Retirement accounts explained and how the new Secure Act changed them.

I am about to release a couple of articles on how these accounts affect taxes and ways to minimize your taxes by timing the withdrawals and conversion from various accounts. I thought it would be better to first fully describe what all these accounts are, especially since the Secure Act (new law) that went into effect this year is the greatest change in individual retirement accounts in 13 years.

First let’s describe Social Security which is not really and “account” in a traditional sense and it is the one you have the least control over, nevertheless it is the one almost everyone has and certainly plays a part in your retirement planning.  

Social Security

I say it is not really an account because they are not taking all the taxes your pay and putting it into an account with your name on it. They are taking your taxes and using them to pay current beneficiaries and fund the trust fund for you and other future recipient’s benefits. The current prediction is that Social Security Trust fund will be insolvent by 2035 just in time for anyone 52 years old today to be eligible for full benefits. If no changes are made to current taxes or benefits it is estimated that all benefits would have to be cut immediately by 20% growing to a 25% cut shortly thereafter. With the Trust Fund insolvent benefits can only be paid out of current taxes, and the work force is shrinking while the number of peoples on social security is growing.

Social Security was always designed as a redistribution of wealth and a safety net for the most vulnerable and least financially secure among us. It was never designed to be a retirement plan. It was meant to supplement pensions and savings, not to be a sole source of income in retirement.  Keeping with the nature of redistribution of wealth, the less you earn the higher percentage of the earnings you made when you were working will be replaced by your Social Security benefit. The goal of Social Security is to replace 40% of the average worker’s pay. The average worker makes around $50,000 the goal is to pay a benefit of $20,000 a year. If you make more than the average worker your percent of replacement will be less although your net payment may be more than $20,000. Whatever your situation, even if there is no reduction in benefits during your retirement, you should not count on being able to live on 40% or less of your current salary in retirement. If you make $100,000 or more 27% or less if your salary will be replaced by Social Security. That comes to $27,000 a year. If you can’t live on that now, don’t count on being able to live on that when you retire, and don’t count on getting the full amount as it is likely to be reduced.

These figures also assume you don’t start collecting social security until your full retirement age which is currently age 67 for anyone born in 1960 or later. You can increase your payment if you wait to take social security until you are 70 years old. But you can reduce it significantly if you take it before full retirement age. You can go to this website to get a rough estimate of how much social security you will receive assuming no reduction in future benefits. Better yet, if you have a little time go to the Social Security Administration’s own website, and check out your “account” to make sure your “balances” are correct. While they don’t hold any money for you it is important to make sure they are correctly crediting all your years of income. Your benefits are based on your 35 highest years of earning adjusted for inflation. Once you make sure they have your account right it is pretty east to get an accurate estimate of what your benefits are likely to be, assuming no reduction of future benefits.

The Secure Act does not affect Social Security.

Pensions

For the purpose of this article when I talk about Pensions I will be talking about defined benefit programs. Technically a defined contribution programs is also a pension but since they operate more like, and are quite often comingled with, 401K programs so I will discuss defined contribution plans with 401ks below. A defined befit pension plan is a promise by your employer to pay you a set amount of money each month after you retire. It is essentially an annuity (which I describe below) guaranteed by your employer.

Private sector pensions are disappearing quickly. Many younger workers do not have one and never will, some older workers have pensions that were frozen but that are no longer growing. A few private sector workers and more public sector workers are still receiving them. You may also have pensions at former employers. If your employer offers a pension there is usually a vesting period of three to five years. Once you meet the vesting period (are employed for that period of time) you have earned a partial pension even if you later leave the company or they terminate or freeze their pension program. In most pension plans you do not start receiving your benefit until full retirement age of 65. Some plans may allow you to draw a reduced amount earlier, others may allow you to take full retirement earlier if your age and years of service combined hit a certain number. Your plan should spell out all the details.

If you work in the private sector your pension is likely guaranteed by the Pension Benefit Guarantee Corporation (PBGC). The PBGC is a Federal government agency that insures pensions much the same way the FDIC insures your bank accounts. This makes those pensions some of the most secure annuities around. You should be able to determine if your pension is guaranteed by the PBGC by asking your Human Resources Department or reviewing your plan materials.

Public sector pensions are not guaranteed by the PBGC and are often severely underfunded. One of the reasons so many public sector pensions still exist is since they are not eligible for PBGC protection there aren’t as many safeguards or watchdogs demanding they be funded correctly. Unfortunately, when dealing with politicians in the public sector it is easy for the employers to give away promises of future payments without figuring out how they are going to pay for them. While I believe PBGC guaranteed pensions are some of the safest annuities around I believe many public sector pensions are not very secure. You should know the security of your pension, if you have one, and factor that into your retirement planning.

If your pension is frozen you should be able to get a very accurate estimate of what your monthly benefit will be either through a website they provide or requesting it from human resources.  If your pension is still active you should be able to get a rough estimate of what your pension will be after allowing for assumptions about how long you plan to work there and what your future pay increases may look like.

The Secure Act does not affect pensions.

Annuities

An annuity is a promise to pay a certain amount of money at periodic intervals for a guaranteed length of time or for life. Defined benefit pensions plans described above are essentially an annuity as is social security (except social security is not guaranteeing anything for any length of time). You can also buy annuities either by paying a lump sum or by making periodic payments. These products are usually sold by insurance companies, and often have high fees when compared to other investments such as stocks and mutual funds. They are very complicated investment and you should read and make sure you understand all the terms before you buy one. The attractiveness to some people is the guaranteed periodic payments. Keep in mind the guarantee is only as good as the insurance company that sells the product. I am not a huge fan of annuities but recognize there may be a need for them especially for people that do not have a pension and desire a consistent reliable string of income in retirement. If you think annuities are right for you I encourage you to read my post on the subject and research them carefully. The Secure Act will make it easier for employers to offer these in your 401K plan so they may be coming to your 401k as an option soon.

401 K and other work sponsored retirement savings plans.

Many private sectors employers offer 401K plans, many public sector and nonprofit employers offer something similar called a 403b plan. If you work for a small company you may be offered what is called a Simple IRA. All three plans are pretty similar but there are some differences. All three plans include penalties if you withdraw funds prior to reaching 59 and a half years old.

Both the 401K and 403b can offer you the traditional option (take tax deduction now for your contributions, but pay taxes on everything when it is withdrawn) or the Roth option (no tax deduction for contributions to the plan but everything including all investment gains are withdrawn from the account tax free).

The simple IRA only offers you traditional contributions.

The 401k and 403b may offer matching contributions from the employer where they match a certain percentage of the employee’s contributions up to a percentage of salary or a set dollar amount. 401ks are much more likely to offer a match than 403bs. Simple IRAs must match at least 100% of an employee’s first three percent in contributions or they can opt to give every employee 2% of their salary whether they contribute or not. At a minimum you should always contribute enough to earn whatever match is available. If you fail to do so you are giving up free money. You may have to remain with the employer a certain amount of time for the matching funds to vest (usually 3 to 5 years) but unless you know you will leave the company before the vesting period you should take full advantage of the match. In a worst case scenario, if you leave before you vest, your contributions are always yours and you can take them with you. All matching contributions are put into a traditional account regardless of whether you elected Roth or traditional for your contributions.

Each year you can contribute up $19,500 ($26,000 if age 50 or older) to a 401k or 403b. The contribution limits for a Simple IRA a slightly lower at $13,500 ($16,000 if age 50 or older). All these plans can and should eventually be rolled into IRAs which is explained below.

In addition to any matching funds (which your employer only gives you if you put something in) your employer may add employer contributions. This is the defined contributions (pension) retirement plan referred to under the description of pensions. Some employers will have this be a subgroup of the 401K others will keep it as a separate account and call in something different. For tax planning purposes it is essentially the same as a traditional 401k.  The only difference is money in this subgroup may have to remain with your employer until retirement age, i.e. you can’t roll it over to a new plan or an IRA. Check your specific plan for details.

The Secure act is making it easier and more attractive for employers to offer annuities. It also make it easier for part time employees to enroll in the plans and allows people with student loans to withdraw up to $10,000 penalty free to pay off student loans.

Individual Retirement (IRA)

Everyone should have an individual retirement account, more commonly referred to as an IRA. There are two types of IRAs, Traditional and Roth.

With a traditional IRA you usually get a tax deduction (subject to income limitations) when you make your contribution. Both your contribution and any earnings you make grow tax differed, meaning you pay no taxes until you withdraw the money. When you withdraw the money it is all taxed as ordinary income according to your tax bracket. With a few exceptions any money you withdraw before the year in which you reach 59 and a half years old will be subject to an excise penalty on top of the tax. You must start taking minimum required distributions (RMD) once you turn 72 whether you need the money or not. If you turned 70 and a half before 2020 you must continue to comply with the old rules that required RMDs at that age.

With a Roth IRA you do not receive a tax deduction when you make your contribution but all the money you put in, and all the money you earn on the investments can be withdrawn from the account tax free once you reach 59 and a half. There are no RMD requirements on a Roth IRA.

Most people can contribute up to $6,000 ($7,000 if 50 or older) to either IRA each year as long as they or their spouse have earned income at least equal to the amount they contribute. However there are income limits that may limit or prevent how much you can contribute to a Roth and weather you contribution is tax deductible if you contribute to a traditional IRA.

For a single filer tax deductibility of a traditional IRA starts to phase out when your modified adjusted gross income (MAGI) reaches $65,000 and there is no tax deduction if your MAGI is greater than $75,000. For a single filer the ability to make a Roth IRA starts to phase out when your MAGI reaches $124,000 and you cannot make any Roth IRA contributions limit if you MAGI is $139,000 or greater.

It should be noted that if you are eligible to make IRA contributions you can max out both your employer sponsored plan (401k) limits and your individual retirement account (IRA) limits each year. They are completely separate limits and do not offset each other. The income limits that restrict IRA contributions do not apply to work sponsored plans so you can contribute up to the maximum amount in those plans each year regardless of your MAGI.

Your work plan retirement accounts can and should eventually be rolled into IRAs and your traditional IRAs can be converted to Roth IRAs, this is explained below. The reason for conversion is explained in detail an upcoming tax management post.

Required Minimum Distributions (RMD) and Secure Act changes to IRAs

One positive change under the secure act is that people still working past age 70 can continue to contribute to their IRA if they are otherwise eligible and would like to. Also another positive change is the increase in age for taking your RMDs. Under the old rules you were required to take RMDs from your Traditional IRAs and 401ks starting at age 70 and a half. The secure act changed that to age 72. RMDs mean you have to take out money every year whether you need it or not. If you fail to take it out the minimum required amount there are very large penalties. A required minimum distribution is determined by using a government table in place at the time you reach the requisite age. They are based on life expectancy. If you have $1,000,000 in your Ira, under the current table you would have to take out over $39,062.50 (a little over 3.9%) when you turn 82 you would be required to take $58,479.53 (a little over 5.8%).

The most damaging change in the Secure Act is how they treat inherited IRAs. It used to be a common strategy in estate planning to develop what are known as stretch IRAs. These were designed to maximize the length of time the money could grow tax free or tax deferred. To set up a stretch IRA you would name a young person, often a grandchild, as a beneficiary. Under the old rules when anyone inherited an IRA they had RMD requirements but could spread them out over their much longer life expectancy. Under the Secure Act all inherited IRAs both traditional and Roth must be liquidated within ten years of the original owner’s death. (There is an exception for spouses and a few other unique individuals). This could cause a huge increase in the tax rate of traditional IRAs.  Even if you spread out the withdrawal of $1,000,000 over 10 years, if there is a single beneficiary and they already have a job, this will likely push them into one of the highest tax brackets. If you have a single beneficiary that is not your spouse or were planning on a stretch IRA as part of your estate plan you should consult your estate planner immediately to see how the new law affects your plan.

401K and IRA Roll Overs

When you leave an employer you have the option to take your work sponsored retirement plan with you. If you cash it in before 59 and a half you will pay huge penalties. Your best option is to roll it over directly to another qualified plan. While you could leave it with your employer or roll it into your new employer’s plan the best thing to do is to roll it into an IRA. IRAs with the right firm will usually have many more options, including better options with lower fees for investing your money. You have much more flexibility in an IRA than a 401k. Along with rolling over old plans, most employers now also allow you to do what is called a 59 and a half roll over. This means even if you are still working for them they will let you roll over the balance of your 401k account to an IRA after you reach the age of 59 and a half. Check with your employer to see if they allow this and what the details are.

If you are not happy with your IRA where it is add, you can directly roll it over to a new IRA and a different financial institution with no penalty.

IRA Conversions

We talked about the difference between traditional IRAs and Roth IRAs. If you don’t have one or don’t have enough of your money in a Roth IRA, you can convert a traditional IRA in whole or in part to a Roth IRA at any time. It is a pretty simple process and your IRA custodian can walk you through it. You must, however, pay taxes on the amount of the conversion. But once the money is in a Roth any future income or withdrawals are made tax free and all futures gains are tax free.   See my post about earning $2,000,000 tax free. In one of my upcoming post I am going talk about minimizing your life time tax bill and part of that strategy involves the timing of converting parts of your traditional IRA to a Roth IRA. This is very important for people that are over-weighed in traditional IRAs.

Health Savings Accounts (HSA)

This is not technically a retirement account but I am using mine like one and think it is a great idea for anyone that can afford this technique to do so. These are not like the old FSA everyone got so used to and became afraid of. There is no use it or lose it rule, and you can take the account with you when you leave an employer.  Anyone that has a qualified high deductible health insurance plan can open a HSA. If you are able to contribute to an HSA through your employer, not only do you avoid the federal and state income tax on that money, you also avoid social security and Medicare tax. It is the greatest legal tax dodge ever invented! Everyone should max this out every year they are eligible.

You get the tax deduction, which is better than the one you get from the traditional 401k or IRA, but, if you use the money for qualified medical expenses, you can pull it all out completely tax free like the Roth IRA! There are no age or income limits or tax consequence for when you pull it out as long as you have enough qualified medical expenses to cover the amount you pull out. If your plan allows you to invest it in stocks, and you can afford to do so, let it continue to grow tax free. You can use it in your retirement years to pay for your medical expenses which will be one of your largest expenses in retirement. It can be used for Medicare and other health insurance premiums and co-pays.

In 2020 an individual can contribute $3,550 and a Family can contribute $7,100 to an HSA. If 55 or older you can add another $1,000 to your contribution.  The Secure act does not affect HSAs.

I talk about some of these accounts in many of my previous post and how they all play a part in financial and retirement planning.  In earlier articles I talked about earning tax free money and the importance of contributing to tax free and tax deferred accounts. If you are not sure why you should be doing this, please review that article by following the hyperlink.  If you have not started your retirement planning please review that article. If you are not sure how much you should be saving please read my article on that.

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