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Retirement Perspectives

IRAs and DC plans, such as the popular 401(k), have unique tax benefits, and different rules. Understanding both can help you manage your retirement savings 

Behold: $16.9 trillion! That’s the aggregate amount that Americans have saved in IRAs and defined contribution (DC) plans (as of December 2017)—and it is more than half the $28 trillion in qualified assets marked for retirement, according to the Investment Company Institute. A careful comparison between savings options can help during both the accumulation phase and planning for retirement income.

The concept for both retirement options is essentially identical: with an IRA or a DC plan such as a 401(k), investors contribute pretax dollars that grow tax-deferred and aren’t subject to taxation until the proceeds are distributed, while, Roth accounts, are invested with aftertax dollars, with the carrot being distributions that are generally tax free. That, however, is more or less where the similarities end; and some of the rules even may come as a surprise. Further, while some of the differences are benign, in that they will have little impact, others can have a substantial effect on retirement investors.

Here are some key points on what separates IRAs from 401(k) plans:

Exceptions to the Early-Distribution Penalty
Generally, distributions from a tax-advantaged retirement plan prior to age 59½ are subject to both income taxes and a 10% penalty unless an exception applies. Be cautious, however: certain exceptions apply to IRA investors younger than 59½, including distributions to pay for higher education, first-time home-purchase expectation, and payment of medical insurance premiums during unemployment. These exceptions do not, however, extend to 401(k) plans. To further complicate matters, there are exceptions (to the 10% penalty) that apply only to qualified plans, such as a 401(k), including age 55 (separation from service); a qualified domestic relations order (QDRO); and age 50 (separation from service) for certain public safety offices.

Last, there are a number of exceptions (to the 10% penalty) that apply to both IRAs and qualified plans, including death, disability, Roth conversions, Section 72(t) payments, distributions upon age 59½, distributions of basis, and 60-day rollovers,

Tip:  Pre-59½ distributions from a 457(b) plan that are taken in cash are never subject to the 10% early distribution penalty; however, income tax will apply.

Distribution Timing
With regard to 401(k) plans, there are strict rules about when a participant is eligible to take a distribution. A qualifying, or “triggering,” event must be satisfied to take a distribution, such as reaching age 59½, or separation from service, retirement, etc.  In addition, some plans offer the option to take a distribution while employed, referred to as an “in-service” distribution, while other plans offer additional distribution options while employed, such as loans and or hardships. More important, these distribution options are discretionary—meaning that the plan instead will determine if and when such distribution options are available. A distribution from an IRA (including SEP and SIMPLE) by comparison doesn’t require the satisfying of a qualifying event. Instead, an investor can take a distribution at any time, age, or reason, although the distribution generally will be subject to taxation and, potentially, a penalty if taken prior to age 59½, unless an exception is satisfied.

Required Minimum Distributions (Part I)
An IRA owner (including SEP or SIMPLE) must begin taking distributions in the year he or she turns age 70½. It doesn’t matter if the individual continues to work: he or she is still required to take a minimum distribution. Thus, even if the individual is still working for a company sponsoring a SEP or SIMPLE IRA plan, and even if he or she is still making and/or receiving employer contributions because they’re still working, once the individual turns age 70½, he or she must begin taking annual distributions

There is, however, when it comes to qualified plans, an exception that offers certain participants to defer their required minimum distributions. One such exception is commonly known as the “still working exception.” Under this exception, an individual may not have to take a required minimum distribution from his or her 401(k) or 403(b) until 70½ or retirement; whichever comes later if: 1) he or she is still working for the employer sponsoring the plan and 2) the individual is not a 5% owner of the company (sponsoring the plan).

Notably, a “5% owner” is defined as an individual who owns more than 5% of a company. Further, ownership is a family affair. Therefore, the “5%” test looks not just at (an individual’s) personal ownership percentage but also that of certain (not all) other related individuals–which is referred to as attribution.  Although most plans offer the “still working” provision, it is optional. In other words, a plan is not required to include this exception. (Check the Summary Plan Description (SPD) for plan rules.)

Tip: The “required begin date” (RBD) for 5% owners to commence taking their required minimum distributions is April 1 of the year after they reach age 70½, regardless of whether they are still working. The 5% ownership test is a once and done” determination. In other words, an individual’s ownership is cemented in the year he or she turns 70½. Therefore, if an individual is a 5% owner of a company when he or she turns age 70½ and doesn’t qualify for the still working exception, the individual will always be a 5% owner.  This is true even if the ownership percentage decreases to 5% or less, thereafter requiring the individual to begin taking RMDs by April 1 of the year after age 70½ and continue taking RMDs thereafter.

Required Minimum Distributions (Part II)
Many investors own multiple IRAs and or 401(k)s from previous employers. Both account types generally require minimum distributions in the year an investor attains 70½.

RMD rules are clear: For investors with more than one 401(k) account, the annual RMD must be determined and taken separately from each plan. On the other hand, investors who own more than one IRA (including SEPs and SIMPLEs) must calculate the RMD separately for each IRA they own, although they can take the aggregate amount from any one or more IRAs.

Tip: RMD rules for 403(b) accounts mostly follow those of IRAs.  So, if an individual owns multiple 403(b) accounts, he or she is required to calculate the RMD for each account separately, but then can aggregate the accounts (like IRAs) and take the total amount from only one of the accounts, or spread the distribution among multiple accounts. Also, 403(b) funds accumulated (prior to 1987) do not have RMDs until age 75. However, account balances must have been  separately tracked by the 403(b) provider or employer.

Required Minimum Distributions (Part III)
While RMDs generally must begin the year an investor turns 70½, Roth IRAs are another exception to the rule.  A Roth IRA account owner or surviving spouse is never subject to RMDs, but a Roth IRA inherited by a non-spouse is.

Although Roth IRAs are not subject to lifetime RMDs, Roth 401(k) (including 403(b) and 457(b)) funds are subject to lifetime minimum distribution rules. That being said, it is possible to avoid depleting designated Roth accounts due to minimum distributions. How? In the year a participant reaches 69½ or earlier (not 70½), he or she could move their Roth assets to a Roth IRA. Of course, the individual can move Roth plan assets to a Roth after 70½; however, he or she would be subject to a RMD first.   

Qualified Charitable Distributions (QCDs)
This popular option allows an IRA owner or beneficiary who is age 70½ or older to distribute up to $100,000 annually from his or her IRA and donate it to a public charity on a tax-free basis. The distribution satisfies the annual minimum distribution, and is excluded from taxable income. However, the amount is not eligible for a tax deduction.

QCDs, however, do not apply to 401(k)s or any other qualified retirement plan. (For more on QCDs, click here.)

Beneficiary Designations
Government rules allow an investor to name virtually anyone as a retirement account beneficiary, including, spouse, family, friends, a charity, trust, estate, or any combination thereof. However, married workers participating in ERISA covered, employer-sponsored plans, such as a 401(k), must name their spouse as their sole primary beneficiary. But a spouse can be removed and replaced (as beneficiary) so long as he or she waives his or her rights in writing.

IRA beneficiary rules, by comparison, allow an account owner to name anyone as beneficiary, regardless of marital status, unless the individual resides in a community-property state (Washington, California, Texas, Wisconsin, Louisiana, Iowa, Arkansas, Idaho, and New Mexico).

Recharacterization
Everyone, regardless of income and/or age, is permitted to convert retirement assets to a Roth account.  Investors have the option of converting IRA funds (including SEP or SIMPLE) to a Roth IRA. In addition, investors can (if the plan allows) convert 401(k) plans funds to a Roth 401(k) account (called an “in-plan” Roth rollover).

Virtually all custodians allow IRA dollars to be converted to a Roth IRA, whereas with an in-plan Roth conversion, participants can move (roll over) some or all of their funds to a designated Roth account, such as a Roth 401(k). And just like a Roth IRA conversion, the in-plan Roth rollover would be subject to taxation in the year of the conversion. Unlike a typical Roth IRA conversion, though, a 401(k) plan must include a provision allowing for the in-plan rollover.

Interestingly, assuming a participant had a choice between an in-plan Roth 401(k) conversion and a Roth IRA conversion, only Roth IRA funds could be recharacterized, or reversed thus eliminating the tax liability. There is no comparable option for an in-plan Roth conversion. In other words, the decision to convert is irreversible.

The Tax Cut and Jobs Act of 2017 changed the dynamic by repealing the ability to recharacterize Roth IRA conversions, thus placing Roth IRA and Roth 401(k) in-plan conversions on equal footing.

Tip: Although, effective January 1, 2018 Roth recharacterizations have been eliminated, this  change does not affect Roth contributions. In other words, an individual still has the option to recharacterize Roth contributions (to a traditional IRA) or vice versa (traditional IRA to a Roth).

Roth Conversion (Inherited Accounts)
Here is another quirky rule: a non-spouse that inherits a traditional IRA (including SEP and SIMPLE) is prohibited from converting the inherited IRA to a Roth IRA. However, a non-spouse that inherits an employer plan, such as a 401(k) or 403(b), can convert those funds directly to a Roth IRA. However, the funds must be transferred directly from the employer plan directly to a Roth IRA via a trustee transfer.

Rollovers
It’s common knowledge that 401(k) investors, upon separation from service, can roll over their funds, tax free, into an IRA. Although not nearly as common, an IRA owner can “roll in” their traditional IRA assets (including SEP) into an employer sponsored plan, such as a 401(k) or 403(b)—if the plan allows, which most plans do.

One of the many rollover nuances that many may not realize is that you are never permitted to rollover aftertax dollars (basis) from an IRA into a qualified plan. Instead, the tax code only allows for pretax dollars to be accepted by a qualified plan. Still, an individual can rollover aftertax funds from a 401(k) or qualified plan to an IRA, although the best option is usually to convert the basis from a qualified plan directly into a Roth IRA.

Tip: The Protecting Americans from Tax Hikes Act signed in December 2015 allowed, for the first time, SIMPLE IRAs to accept rollovers from other types of retirement plans (e.g., IRA, 401(k), 403(b), etc.) two years after the first funds have been deposited into  a participant’s SIMPLE account.

Under prior rollover rules a SIMPLE IRA was prohibited from receiving funds from any other retirement plans other than another SIMPLE IRA.

Distribution “Ordering Rules”
One of the biggest benefits of owning a Roth account is that the funds grow tax-deferred and are distributed tax-free if certain requirements are satisfied. This tax-free treatment (of earnings) is known as a “qualified distribution”; it requires that: 1) the distribution occurs after age 59½, death, or disability, and 2) the account has been held for five calendar years.

What happens if a Roth distribution is nonqualified? Here is where it gets tricky.

Distribution of Roth IRAs are “basis first,” thus the distribution of contributions is considered a return of principal and not subject to taxation and or penalty. However, Roth 401(k) distributions follow a different set of rules. Here, distributions are taken pro rata. That means an individual has to determine which portion of the distribution is derived from contributions rather than earnings. The portion representing contributions would be tax-free, while the portion of the distribution representing earnings would be taxable and potentially subject to the 10% penalty.

Taxes: Timing Varies
Distributions from tax-advantaged retirement accounts are usually subject to federal income taxes. Interestingly, IRA distributions are not subject to any required federal tax withholding, whereas a mandatory 20% federal tax withholding applies to 401(k) distributions that aren’t rolled over but instead are paid out to the investor.

Divorce
Upon getting divorced, the former spouse receives qualified plan assets, such as a 401(k) via a QDRO. Interestingly, QDROs do not apply to IRAs. Instead, IRAs would be split via a divorce decree.

(For more detail, see my column on how to correctly split retirement assets upon divorce.)

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.

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