Retirement plans encourage investors to save for their later years. 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 support a comfortable retirement.
This chapter covers the general features of retirement plans. The following concepts are discussed in this chapter:
The following retirement plan concepts are discussed in this chapter:
Contributions are the funds you put into a retirement account. Contributions must always be made in cash, regardless of the type of account. You can’t contribute securities or other assets directly into a retirement account.
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 in the year the contribution is made. For example, assume an investor earns $100,000 from their job during the year. If they make a $5,000 deductible contribution, they pay income taxes on $95,000 ($100,000 earned minus the $5,000 deductible contribution). This is the tax system’s way of encouraging retirement saving by lowering taxes today.
Non-deductible contributions are made with after-tax funds 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 assets in the retirement plan can be invested according to the account owner’s instructions. Normally, investors owe taxes when they receive dividends or interest, or when they realize capital gains. However, most retirement plans are tax-deferred, meaning taxes are generally postponed until money is distributed (withdrawn). This tax structure applies to virtually all retirement plans except for Roth IRAs or 401(k)s, which are discussed in the next chapter.
Most securities are eligible for investment in retirement plans, but some are prohibited. In general, strategies involving 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 they’re not explicitly prohibited, investors should generally avoid municipal bonds in retirement plans. Municipal bonds typically have lower yields because of their tax benefits. But retirement plans already provide tax benefits (no current taxes on interest, dividends, or gains in most plans). So a municipal bond’s tax advantage is usually wasted inside a retirement account. If an investor wants a relatively safe, income-producing bond in a retirement plan, US Government bonds are often a more suitable choice.
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, steep penalties can apply if a distribution is taken too early or if required distributions 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 improperly, the account owner may face significant Internal Revenue Service (IRS) penalties. This section covers key rules and the penalties for breaking them.
Nearly every retirement plan has a contribution limit. In other words, 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 to their IRA, they’re subject to excess contribution penalties. A 6% annual penalty is assessed on the amount above the contribution 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 any applicable taxes. For example, assume an investor withdraws $10,000 from their retirement plan at age 40. They owe a 10% penalty ($1,000) plus ordinary income taxes on the distribution. If the investor is in the 37% federal tax bracket and owes 5% state income tax, roughly 52% of the distribution goes to taxes and penalties (37% federal tax + 5% state tax + 10% penalty). This is why financial advisers generally recommend avoiding early retirement distributions.
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 of funds (either electronically or by check) from a retirement account and then deposits those funds into a retirement account (which could be the same account) within 60 days. If the funds aren’t returned in time, the distribution becomes taxable and may be subject to penalties (if the investor is under age 59 1/2). Some investors use rollovers to move assets between accounts or for short-term access to funds. Because the investor takes possession of the money (often meaning it lands in the investor’s bank account), these are sometimes called 60-day rollovers. These transfers may only occur once per year, and the rollover is reportable to the IRS.
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). For these transfers, brokerage firms typically use the Automated Customer Account Transfer Service (ACATS) system. 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 the assets are in the account and eligible to be transferred. Account restrictions and proprietary products may cause the 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 the assets arrive, they’re 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, so it requires distributions that create taxable income.
The IRS requires investors aged 73 or older to perform an annual calculation based on the account balance and life expectancy*. While the details aren’t important for test purposes, assume a 75 year old with a life expectancy factor of 24.6 years has a year-end account balance of $100,000 on December 31st, 2025. The investor divides the year-end account balance ($100,000) by their life expectancy (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.
Most of the time, RMDs must be fully distributed by the end of the year (by December 31st). However, investors taking their first RMD have more time: they may postpone their first RMD until April 1st of the year after they turn 73. This gives an extra three months (January, February, and March) to withdraw the required amount.
If an RMD is skipped or missed, one of two penalties applies. A general 25% penalty may apply, although the IRS reduces the penalty to 10% if the investor takes the RMD within two years. For example, assume an 80 year old investor calculates a $20,000 RMD in 2025, forgets about it, and fails to take it by the end of the year. If they take the distribution by December 31st, 2027, the penalty is 10%.
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