As with anything related to money, there are tax implications for your retirement accounts. It mostly depends on the type of account you have. There are many retirement savings options available. Some plans are offered through employers, while others are up to us. Here’s a look at what’s out there, and what they mean for your taxes.
Contributions to a traditional 401(k) plan are tax-deferred on the front end; that is, you won’t pay tax on the money you contribute (usually through payroll deduction). You will, however, be taxed on distributions you take from the plan. The rules are just the opposite for Roth 401(k) accounts: contributions are taxable, but distributions are tax-free.
Annual contributions to a 401(k) are capped at $19,000 for 2019 and $19,500 for 2020. A 401(k) generally offers greater flexibility in contributions, and participants can contribute more than to an IRA. The plan may allow optional participant loans (taking an early distribution as a loan to be paid back by the employee’s contributions), and employees are always 100 percent vested in the contributions they made.
Being “100 percent vested” means the money is yours; if you leave the company, you don’t lose it. That does not mean you can tap it anytime you want, or at least without feeling a pretty big pinch. You have to be at least 59½ when you withdraw, or else you’re probably going to be hit with an extra 10 percent penalty, on top of the tax you’ll pay on the income.
Also called a tax-sheltered annuity or TSA plan, the 403(b) is a retirement plan offered by public schools and certain tax-exempt organizations such as churches or other charitable entities. Employees save for retirement by contributing to their individual accounts; employers can also contribute. The 403(b) shares many aspects of the 401(k), including tax-deferred contributions and taxable distributions. There may also be a Roth variant of the 403(b), depending on the plan.
The limit on annual additions (the combination of all employer contributions and employee deferrals) to all 403(b) accounts is generally the lesser of $56,000 for 2019 ($57,000 for 2020), or 100 percent of “includible” compensation for the employee’s most recent year of service. Includible compensation is the amount of taxable wages and benefits you received in your most recent full year on the job.
The limit on elective deferrals – the most an employee can contribute to a 403(b) account by means of a salary reduction agreement – is $19,000 for 2019 ($19,500 for 2020). And like a 401(k), early withdrawals from a 403(b) are subject to an extra 10 percent penalty added to the tax.
This is basically a 401(k) plan for state or local governmental employees and officials, as well as tax-exempt 501(c) organizations. Contributions are made through salary reductions and are tax-deferred, as are any earnings. A 457(b) plan may have a Roth provision, with taxable contributions but tax-free distributions. Contributions are capped at $19,000 for 2019 and $19,500 for 2020.
Individual Retirement Arrangements (IRAs)
An IRA is a retirement plan that you set up for yourself, rather than participating in a plan your employer has set up. Plans come in two basic types: traditional or Roth. With a traditional IRA, your contributions may be totally or partially deductible, depending on your situation. If you or your spouse are already covered by a retirement plan at work, and your income exceeds certain levels, your deduction for contributions may be limited. If you aren’t covered by a plan at work, you get the full deduction for contributions. Distributions are taxable.
You can set up an IRA with a bank or other financial institution, a life insurance company, a mutual fund or stock broker. You must start taking required minimum distributions from your Traditional IRA after you turn age 70½. There is a 10 percent penalty for early distributions.
The most you can contribute to a traditional IRA is the smaller of $6,000 for 2019 ($7,000 if you’re age 50 to 70 1/2), or your taxable compensation for the year, whichever is less. (The amounts are the same for 2020.)
A Roth IRA shares many of the characteristics of a traditional IRA, except the contributions are taxable, while the distributions are tax-free. In order to meet the IRS test for a qualified distribution (and thus escape taxation) the distribution must be taken at least 5 years after the first contributions were made, and the beneficiary of the plan must be at least 59½ years old.
The contribution limit for your combined traditional and Roth IRAs depends on your age:
- Under age 50:
- 2020: $6,000
- 2021: $6,000
- Age 50 or older:
- 2020: $7,000
- 2021: $7,000
|Modified AGI and Contribution Limit
|Married filing jointly or qualifying widow(er)
|Married filing separately and you lived with your spouse at any time during the year
|Single, head of household, or married filing separately and you did not live with your spouse at any time during the year
For more information on traditional and Roth IRAs, see this IRS table.
Some employers offer a Payroll Deduction IRA, where employees establish their own IRA – whether traditional or Roth – with a financial institution and authorize a payroll deduction for it. A business of any size, even a self-employed one, can establish a Payroll Deduction IRA program.
Some taxpayers start with a traditional IRA, then decide later to convert their account to a Roth IRA. That's possible, although there could be tax consequences. The amount transferred from traditional IRA to Roth IRA has to be included in gross income after the transfer, since the move takes tax-deferred funds and rolls them into a taxable account. That means there will be tax owed on the new Roth funds.
There are three basic methods of conversion from traditional to Roth IRA:
- Rollover – You can get a distribution from a traditional IRA and roll it over (contribute it) to a Roth IRA within 60 days of the distribution.
- Trustee-to-trustee transfer – You can direct the trustee of your traditional IRA to transfer an amount to the trustee of the Roth IRA.
- Same trustee transfer – If the trustee of your traditional IRA is also a trustee of the Roth IRA, you can instruct the trustee to simply transfer the amount between the two plans. In fact, in this scenario, the traditional IRA can actually be designated a Roth IRA, rather than opening a new account or issuing a new contract.
If you have a qualified retirement plan at work and want to convert it to a Roth IRA, there are two avenues:
- Rollover – You can get a distribution from your qualified retirement plan and roll it over (contribute it) to a Roth IRA within 60 days of the distribution. Since the distribution is paid directly to you, the payer generally must withhold 20 percent.
- Direct rollover – Your employer’s plan must give you the option to have any part of an eligible rollover distribution paid directly to a Roth IRA. Generally, no tax is withheld from a distribution paid directly to the trustee of the Roth plan. Instead, you’ll be responsible for any owed tax later, when you file your taxes.
Other Retirement Plans
Simplified Employee Pension (SEP) Plans let employers to set aside money in retirement accounts for themselves and their employees. All contributions come from the employer. SEPs allow for flexible contributions from the employer, and contributed amounts can vary depending on cash flow or other factors. But the employer must contribute equally for all eligible employees. Contributions go to traditional IRAs set up for each participating employee, who has ownership of all money in his account.
Savings Incentive Match Plan for Employees (SIMPLE) Plans allow both employees and employers to contribute to traditional IRAs set up for employees. This type of plan could be suitable as a start-up option for small employers not currently sponsoring a retirement plan. Under the SIMPLE plan, employers are required to contribute matching funds up to 3 percent of the employee’s compensation, or opt to contribute a flat 2 percent of each eligible employee’s compensation, without a voluntary contribution from the employee. In the case of matching funds, if the employee does not contribute to the plan, the employer is not required to contribute.
Salary Reduction Simplified Employee Pension (SARSEP) Plans are lesser-known, and avoid the tax burden on employee contributions by permitting employee salary reductions for contributions. Since the amount of the salary reduction is not paid to the employee, it’s not taxable as wages. That amount is contributed to the SEP plan. Only plans established before 1997 can qualify as a SARSEP plan. At least half of eligible employees must opt for the salary reduction to fund the plan, and participating employees are capped at 25.