Retirement plans encourage investors to save for retirement. When you retire, you’ll need enough money to cover living expenses for the rest of your life. While Social Security, Medicare, and other government benefits can help, many people need additional savings to maintain a comfortable lifestyle.
In this chapter, you’ll learn the general features of retirement plans. The following concepts are discussed in this chapter:
Contributions are the funds you place into a retirement account. Contributions must be made in cash, regardless of the type of retirement account. You can’t contribute securities or other assets directly into a retirement plan.
Depending on the type of retirement account, contributions may be deductible or non-deductible (after-tax).
Deductible contributions provide an immediate tax benefit by reducing taxable income. For example, assume an investor earns $100,000 in wages during the year. If the investor makes a $5,000 deductible contribution, they pay income taxes on $95,000 ($100,000 − $5,000). This is one way the government incentivizes retirement saving. Almost all qualified retirement plans, discussed in the next chapter, follow this tax structure.
Non-deductible contributions are made with after-tax dollars and provide no immediate tax benefit. Using the same example, if the investor makes a $5,000 non-deductible contribution, they still pay income taxes on the full $100,000 of earnings.
After a contribution is made, the retirement plan assets can be invested according to the account owner’s instructions. In a non-retirement account, taxes are due when you receive income (like interest or dividends) or realize capital gains. Most retirement plans are tax-deferred, meaning investment income and gains aren’t taxed until money is distributed (withdrawn). This tax structure applies to virtually all retirement plans except Roth IRAs or 401(k)s, which are discussed later in this unit.
Most securities can be held in retirement plans, but some investments and strategies are prohibited. In general, strategies with unlimited risk are restricted. That means investors must avoid short sales, margin, and some option strategies. Investors also can’t invest in collectibles or art.
*In particular, an investor cannot sell uncovered (naked) options due to the significant risk involved.
While not explicitly prohibited, municipal bonds are generally unsuitable for retirement plans. Municipal bonds typically offer lower yields because of their tax benefits. But retirement plans already provide tax advantages (for example, interest isn’t taxed while it remains in the account). Because of that, it often makes more sense to consider higher-yielding taxable bonds - such as US Government bonds - if the goal is a relatively safe, income-producing investment.
Generally speaking, investors can invest in the following:
Distributions (withdrawals) are funds taken out of a retirement plan. These accounts are designed to provide income in retirement, but an investor can typically withdraw funds at any time. However, penalties may apply if withdrawals occur too early, and other penalties can apply if required withdrawals aren’t taken on time (discussed below).
Most retirement plan distributions are taxable as ordinary income. Like wages from a job, ordinary income is taxed at the investor’s marginal tax bracket.
Retirement plans are subject to many rules and regulations. If an account is managed incorrectly, the account owner may owe significant Internal Revenue Service (IRS) penalties. This section covers common rules and the penalties for breaking them.
Nearly every retirement plan has a contribution limit. The IRS allows only a certain amount of money to be contributed each year. For example, the 2026 contribution limit for individual retirement accounts (IRAs) is $7,500. If an investor contributes $10,000, the amount above the limit is an excess contribution and is subject to excess contribution penalties. A 6% annual penalty is assessed on the amount over the limit until the excess is withdrawn.
The IRS defines retirement age as 59 ½ or older. If an investor withdraws retirement plan money before this age, they’re generally subject to a 10% early withdrawal penalty in addition to applicable taxes. For example, assume an investor withdraws $10,000 from a retirement plan at age 40. The investor owes a 10% penalty ($1,000) plus ordinary income taxes on the distribution. If the investor is in the 37% federal bracket and owes 5% state income tax, then roughly 52% of the distribution goes to taxes and penalties (37% + 5% + 10%).
There are exceptions to the 10% early withdrawal penalty. When any of the following situations apply, distributions can be taken without the penalty. Ordinary income taxes are still due on the withdrawal. Early withdrawal exceptions include:
*The death exception applies to those inheriting retirement assets. For example, a 25 year old inheriting an older family member’s IRA can immediately distribute funds while avoiding the 10% early withdrawal penalty.
Another exception to the early withdrawal penalty applies to rollovers and trustee-to-trustee transfers.
Rollovers occur when an investor requests a distribution (electronically or by check) from a retirement account and then redeposits the funds into a retirement account (which could be the same account) within 60 days. If the funds aren’t returned within 60 days, the distribution becomes taxable and may also be subject to the 10% early withdrawal penalty (if the investor is under age 59 1/2). Because the investor takes possession of the funds (often depositing them into a bank account), rollovers are sometimes used for short-term spending or to move assets between accounts. These are often called 60-day rollovers.
Key rollover rules:
Trustee-to-trustee transfers are generally a better way to move retirement assets between firms (for example, from a TD Ameritrade account to a Fidelity account, or vice versa). Brokerage firms typically use the Automated Customer Account Transfer Service (ACATS) system for these transfers. To request a trustee-to-trustee transfer, the investor goes to the receiving firm (the firm where the assets are going; the new firm) and completes the ACATS paperwork. The investor provides details about the account at the delivering firm (where the assets are coming from; the old firm).
The receiving firm submits the request through ACATS, which forwards it to the delivering firm. The delivering firm has one business day to validate the request by confirming that:
Account restrictions and proprietary products can cause a request to be denied. Proprietary products typically must be liquidated before transfer. If the request is in good order, it’s validated. The delivering firm then has three business days to transfer the assets to the receiving firm. Once received, the assets are placed in the investor’s account at the new firm, and the transfer is complete.
Trustee-to-trustee transfers avoid early withdrawal penalties because the investor never takes possession of the assets. Even if the process takes several weeks, there’s no 60-day deadline. Trustee-to-trustee transfers are not reportable to the IRS, so investors can perform them an unlimited number of times.
Many retirement plans are subject to required minimum distributions (RMDs) when the account owner turns 73. The IRS doesn’t allow investors to keep money tax-sheltered indefinitely. Requiring distributions creates taxable income.
The IRS requires investors age 73 or older to calculate an annual RMD based on the account balance and a life expectancy factor*. While the calculation details aren’t important for test purposes, here’s an example. Assume a 75 year old has a life expectancy factor of 24.6 years and a year-end account balance of $100,000 on December 31st, 2025. The investor divides $100,000 by 24.6 to determine a 2026 RMD of $4,065.
*The IRS requires most investors to utilize their uniform life expectancy table to determine life expectancy. The older an investor, the lower their life expectancy, which results in a larger distribution.
In most cases, RMDs must be taken by the end of the year (December 31st). However, the first RMD can be delayed until April 1st of the year after the investor turns 73. This gives the investor an extra three months (January, February, and March) to take the first required distribution.
If an RMD is missed, one of two penalties applies. A general 25% penalty may apply, although the IRS reduces it to 10% if the investor takes the RMD within two years. For example, assume an 80 year old calculates a $20,000 RMD for 2025 but fails to take it by year-end. If the investor takes the distribution by December 31st, 2027, the penalty would be 10%.
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