states provide tax deductions or credits of varying amounts for contributions to a 529 plan. In general, you'll need to invest in your home state's plan if you want a state tax deduction or credit. If you're willing to forgo a tax break, some states will allow you to invest in their plans as a nonresident.
The money you contribute to a 529 plan isn't tax-deductible for federal income tax purposes. However, more than 30 states provide tax deductions or credits of varying amounts for contributions to a 529 plan. In general, you'll need to invest in your home state's plan if you want a state tax deduction or credit. If you're willing to forgo a tax break, some states will allow you to invest in their plans as a nonresident.
529 Transferability Rules
529 plans have very specific transferability rules, governed by the federal tax code (Section 529). The owner (typically you) may transfer to another 529 plan once per year unless a beneficiary change is involved. You are not required to change plans to change beneficiaries. You may transfer the plan to another family member, defined as:
- Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them
- Brother, sister, stepbrother, or stepsister
- Father or mother or ancestor of either
- Stepfather or stepmother
- Son or daughter of a brother or sister
- Brother or sister of father or mother
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
- The spouse of any individual listed above
- First cousin
529 plans have very specific transferability rules, governed by the federal tax code (Section 529). The owner (typically you) may transfer to another 529 plan once per year unless a beneficiary change is involved. You are not required to change plans to change beneficiaries. You may transfer the plan to another family member, defined as:
- Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them
- Brother, sister, stepbrother, or stepsister
- Father or mother or ancestor of either
- Stepfather or stepmother
- Son or daughter of a brother or sister
- Brother or sister of father or mother
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
- The spouse of any individual listed above
- First cousin
What Are Qualified Expenses for a 529 Plan?
Qualified expenses for a 529 plan include:
- College, graduate, or vocational school tuition and fees
- Elementary or secondary school (K-12) tuition and fees
- Books and school supplies
- Student loan payments
- Off-campus housing
- Campus food and meal plans
- Computers, internet, and software used for schoolwork (student attendance required)
- Special needs and accessibility equipment for students
- College, graduate, or vocational school tuition and fees
- Elementary or secondary school (K-12) tuition and fees
- Books and school supplies
- Student loan payments
- Off-campus housing
- Campus food and meal plans
- Computers, internet, and software used for schoolwork (student attendance required)
- Special needs and accessibility equipment for students
A Simplified Employee Pension (SEP) plan provides business owners with a simplified method to contribute toward their employees' retirement as well as their own retirement savings. Contributions are made to an Individual Retirement Account or Annuity (IRA) set up for each plan participant (a SEP-IRA).
A SEP-IRA account is a traditional IRA and follows the same investment, distribution, and rollover rules as traditional IRAs. See the IRA FAQs.
What Is a SEP IRA ?
A simplified employee pension (SEP) IRA is a retirement savings plan established by employers for the benefit of their employees and themselves. It can also be established by self-employed individuals. Employers may make tax-deductible contributions on behalf of eligible employees to their SEP IRAs.
SEPs are advantageous because they are easy to set up, have low administrative costs, and allow an employer to determine how much to contribute each year.
SEP IRAs also have higher annual contribution limits than standard IRAs. Fundamentally, a SEP IRA can be considered a traditional IRA with the ability to receive employer contributions. One major benefit of a SEP IRA is that employer's contributions are vested immediately.
How Traditional IRAs Work
A SEP IRA is an attractive option for many business owners because it does not come with many of the start-up and operating costs of most conventional employer-sponsored retirement plans. Many employers also set up a SEP plan so that they can contribute to their own retirement at higher levels than a traditional IRA allows. And workers can start a SEP for their self-employed business even if they participate in an employer's retirement plan at a second job.
A simplified employee pension (SEP) IRA is a retirement savings plan established by employers for the benefit of their employees and themselves. It can also be established by self-employed individuals. Employers may make tax-deductible contributions on behalf of eligible employees to their SEP IRAs.
SEPs are advantageous because they are easy to set up, have low administrative costs, and allow an employer to determine how much to contribute each year.
SEP IRAs also have higher annual contribution limits than standard IRAs. Fundamentally, a SEP IRA can be considered a traditional IRA with the ability to receive employer contributions. One major benefit of a SEP IRA is that employer's contributions are vested immediately.
SEP IRA accounts are treated like traditional IRAs for tax purposes and allow the same investment options. The same transfer and rollover rules that apply to traditional IRAs also apply to SEP IRAs. When an employer makes contributions to SEP IRA accounts, it receives a tax deduction for the amount contributed. Additionally, the business is not locked into an annual contribution—decisions about whether to contribute and how much can change each year.
Another thing that is good for business owners is that the employer is not responsible for making investment decisions. Instead, the IRA trustee determines eligible investments, and the individual employee account owners make specific investment decisions. The trustee also deposits contributions, sends annual statements, and files all required documents with the IRS.
Who Can Participate in a SEP IRA Plan?
According to IRS rules as of 2021, an individual must be at least 21 years old, have worked for the employer in at least three of the previous five years, and have received a minimum of $650 in compensation from the employer during the current year to qualify for an employee SEP IRA.
Individual employers are allowed to be less restrictive in their qualification requirements for their specific SEP IRA plans but may not be more restrictive than IRS rules.
Employers may exclude certain types of employees from participating in a SEP IRA, even if they would otherwise be eligible based on the plan’s rules. Workers who are covered in a union agreement that bargains for retirement benefits can be excluded, as can workers who are immigrants without papers as long as they do not receive U.S. wages or other service compensation from the employer.
SEP IRAs were primarily designed to encourage retirement benefits among businesses that would otherwise not set up employer-sponsored plans. Sole proprietors, partnerships, and corporations can establish SEPs.
IMPORTANT: SEP IRAs are tax-deferred accounts and have the same investment options as traditional IRAs.
SEP IRA Contributions
One big advantage of a SEP IRA is the amount that can be contributed annually. As of 2021, contributions cannot exceed the lesser of 25% of the employee’s compensation for the year or $58,000 and $61,000 for 2022.
The limit on compensation that can be used to calculate the contribution is $290,000 in 2021 and increases to $305,000 in 2022.
This contribution limit is significantly higher than the $6,000 limit imposed on standard IRAs, which doesn't include the extra $1,000 that anyone aged 50 or over is permitted as a catch-up contribution. The deadline for contributions is the tax filing deadline (plus extensions) of the company or self-employed individual who sets up the SEP IRA.
2021
- For workers under 50 years old, the total contributions to SEP IRA cannot exceed $58,000 per year.
2022
- For workers under 50 years old, the total contributions to SEP IRA cannot exceed $61,000 per year.
Note: Elective salary deferrals and catch-up contributions are not permitted in SEP plans.If you’ve contributed more than the annual limits to an employee’s SEP-IRA, find out how to correct this mistake.
Taking Withdrawals From Traditional IRA
One big advantage of a SEP IRA is the amount that can be contributed annually. As of 2021, contributions cannot exceed the lesser of 25% of the employee’s compensation for the year or $58,000 and $61,000 for 2022.
The limit on compensation that can be used to calculate the contribution is $290,000 in 2021 and increases to $305,000 in 2022.
This contribution limit is significantly higher than the $6,000 limit imposed on standard IRAs, which doesn't include the extra $1,000 that anyone aged 50 or over is permitted as a catch-up contribution. The deadline for contributions is the tax filing deadline (plus extensions) of the company or self-employed individual who sets up the SEP IRA.
2021
- For workers under 50 years old, the total contributions to SEP IRA cannot exceed $58,000 per year.
2022
- For workers under 50 years old, the total contributions to SEP IRA cannot exceed $61,000 per year.
Participants can withdraw funds from their SEP IRA at any time without being required to show evidence of financial hardship. However, withdrawals taken before the age of 591/2 –referred to as early distributions – may be subject to a 10% tax penalty in addition to the applicable income tax liability.
There are a number of situations where the penalty may be waived, including the following:
- Death of the accountholder
- Disability
- Certain higher education expenses
- A series of substantially equal payments
- Up to $10,000 for first-time home buyers
- As a result of an IRS tax levy
- Certain qualified unreimbursed medical expenses
- Health insurance premiums while unemployed
- Qualifying situations in which a military reservist is called for active duty
If any of these exceptions apply, distributions taken before the age of 591/2 are still subject to income tax, but accountholders are not responsible for the additional 10% penalty.
It's important for an individual to check with a tax attorney or the IRS to be sure that the particulars of their situation qualify for a waiver of the 10% penalty.
- Death of the accountholder
- Disability
- Certain higher education expenses
- A series of substantially equal payments
- Up to $10,000 for first-time home buyers
- As a result of an IRS tax levy
- Certain qualified unreimbursed medical expenses
- Health insurance premiums while unemployed
- Qualifying situations in which a military reservist is called for active duty
Required Minimum Distribution (RMDs)
Because contributions to SEP IRAs are tax-deferred, the IRS put rules in place to ensure that funds are eventually withdrawn from the protected account. When participants reach the age of 701/2, they must begin taking required minimum distributions (RMD). The amount of the RMD is calculated based on life expectancy, and the IRS offers a number of helpful tools to ensure that you withdraw the correct amount.
Compliance with this regulation is critical as the tax penalty for failure to withdraw the RMD is 50% of the amount that should have been distributed. Note that RMDs are required for all participants when they reach the age of 701/2, even if they are still employed and receiving employer contributions.
Beginning date for your first required minimum distribution
- April 1 of the year following the calendar year in which you reach age 70½, if you were born before July 1, 1949.
- April 1 of the year following the calendar year in which you reach age 72, if you were born after Jun 30, 1949.
While the SEP IRA is intended to provide financial security in retirement, it comes with the added benefit of flexibility in making withdrawals at any time and for any reason, although an early withdrawal penalty may apply. When withdrawals are made after the age of 591/2, accountholders are only responsible for standard income taxes. These rules make the SEP IRA a popular choice among employer-sponsored retirement plans.
- April 1 of the year following the calendar year in which you reach age 70½, if you were born before July 1, 1949.
- April 1 of the year following the calendar year in which you reach age 72, if you were born after Jun 30, 1949.
A SIMPLE IRA plan provides small employers with a simplified method to contribute toward their employees' and their own retirement savings. Employees may choose to make salary reduction contributions and the employer is required to make either matching or nonelective contributions. Contributions are made to an Individual Retirement Account or Annuity (IRA) set up for each employee (a SIMPLE IRA).
A SIMPLE IRA plan account is an IRA and follows the same investment, distribution and rollover rules as traditional IRAs. See the IRA FAQs.
What Is a SIMPLE IRA ?
A SIMPLE IRA is a retirement savings plan that most small businesses with 100 or fewer employees can use. "SIMPLE" stands for "Savings Incentive Match Plan for Employees," while IRA is the acronym for individual retirement account. Employers can choose to make a non-elective contribution of 2% of the employee's salary or a dollar-for-dollar matching contribution of the employee's contributions to the plan up to 3% of their salary.
How Traditional IRAs Work
A SIMPLE IRA is a retirement savings plan that most small businesses with 100 or fewer employees can use. "SIMPLE" stands for "Savings Incentive Match Plan for Employees," while IRA is the acronym for individual retirement account. Employers can choose to make a non-elective contribution of 2% of the employee's salary or a dollar-for-dollar matching contribution of the employee's contributions to the plan up to 3% of their salary.
One of the many major provisions, now law, under the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, the government will provide a maximum tax credit of $500 per year to employers who create a 401(k) or SIMPLE IRA plan with automatic enrollment. The appeal of SIMPLE IRAs is that they have minimal paperwork requirements, just an initial plan document and annual disclosures to employees. The employer establishes the plan through a financial institution that administers it. Startup and maintenance costs are low, and employers get a tax deduction for contributions they make for employees.
To be eligible to establish a SIMPLE IRA, the employer must have 100 or fewer employees. Those who are self-employed or sole-proprietors are eligible to establish a SIMPLE IRA as well. To participate in the plan, employees must have earned at least $5,000 in compensation in any two previous calendar years and be expected to earn at least $5,000 in the current year. Employers can choose less restrictive participation requirements if they wish. An employer may also choose to exclude from participation employees who receive benefits through a union.
Employers establish the plan using Internal Revenue Service (IRS) Form 5304-SIMPLE if they want to allow employees to choose the financial institution where they will hold their SIMPLE IRAs, or using Form 5305-SIMPLE if the employer wants to choose the financial institution where employees will hold their IRAs. Employees must fill out a SIMPLE IRA adoption agreement to open their accounts.
Once the plan is established, employers are required to contribute to it each year unless the plan is terminated. However, employers may change their contribution decision between the 2% mandatory contribution and the 3% matching contribution if they follow IRS rules.
SIMPLE IRA Contributions
Employees can contribute a maximum of $13,500 annually in 2021 ($14,000 in 2022). The maximum is increased periodically to account for inflation. Retirement savers ages 50 and older may make an additional catch-up contribution of $3,000, bringing their annual maximum to $16,500 in 2021 ($17,000 for 2022).
2021
- For workers under 50 years old, the total contributions to SIMPLE IRA cannot exceed $13,500 per year
- If we include the catch-up contribution for those 50 and over, the limit is $16,500.
2022
- For workers under 50 years old, the total contributions to SIMPLE IRA cannot exceed $14,000 per year.
- Including the catch-up contribution for those 50 and over, the limit is $17,000.
Taking Withdrawals From Traditional IRA
Employees can contribute a maximum of $13,500 annually in 2021 ($14,000 in 2022). The maximum is increased periodically to account for inflation. Retirement savers ages 50 and older may make an additional catch-up contribution of $3,000, bringing their annual maximum to $16,500 in 2021 ($17,000 for 2022).
2021
- For workers under 50 years old, the total contributions to SIMPLE IRA cannot exceed $13,500 per year
- If we include the catch-up contribution for those 50 and over, the limit is $16,500.
2022
- For workers under 50 years old, the total contributions to SIMPLE IRA cannot exceed $14,000 per year.
- Including the catch-up contribution for those 50 and over, the limit is $17,000.
Generally, you have to pay income tax on any amount you withdraw from your SIMPLE IRA. You may also have to pay an additional tax of 10% or 25% on the amount you withdraw unless you are at least age 59½ or you qualify for another exception.
- 10% tax
- 10% tax
You have to pay a 10% additional tax on the taxable amount you withdraw from your SIMPLE IRA if you are under age 59½ when you withdraw the money unless you qualify for another exception to this tax. In some cases, this tax is increased to 25%.
- 25% Tax
- 25% Tax
The amount of the additional tax you have to pay increases from 10% to 25% if you make the withdrawal within 2 years from when you first participated in your employer's SIMPLE IRA plan.
Exceptions to Additional Taxes
You don’t have to pay additional taxes if you are age 59½ or older when you withdraw the money from your SIMPLE IRA. You also don’t have to pay additional taxes if, for example:
- Your withdrawal is not more than:
- Your unreimbursed medical expenses that exceed 10% of your adjusted gross income (7.5% if your spouse is age 65 or older),
- Your cost for your medical insurance while unemployed,
- Your qualified higher education expenses, or
- The amount to buy, build or rebuild a first home
- Your withdrawal is in the form of an annuity
- Your withdrawal is a qualified reservist distribution
- You are disabled
- You are the beneficiary of a deceased SIMPLE IRA owner
- The withdrawal is the result of an IRS levy
It's important for an individual to check with a tax attorney or the IRS to be sure that the particulars of their situation qualify for a waiver of the 10% penalty.
You don’t have to pay additional taxes if you are age 59½ or older when you withdraw the money from your SIMPLE IRA. You also don’t have to pay additional taxes if, for example:
- Your withdrawal is not more than:
- Your unreimbursed medical expenses that exceed 10% of your adjusted gross income (7.5% if your spouse is age 65 or older),
- Your cost for your medical insurance while unemployed,
- Your qualified higher education expenses, or
- The amount to buy, build or rebuild a first home
- Your withdrawal is in the form of an annuity
- Your withdrawal is a qualified reservist distribution
- You are disabled
- You are the beneficiary of a deceased SIMPLE IRA owner
- The withdrawal is the result of an IRS levy
Required Minimum Distribution (RMDs)
SIMPLE IRA account holders are subject to required minimum distributions, or RMDs, after reaching a certain age. (Withdrawals are often referred to as "distributions" in IRS parlance.)
After age 72, account owners who have retired must withdraw at least a specified percentage from their SIMPLE IRA, using IRS tables based on their life expectancy at the time. (Prior to 2020, the RMD age was 70½ years old.)
SIMPLE IRA Drawbacks
One drawback of SIMPLE IRAs is that the business owner cannot save as much for retirement as with other small business retirement plans, such as a simplified employee pension (SEP) or a 401(k) plan, the latter of which also offers higher catch-up contribution limits. Also, a SIMPLE IRA cannot be rolled over into a traditional IRA without a two-year waiting period from the time the employee first joined a plan, unlike a 401(k).
As of December 2015, SIMPLE IRA accounts are permitted to accept transfers from SEP IRAs, traditional IRAs and employer-sponsored plans such as a 401(k).
Pros & Cons of Qualified Plans
Pros
- Contributions are tax deductible
- Earnings and returns are tax-deferred until they are withdrawn
Cons
- Lack of liquidity, 591/2 rule (money cannot be touched before 591/2 otherwise you must pay 10% early withdrawal penalty, then federal and state taxes ). There are some exemptions.
- Volatility, money in these accounts most of the time heavily invested in the stock markets or in particular stock market index such as S&P 500, The Dow Jones, Nasdaq Etc. Consequently you may lose money.
- Distributions are Taxable (at the retirement)
- Uncertainty of Tax rates in next 10, 20, 30 years, who knows what would be the tax rates in 20 years? History shows in the US taxes always go up not down.
- Contribution Limits.