Generalities

Retirement plans incentivize investors to save for their golden years. When you retire one day, you’ll need enough money to live on for the rest of your life. While social security, Medicare, and other government-provided benefits help, many need additional resources to enjoy a comfortable retirement.

In this chapter, we’ll learn about the generalities of retirement plans. The following concepts are discussed in this chapter:

The following retirement plan concepts are discussed in this chapter:

• Contributions
• Eligible investments
• Distributions
• Penalties

Contributions

Contributions represent the funds placed into an account to save for retirement. They must always be made in cash, regardless of the type of account. Investors may not contribute securities or other assets when they put money in their retirement accounts.

Depending on the type of retirement account, contributions may be deductible or non-deductible (after-tax). Deductible contributions provide immediate tax benefits; in particular, they result in lower overall taxes when a contribution is made. For example, let’s assume an investor makes $100,000 from their job during the year. If they make a $5,000 deductible contribution, they only pay income taxes on $95,000 ($100,000 earned minus the $5,000 deductible contribution). This is our tax system’s way of saying - “put money away for retirement, and your taxes will be lower!”

Non-deductible contributions are made with after-tax funds and have no immediate tax benefits. Using the same example above, let’s assume the investor makes a $5,000 non-deductible contribution. This time, they will pay income taxes on $100,000 of earnings and receive no tax benefits for the contribution.

After making a contribution, retirement plan assets may be invested according to the account owner’s specifications. Normally, taxes are due when investors obtain a dividend, interest, or realize a capital gain on their investments. However, retirement plans are tax-deferred vehicles, which avoid taxation until money is distributed (withdrawn).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.

Eligible investments

Most securities are eligible for investment in retirement plans, but some are prohibited. Generally speaking, strategies involving unlimited risk are restricted. Therefore, investors must avoid short sales, margin, and some option strategies. Additionally, investors cannot 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 avoid municipal bonds in retirement plans. If you recall, municipal bonds have low yields due to their tax benefits. Retirement plans already provide those same tax benefits (no taxes on received interest). Why would an investor purchase a low-yielding municipal bond when their account already gives them tax benefits? Instead, investors should consider US Government bonds if they seek a safe, income-producing bond.

Generally speaking, investors can invest in the following:

• Stocks (common and preferred)
• Bonds
• Mutual funds
• Unit investment trusts (UITs)
• US Government issued coins

Distributions

Distributions (withdrawals) represent funds from a retirement plan. While these accounts are structured to disperse funds in retirement, an investor can typically withdraw funds at any time. However, steep penalties can apply if a distribution is not taken in a timely manner (discussed below).

Most retirement plan distributions are taxable as ordinary income. Similar to paying tax on earnings from a job, ordinary income is taxed at the investor’s marginal tax bracket.

Penalties

Retirement plans are subject to many rules and regulations. If managed improperly, account owners could be subject to significant Internal Revenue Service (IRS) penalties. In this section, we’ll discuss various rules to follow and the penalties assessed when they’re broken.

Nearly every retirement plan we’ll discuss is subject to a contribution limit. Meaning, the IRS only allows a certain amount of money to be placed into the account. For example, the 2024 contribution limit for individual retirement accounts (IRAs) is $7,000. If an investor were to transfer $10,000 into their IRA, they would be subject to excess contribution penalties. A 6% annual penalty is assessed on the amount above the contribution limit until the customer withdraws the excess.

The IRS defines retirement age as 59 ½ or older. If an investor were to withdraw retirement plan money before this age, they would be subject to a 10% early withdrawal penalty in addition to any applicable taxes. For example, assume an investor pulls $10,000 from their retirement plan at age 40. They are subject to a 10% penalty ($1,000) plus ordinary income taxes on their distribution. A sizeable chunk of the customer’s money will go to the IRS through taxes and penalties. If the investor was subject to the 37% federal tax bracket and a 5% state income tax, roughly 52% of the distribution is subject to taxation (37% fed tax + 5% state tax + 10% penalty). This is why financial advisers strongly recommend against early retirement distributions.

There are exceptions to the 10% early withdrawal penalty. When any of the following situations apply, distributions can be taken without penalty. Regardless, ordinary income taxes are still due on every withdrawal. Early withdrawal exceptions include:

• Disability
• Death*
• First-time home purchases
• Educational expenses
• Certain medical expenses

*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 is for rollovers and trustee-to-trustee transfers. Rollovers occur when an investor requests the disbursement of funds (either electronically or by check) from their retirement account, then returns the funds to a retirement account (could be the same account) within 60 days. If the funds are not returned in time, the disbursement is subject to taxation and penalties (if under age 59 1/2). Some investors utilize rollovers for short-term spending or to move assets between accounts. Technically a rollover involves the investor gaining access to the funds, which usually means the assets end up in the person’s bank account. Sometimes referred to as 60-day rollovers, these transfers may only occur once per year. Additionally, the rollover is reportable to the IRS.

Trustee-to-trustee transfers are better ways 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 utilize the Automated Customer Account Transfer Service (ACATS) system. To request a trustee-to-trustee transfer, the investor will go to the receiving firm (the firm where assets are going; the new firm) and fill out their ACATS paperwork. The details of the account held at the delivering firm (where the assets are coming from; the old firm) are provided to the receiving firm for processing.

The receiving firm then submits the paperwork into the ACATS system, which forwards the request to the delivering firm. The delivering firm has one business day to validate the request. To validate it, they’ll confirm the assets requested are in the account and eligible to be transferred. Account restrictions and proprietary products may result in the request being denied. Proprietary products typically must be liquidated before transfer. If the request is in good order, the request is validated. The delivering firm then has three business days to transfer the assets to the receiving firm. Once the assets are received, 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 assets never came into possession of the investor. Even if the process is delayed and takes several weeks, investors are not subject to a 60-day deadline. Trustee-to-trustee transfers are not reportable to the IRS, allowing investors to perform these transfers unlimited times.

Many retirement plans are subject to required minimum distributions (RMDs) when the account owner turns 73. Unfortunately, the IRS does not allow investors to keep their money tax-sheltered forever. They want their taxes eventually! Forcing investors to take money out of their retirement plans results in additional tax obligations.

The IRS requires investors aged 73 or older to perform an annual calculation involving their account balance and life expectancy*. While the specifics aren’t important for test purposes, let’s 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, 2023. The investor divides the year-end account balance ($100,000) by their life expectancy (24.6) to determine their 2024 RMD is $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 a bit more time. They may postpone their first RMD until April 1st of the year after they turn 73. This rule gives the investor an extra three months (all of January, February, and March) to withdraw the necessary funds.

If an RMD is skipped or missed, one of two penalties apply. 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 2023, forgets about it, and fails to take it by the end of the year. If they were to take the distribution by December 31st, 2025, the penalty is 10%.