Chapter 1

Explaining IRAs and 401(k)s

IN THIS CHAPTER

Finding out about 401(k)s and IRAs

Recognizing the pros and cons of each

Seeing the benefits of saving for retirement

My primary goal is to help people concerned about having enough money to successfully retire. Even young people, for whom retirement would normally be low on the priority list, have jumped on the retirement savings bandwagon. They're the smart ones, because in some respects, how long you save is more important than how much you save.

Looking forward to not having to work is a worthy goal, but remember the paychecks cease when you stop working. Having enough income to sustain yourself during the next 20 to 30 years isn't easy. Your plans may be disrupted before you reach your planned retirement age. The current COVID-19 pandemic is an example.

Exploring the Basics of Retirement Savings Plans

A retirement plan lets you put some of your income away now to use later, presumably when you're retired and not earning a paycheck. This process may not appeal to everyone; human nature being what it is, many people would rather spend their money now and worry about later when later comes. That's why the federal government approved tax breaks to enjoy now - or in April, anyway. Uncle Sam knows that your individual savings are going to be an essential part of your retirement and wants to give you an incentive to participate.

Currently, you have several options for saving for your retirement:

• Joining a 401(k) plan, which is an employer-sponsored plan that takes an amount you determine out of your paycheck or automatically enrolls you to contribute and deposits your contributions into your 401(k) account
• Starting an IRA, an individual retirement account, on your own and determining your contribution amount and schedule on your own
• Joining an IRA-based employer-sponsored retirement plan that takes an amount you determine out of your paycheck and deposits your contributions into an IRA
• Your employer automatically contributes a percentage of your pay to a retirement plan
• If you're a solo entrepreneur, setting up a 401(k) or IRA-based plan that may include either employee contributions, employer contributions, or both

I guess you can open a savings account and put money into that, or stick money under your mattress, but neither of these methods will beat 30 to 40 years of inflation, and the mattress method is open to many hazards - fire, flood, boll weevils, and so on. You also won't get any tax breaks (unless you're hiding money that hasn't been taxed, in which case you'll probably have legal problems to worry about).

The next sections explain both 401(k) and IRA plans.

Getting down to 401(k) basics

When you sign up for a 401(k) plan, you agree to let your employer deposit some of your paycheck into the plan as a pre-tax contribution or as a Roth after-tax contribution or a combination of the two. You put money into your 401(k) plan through a payroll deduction.

Your employer is also permitted to sign you up without your approval, but you have the right to override the percentage you're automatically enrolled to contribute, including totally opting out. Your employer is required to give you advance notice before automatically enrolling you.

The beauty of a 401(k) is that it makes saving easy and automatic, and you probably won't even miss the money you put into your retirement account.

I cover the four types of 401(k)s in this book:

• A regular 401(k) is sponsored by your employer. Your 401(k) is funded by contributions deducted from your paycheck and deposited into your account. Check out the chapters in Part 2 for information about regular 401(k)s.
• Several types of 401(k) serve the self-employed and other small business owners. I go into detail about the following plans in Chapter 19:
  • Safe harbor 401(k)
  • Solo 401(k)
  • Qualified automatic contribution arrangement (QACA) 401(k)

Your employer may set up its own 401(k) or adopt one using a pooled plan provider (PPP) to set up a pooled employer plan (PEP) or become part of a multiple-employer plan (MEP). I cover the different rules for these plans in Chapter 19.

Your employer may throw in some extra money known as a matching contribution. You don't pay federal income tax on any 401(k) money until you withdraw it.

401(k) plans are like snowflakes - each one is unique. If you're looking for a standard 401(k) plan, be aware that there's no such animal. Each company creates its own plan, and some are better than others. Part 2 goes into detail about all the aspects of 401(k)s.

Federal laws govern many aspects of 401(k) plans, but employers are allowed to be more restrictive with their plan rules. For example, the contributions your employer allows may be less than what Uncle Sam permits.

The 401(k) gets its memorable name from the section of Internal Revenue Code (IRC) that governs it. Section 401 of the IRC applies to pension, profit sharing, and stock bonus plans.

A 401(k) plan must satisfy the IRC in both form and operation to be a qualified plan. The rules and regulations governing these plans are massive and complex. Fortunately, your employer deals with making sure the plan you're offered meets IRC standards. You just have to worry about upholding your end of the arrangement, which this book helps you do.

To meet IRC standards, an employer must adopt a lengthy plan document (150 to 175 pages) and have it approved by the Internal Revenue Service (IRS). The document specifies

• Who's eligible to join the plan
• When they're eligible
• How much eligible employees may contribute
• The type and amount of any employer contributions
• When the employer contribution belongs to the participant

Each plan's operation must satisfy all the applicable rules and regulations. This includes legislative requirements enacted by Congress and regulations issued by the governmental agencies that have jurisdiction, which include the Treasury Department, the Department of Labor (DoL), and the Securities and Exchange Commission (SEC). The IRS and DoL conduct audits to determine whether an employer is in full compliance.

Introducing IRAs

An IRA, or individual retirement account, is a tax-advantaged way to save for retirement. This is how the government helps workers save for retirement whenever their employers don't offer a retirement plan.

This book includes information about all the different types of IRAs:

• Traditional IRA
• Roth IRA
• Spousal IRA
• Rollover/Conduit IRA
• Inherited IRA

Head to Part 3 for details about all these IRAs.

The eligibility rules for a pre-tax traditional IRA depend on whether you or your spouse are covered by an employer-sponsored retirement plan. Otherwise, anyone with earned income can open a traditional IRA. (I cover tax issues and tax terms in Chapter 2.)

With a traditional IRA, you can make contributions on your own anytime up to the date you file your tax return and claim a deduction for your contributions. You don't get a tax deduction when you contribute to a Roth IRA.

Both a traditional IRA and Roth IRA are invested at a financial institution you select. Your money grows without being taxed with both types of IRA. All withdrawals from a traditional IRA are taxable, and a 10 percent penalty tax is imposed if you withdraw the money prior to age 59½ for any reason other than those that exclude you from the penalty tax. Withdrawals from a Roth IRA aren't taxable if you follow the rules.

A LITTLE RETIREMENT HISTORY

Did you know that IRAs were permitted long before 401(k)s? What you know as a traditional pre-tax IRA was included in the Employee Retirement Income Security Act (ERISA) passed by Congress on September 2, 1974. That IRAs were included in ERISA is especially surprising because ERISA's primary purpose was to strengthen the defined-benefit pension system.

Originally, you could own an IRA only if you weren't covered by an employer-sponsored retirement plan. If you were covered by an employer-sponsored plan, no matter how many or how few benefits the plan provided, you were not eligible to contribute to an IRA.

For example, you can lose all the benefits you earned under an employer-provided pension plan if you left before completing 20 years of service. Or you may have been a participant in an employer-funded profit-sharing plan by an employer that did not make any contributions to the plan or perhaps only small contributions. The 1981 Economic Recovery Tax Act removed the inequity of such situations resulting in the expansion of IRAs to most individuals who have earned income including those covered by employer-sponsored plans.

The Taxpayer Relief Act of 1997 added an additional option - Roth after-tax IRAs. Another step was to expand the Roth option by adding it to 401(k)s during 2006, giving 401(k) participants the option of making pre-tax contributions, Roth after-tax contributions, or some of each.

The traditional IRA and Roth IRA have income thresholds that make higher income earners ineligible to contribute. Participants in 401(k)s are eligible to make...