Qualified Retirement Plans (QP’s) are the most common form of Savings in America. They’re the one thing that it seems like most people do. So since most people are involved in them, they must be great, right? Aside from the fact that they don’t seem to be working for most people, many of our clients decide that there are a lot more disadvantages to advantages within these plans once they better understand them. At the same time, there are sometimes some distinct advantages. So we’re now going to spend some time investigating those.
First we should explain what QP’s are. The US government has a plan for your retirement and these are that plan. Individual Retirement Accounts (IRA’s) are the most basic form of this plan. The idea is that money goes into these accounts before it is subject to Income Tax. The account itself is a trust that is jointly owned by you and the US Government. Neither of you can access it without the other’s involvement. Once money is distributed from the plan, it will then be subject to the tax that you were trying to avoid. Current law states that, in most cases, to do so before 59 ½ would be with a 10% penalty, but on the other hand, you must begin taking withdrawals by age 70 ½. As with all tax law, these things can change.
Some people think that an IRA is itself an investment, but this is not the case. All of the different forms listed below are simply tax language that Congress and the IRS have set up to distinguish the different types of plans. Within the plans themselves, the money can be saved or invested within any type of vehicle allowable by that particular plan and administrator. Because you (as the Saver/Investor) are usually introduced to the prospect of Saving/Investing into this plan by an administrator or someone affiliated with one, your options are usually much more limited, but again, this is usually due to the constraints set forth by the administrator more than by the US Government. Although they do have some of their own constraints, they cast a much wider net.
Let’s look at the most common types of QP:
401K – The most common type for those working at larger companies. This is a plan that your company sets up with an administrator as an employee benefit. Some companies will offer a match to your contributions.
403B – This is very similar to a 401K, but is the tax code for those working for schools, churches, etc.
SEP, Simple, KEOGH – These are retirement plans set up by small business owners. You might have started one as a business owner, or been able to participate if you worked for a company that offered this type of plan.
Traditional IRA – The are usually encountered at local bank branches and are the easiest to set up as an individual. (We’ll discuss Roth IRA’s which work differently later on.)
Rollover IRA – These are set up when rolling from another plan (such as an employer sponsored plan) to a new vehicle with gives you more control over your investment options.
These are different names, but the tax rules that apply are basically the same for each. We’ll get into the advantages and disadvantages of each in the days ahead.
Photo credit: Paul Tillinghast