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.
In this chapter, you’ll learn the basics of retirement plans. The following concepts are discussed in this chapter:
Contributions are the funds you place into an account to save for retirement. Contributions must 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. 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 one way the government incentivizes retirement saving. Almost all qualified retirement plans, which are discussed in the next chapter, follow this tax structure.
Non-deductible contributions are made with after-tax funds and provide no immediate tax benefit. Using the same example, assume the investor makes a $5,000 non-deductible contribution. They still pay income taxes on the full $100,000 of earnings and receive no tax benefit for the contribution.
After a contribution is made, 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 or realize a capital gain. Most retirement plans, however, are tax-deferred: taxes are generally not due until money is distributed (withdrawn).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 that can create 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, investors should generally avoid municipal bonds in retirement plans. Municipal bonds typically offer lower yields because of their tax benefits. A retirement plan already provides tax advantages (for example, no current taxes on interest inside the account). So, buying a lower-yielding municipal bond inside a tax-advantaged account usually doesn’t make sense. If an investor wants a relatively safe, income-producing bond, 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. Ordinary income is taxed at the investor’s marginal tax bracket, similar to wages from a job.
Retirement plans follow strict rules. If an account is handled incorrectly, the account owner may face 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 caps how much money can be added to the account 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, the amount above the limit is subject to excess contribution penalties. A 6% annual penalty is assessed on the excess amount until the investor withdraws it.
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 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 pays 5% state income tax, roughly 52% of the distribution goes to taxes and penalties (37% federal + 5% state + 10% penalty). This is why advisers typically recommend avoiding early retirement distributions.
There are exceptions to the 10% early withdrawal penalty. If 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 involves 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 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 depositing it into a bank account), this is sometimes called a 60-day rollover. 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). 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 new firm) and completes the ACATS paperwork. The investor provides details about the account at the delivering firm (the old firm) so the receiving firm can process the request.
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 can cause a request to be denied. Proprietary products typically must be liquidated before transfer. If everything 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 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, and 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 age 73 or older to calculate an annual RMD based on their account balance and a life expectancy factor*. While the 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.
Most of the time, RMDs must be taken by the end of the year (December 31st). However, the first RMD can be delayed. An investor 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 missed, one of two penalties applies. A general 25% penalty may apply, but 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 forgets to take it by year-end. If they take the distribution by December 31st, 2027, the penalty would be 10%.
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