Investing Unit 7: Retirement Plans



Penalties for Early Withdrawal

All tax-deferred accounts carry a penalty for withdrawing the money before age 59 1/2. However, some types of accounts have exceptions, such as money withdrawn to be used to buy a first home, or if the owner of the account becomes disabled or dies. In addition, for some accounts, the penalty may not apply if the individual is taking equal periodic payments over his or her life expectancy for at least five years or until age 59 1/2, whichever comes later, or for college expenses, and certain medical expenses. The penalty is usually 10% of the amount withdrawn and then, of course, federal and state income taxes also have to be paid on the withdrawal.

Types of Retirement Plans

The government allows several different types of tax-deferred retirement programs. Among these are employer-sponsored plans, plans for self-employed persons, and individual retirement accounts (IRAs). Many of the plans are named for sections of the tax code that establish these plans, [e.g., 401(k) and 403(b)]. These plans differ in who is eligible to participate, administrative responsibilities, allowable contribution limits, the types of investments available in the plan, and tax consequences and penalties for early withdrawal (a 10% penalty, plus ordinary income tax, is charged for withdrawals made prior to age 59 1/2; certain exceptions apply).

Employer-Sponsored Retirement Plans

Salary-reduction plans allow employees to deposit, through payroll deduction, part of their salary into a retirement account. There are a number of ways you, as an employee, can invest on a tax-deferred basis so that your investment will grow free of taxes and will not be taxed until you start making withdrawals. Types of employer-sponsored retirement plans include:

  • 401(k) A retirement plan for employees in private corporations which defers the taxes on employee contributions and earnings on these contributions until retirement withdrawals are made. The 2020 limit on the amount that can be contributed from income before taxes is $19,500 ($26,000 for workers age 50 and over with the additional $6,500 catch-up contribution). Contributions are deducted directly from your paycheck (e.g., 5% of your salary). Some employers contribute a match or a percentage of your contribution. Many companies also allow their employees to borrow up to one-half of the funds from their 401(k) plan for any reason. Interest paid by the employee on the money that is borrowed from his 401(k) is paid into the employee’s own account.
  • 403(b) A tax-deferred retirement plan that is similar to corporate 401(k) plans. A big difference is fewer employers match contributions because participants are often public (read: taxpayer-funded) employees. 403(b) plans are available to employees of schools and non-profit organizations. The 2020 limit for contributions is $19,500 ($26,000 for workers age 50 and over). The mix of available investment choices differs among institutions. Many allow participants to borrow from their account and have a catch-up provision if you have not contributed fully in the past.
  • Section 457 This employer retirement savings plan is similar to the 401(k) and 403(b) but is for state and local government employees. With Section 457 plans, employer matching is virtually non-existent. The 2020 limit that you can contribute is $19,500 ($26,000 with catch-up).  Note: Contribution limits for all of the employer plans listed above will be adjusted for inflation in future years.

Self-Employed or Small Business Retirement Plans

There also are tax-deferred plans available to individuals who are self-employed or employees of small businesses. These include:

  • Keogh Plans
  • Simplified Employee Pension Plan (SEP)
  • Savings Incentive Match Plan for Employees (SIMPLE)

The following descriptions can help determine which plan could work for you.

Keogh Plan

Named after U.S. representative Eugene James Keogh, who first introduced the idea in 1962, this plan is available to anyone who has self-employment income. This is generally income from any unincorporated business that you conduct, whether it is your primary job or a business “on the side.” Annual dollar limits and percentages of pay apply. Self-employed persons may contribute as much as $57,000 in 2020 with periodic adjustments for inflation. For purposes of a Keogh, the definition of earned income is net profit (i.e., net income after subtracting business expenses). The money contributed to a Keogh plan is not taxed and grows in value until it is withdrawn. You may have both a Keogh plan and an IRA. If you work for an employer and are self-employed on the side.

To set up a Keogh plan, you must first select a bank, mutual fund, or other financial institution. Usually they will supply the needed paperwork and provide you with a prototype plan. You will be asked to choose a defined-contribution and/or a defined-benefit Keogh plan. These two options are not mutually exclusive – your plan can include both. There are three forms of defined-contribution Keogh plans:

1. A money-purchase Keogh requires you to choose a fixed percentage of your earnings and contribute that percentage every year to the plan.

2. A profit-sharing Keogh allows you to contribute a fixed percentage of business profits. You can contribute the full amount one year and less or nothing the next, depending on how the business does.

3. A combination of money-purchase and profit sharing offers the option of contributing up to the maximum allowed, but doesn’t lock a business owner into high payments.

Under a defined benefit Keogh plan, rather than contribute a percentage of your earnings, you are allowed to contribute more than the annual limit imposed on defined-contribution plans. Also, the amount contributed each year can vary greatly. These plans can be complicated and costly to set up and administer because a professional actuary is required to oversee the plan. Generally, defined-benefit Keogh plans are used as a catch-up strategy by older business owners who have put off setting up a retirement plan.

SEP or SEP-IRA (Simplified Employee Pensions)

Simplified Employee Pensions (a.k.a., SEPs or SEP-IRAs) allow business owners to make contributions to their own individual retirement account (IRA) and the IRAs of their employees. Annual dollar limits and percentages of earnings apply. Employers must contribute the same percentage to their employees’ IRA as they do to their own. One advantage to an employer or self-employed person is that contributions do not have to be made every year. Little paper work is required, it is much simpler than setting up a Keogh plan, and does not have the reporting requirements of a Keogh. A disadvantage is that you cannot contribute as much to a SEP as you can to a Keogh plan. Generally, contributions are made by the employer and are tax-deductible to the employer.


A SIMPLE plan is a tax-deferred savings plan that can be set up by owners of a business that employs 100 or fewer employees to cover all employees and themselves. To be covered, employees must earn at least $5,000 a year. The maximum annual contribution for SIMPLE plans in 2020 is $13,500 with an additional $3,000 catch-up contribution for workers age 50 and older ($16,500 total). The contribution limit is adjusted periodically for inflation. The employer can match up to 3% of the employee’s compensation.

The employee’s contribution reduces taxable income and the employer’s contribution reduces the business’s taxable income. A SIMPLE-IRA is owned by the employee and belongs to the employee, even if employment is terminated. The employer can’t sponsor another retirement plan in addition to a SIMPLE. Like SEPs, SIMPLE-IRAs have low administrative responsibilities and costs compared to Keogh plans.

Individual Retirement Accounts (IRAs)

For individuals who qualify, another smart way to build a retirement nest egg is to take advantage of the tax-deferred growth offered by an Individual Retirement Account (IRA). An IRA is a personal retirement savings plan, which may be set up with banks, mutual fund companies, brokerage firms, or similar investment organizations. Three types of IRAs are described below:

Traditional IRAs

For tax-deferment purposes, an IRA can be funded until the tax filing deadline (typically April 15 of the following year). Of course, the earlier in the year an IRA is funded, the quicker the interest will begin to accumulate.

The maximum that can be contributed in any one year is the lesser of the amount of the annual limit or up to 100% of earned income. Your spouse can do the same. However, you don’t have to have to make the entire contribution all at once. You can start with whatever money is available (e.g., $500) that meets the minimum amount set by a financial institution (e.g., bank or mutual fund).

The maximum IRA contribution limit is $6,000 for 2020, to be adjusted for inflation in $500 increments. In addition, people age 50 and over can contribute an additional $1,000 ($7,000 total). .

Traditional IRAs may be:

Tax-deductible (for taxpayers who are not participants in an employer retirement plan or plan participants with income below certain levels)

Non-deductible (for taxpayers with earned income who fail to qualify for a deductible IRA).

Deductible IRAs provide a double tax benefit: contributions – and all earnings – are tax-deferred until retirement. You can also deduct (from taxable income) the full amount contributed if you are an active participant in an employer-sponsored retirement plan, but your adjusted gross income (AGI) is $65,000 or less if you are single or $104,000 or less if you are married and filing jointly (2020 amounts). Once you reach this level, a phase-out range begins. The deduction is eliminated at a maximum AGI of $75,000 for single filers and $124,000 for married joint filers (2020 amounts).

The IRS no longer considers one spouse an “active participant” in a retirement plan simply because the other spouse has an employer-sponsored retirement plan. As a result, the spouse who does not have an employer-sponsored retirement plan can make a tax-deductible contribution to an IRA, provided the couple’s AGI is less than $206,000 in 2020 (subject to phase-out rules starting at $196,000).

If you withdraw money from an IRA before age 59 1/2, there will be a 10% penalty on the amount withdrawn, and federal and state income taxes will be due on the amount withdrawn on that year’s income tax return. You can withdraw funds from an IRA without a penalty after you reach age 59 1/2. Withdrawals from a Traditional IRA are taxable and are treated as ordinary income. Withdrawals must begin no later than April 1 of the year after you turn 70 1/2.

Roth IRAs

Although contributions to a Roth IRA are not tax-deductible, qualified withdrawals are tax-exempt if made more than 5 years after the Roth IRA was established and the taxpayer has reached age 59 1/2, becomes disabled, or dies. Roth IRAs accumulate like whole life insurance – they go in after-tax, accumulate tax-deferred, and come out tax-free. Another big plus: Unlike traditional IRAs, investors in a Roth IRA are not subject to the required minimum distribution (RMD) rules, and you can make contributions after age 70 1/2 as a worker or spouse of a worker. Early withdrawals from a Roth IRA are tax-free and penalty-free if they satisfy the five-year holding requirement or the money is used to cover qualified first-time homebuyer expenses of up to $10,000, or if the taxpayer becomes disabled before age 59 1/2, or dies.

Individuals can contribute up to $6,000 in 2020 (to be adjusted for inflation in $500 increments) to a Roth IRA if they have an AGI of up to $139,000 (for married taxpayers filing a joint return, the AGI limit is $206,000). Eligibility for contributing to a Roth IRA begins to phase out for individuals with an AGI over $124,000 and ends once an individual’s AGI exceeds $137,000. For joint filers, the phase-out figures are between $196,000 and $206,000. Investors can roll funds over from a traditional IRA to a Roth IRA, regardless of income. Income taxes must be paid on the amount of a conversion during the tax year that the conversion is made. Tax withholding or estimated payments should be planned accordingly.