Every area of your life has its own language. Oh it may still be in English, or Spanish or even Mandarin Chinese, but the terms, phrases, and meanings change depending on the application. For example, when a carpenter mentions the word “stud” it has a whole different meaning to a horse breeder, a tire changer, someone trying on earrings, or looking for a husband.
Other terms are confusing because they are rarely used in any other arena and a lot of the terms used in retirement plans fit that bill. To make certain you can make the best decision between your plan choices, you need to know what all these various terms mean. Deciding which plan fits you best is a decision that’s best made after you’ve done just a little research, asked a few questions, and educated yourself on retirement plan terminology.
The IRS has firm annual enrollment deadlines and contribution deadlines for each type of retirement plan:
- Enrollment deadlines: Specify the date by which you must set up the retirement plan account
- Contribution deadlines: Specify the date by which you must make contributions into the account
These deadlines vary from plan to plan and are separate from any deadlines that your company might impose.
Every retirement plan requires you to meet certain criteria. These may include age, length of employment, amount and type of income, marital status, and whether or not you already participate in other retirement plans. Eligibility requirements frequently vary from plan to plan, but two general rules apply to all retirement plans:
- Earned income vs. passive income: Retirement plans require you to have earned income in order to open an account or contribute. Earned income is income from salary, commissions, or other work-related sources, or from alimony. Passive income, such as income you receive from investment-related dividends, annuities, or rental properties, does not qualify you to invest in retirement plans.
- Individual vs. joint ownership: All retirement plans are owned solely by the person who establishes the account. Qualified plans cannot be owned jointly, even by married couples.
Any money you contribute to a retirement plan is yours immediately. Employer matched contributions, though, may not be yours to keep right away. The vesting schedule of a retirement plan refers to the timeframe in which your ownership of your employer’s contributions vests, or takes effect. For instance, your employer’s contributions might vest one year from each contribution date. If you cancel the plan or leave your job, you won’t receive any unvested employer contributions (though you’ll keep all vested contributions, as well as money that you yourself contributed).
Each type of plan has strict contribution limits that specify the total amount of money that you can contribute into your account each year. Contribution limits vary widely from plan to plan based on many factors, such as your total annual income and the other types of retirement plans you own. Certain plans allow participants who are 50 or older to make catch-up contributions, which increase the plan’s contribution limit by several thousand dollars per year.
You can fund retirement plans in two main ways (though your employer may also contribute to your plan).
- Payroll deductions: Employer-sponsored plans deduct money directly from your paycheck each pay period. These deductions can consist of pretax or after-tax dollars, depending on the plan.
- Independent earnings: Plans not affiliated with employers, such as most IRAs, require you to use your own savings (from earned income) to fund your accounts, either on a pretax or an after-tax basis. In this case, “pretax” contributions sometimes qualify for an immediate income tax deduction since they can’t be deducted directly from your paycheck.
Pretax Dollars vs. After-Tax Dollars
- Pretax dollars: Money deposited into a retirement account (or elsewhere) before it’s taxed. Using pretax dollars to contribute to a retirement account is among the few ways you can use your “raw” pay before taxes reduce it to the amount you actually receive. Employer-sponsored plans, such as 401(k)s, can be funded with pretax dollars.
- After-tax dollars: Money deposited into a retirement account (or spent elsewhere) that has already been subject to tax. Your “take-home” pay—the amount of money you actually receive after taxes have been taken out of your paycheck—consists of after-tax dollars. Some retirement plans, such as Roth IRAs, can be funded only by after-tax dollars.
Retirement plans allow you to specify the primary and contingent beneficiaries who will receive your plan’s assets when you die. Contingent beneficiaries receive your plan’s assets only if your primary beneficiaries are deceased or otherwise unable to receive your assets upon your death. Some plans may also allow tertiary beneficiaries.
All retirement plans (except Roth plans) require you to start taking required minimum distributions (RMDs), or withdrawals from the plan, after age 70 1/2. The amount of the withdrawals varies based on a number of factors, including your specific age and retirement plan account balance. You can make withdrawals periodically throughout the year, and you always have the option to withdraw more than the RMD amount. Failure to make annual RMDs can result in an excess accumulation penalty equal to 50% of the amount that you should have withdrawn.
A few exceptions apply. For instance, if you continue to work past age 70 1/2 for the company that sponsors your 401(k) plan, you don’t have to take RMDs.
Some retirement plans charge annual maintenance fees of about $15–50. Typically, fees for most employer-sponsored plans are paid by your employer, not by you. In addition to annual fees, some plans require you to maintain a minimum balance and/or to make a minimum annual contribution.
The IRS imposes a 10% penalty for most withdrawals made before you reach age 59 1/2. The 10% is in addition to any taxes owed on investment gains within the account.
Exceptions to the Withdrawal Penalty
The government allows penalty-free withdrawals from retirement plans for certain qualified expenses, such as medical emergencies, disability-related costs, college tuition, and the purchase of a first home. Penalty exceptions vary from plan to plan. Despite these exceptions, it’s always best to avoid withdrawing money early from a retirement plan. By not withdrawing early, your money stays invested and takes full advantage of the tax-deferred growth that all retirement plans offer.
The IRS has made it increasingly easier to move and combine retirement accounts, so long as you keep your money within a qualified plan of some kind. There are two terms that refer to the process of moving assets from one retirement plan account into another: rollovers and transfers.
- Rollovers: When you leave a company, you’re typically allowed either to leave your retirement money in that company’s retirement plan, move it into your new company’s plan, or move it into a special kind of IRA called a rollover IRA. Transfers of employer-sponsored retirement plan assets are called “rollovers.“
- Transfers: “Transfers” occur when you move assets between retirement plans not sponsored by employers, such as IRAs. Note that transfers are sometimes also referred to as rollovers.
Employer-sponsored plans often allow you to borrow money from your retirement plan account, though some plans allow borrowing only for “hardship” circumstances, such as medical emergencies. Borrow from your retirement plan only as an absolute last resort: borrowed assets don’t benefit from tax-deferred or tax-free growth until the money is returned to the account.
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