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 general features of retirement plans. The following concepts are discussed in this chapter:
Contributions are the funds you put 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 when funding 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, if the investor makes a $5,000 non-deductible contribution, they still pay income taxes on the full $100,000 of earnings.
After you contribute, the assets in the retirement plan can be invested based on 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 Most retirement plans, however, are tax-deferred vehicles: taxes are generally avoided until money is distributed (withdrawn). This tax structure applies to virtually all retirement plans except for Roth individual retirement accounts (IRAs) or 401(k)s, which are discussed later in this unit.
Most securities can be held in retirement plans, but some 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. But retirement plans already provide tax benefits (no taxes on received interest while funds remain in the plan). In other words, you’re often giving up yield for a tax benefit you don’t need inside the account. If an investor wants a relatively safe, income-producing bond in a retirement plan, US Government bonds are often a better fit.
Generally speaking, investors can invest in the following:
Distributions (withdrawals) are funds taken out of a retirement plan. These accounts are designed to provide money in retirement, but an investor can typically withdraw funds at any time. However, penalties may apply if a distribution is taken too early, and other penalties can apply 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 governed by many rules. If an account is managed improperly, 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 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 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 owes 5% state income tax, roughly 52% of the distribution goes to taxes and penalties (37% federal + 5% state + 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 every 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.
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 for the investor.
The IRS requires investors aged 73 or older to perform an annual calculation based on their account balance and life expectancy*. The details of the calculation aren’t important for test purposes, but the basic idea is straightforward. 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 their 2026 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 more time: they may postpone their first RMD until April 1st of the year after they turn 73. This gives the investor an extra three months (January, February, and March) to withdraw the required funds.
If an RMD is skipped or 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 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 would be 10%.
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