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Not that long ago, after 25 or 30 years of working for one employer, you could expect to be rewarded with a consistent monthly stream of income lasting the length of your retirement. However in the early 1980’s those guarantees, which came courtesy of Pension Plans (or Defined Benefit Plans), began to change and are now mostly a thing of the past for most private sector employees.
Today, if you have the opportunity to participate in a workplace retirement plan, then you're more likely to be the proud owner of a Defined Contribution Plan (more commonly known to participants as either 401(k), 403(b), or 457(b) plans). This shift away from the traditional Defined Benefit Plan to today's more common ‘Defined Contribution Plan’ effectively shifts the responsibility of saving for your retirement from the employer to the employee.
In fact today, workplace retirement defined contribution plans are responsible for a significant amount of retiree savings in the United States.
If you’re one of the many Americans that has an employer-sponsored defined contribution plan, then understanding the intricacies around the rules related to contributions, withdrawals, & investments is paramount to maximizing the value this benefit can provide to you and your family.
Here are some common questions about workplace retirement accounts every soon-to-be-retiree should be seeking answers to:
A very common concern for my empty nester clients is the sudden feeling that they are behind as a looming retirement draws closer. Often they feel they simply started too late and they no longer can get those savings years back.
The good news is the Internal Revenue Service (IRS) has pretty liberal rules governing how much you can contribute through your paycheck withholding into your workplace 401(k) retirement account each year.
This amount is updated periodically to keep pace with inflation and increases in the cost of living. For 2022, the IRS raised the limit on salary deferrals to $20,500 for defined contribution plans.3
But did you know that once you turn 50, there is a special “catch-up” contribution rule that lets you contribute even more? The IRS allows you to place an additional $6,500 into your account, on top of the standard $20,500. That means you can potentially have $27,000 of your compensation withheld from your paycheck for your retirement account each year. 4
If you feel like you’ve been slacking on retirement savings, then catch-up contributions allow you to do just that — catch up! Even if you’ve been diligent with your retirement savings, this offers a great option to help beef up your savings with an extra cushion.
Many pre-retires have a tax ‘imbalance’ in their retirement savings. It’s not uncommon for near-retirees to have most of their retirement savings in tax-deferred accounts. In fact most of the retirement funding vehicles available during your working years were probably tax deferred, and all of that will eventually be taxable when drawn upon during retirement. The problem is this imbalance can create some unintended tax issues for you down the road.
One strategy to reduce this tax risk is to better diversify your retirement accounts now by funding a Roth 401k. You might be thinking, this sounds great, but I am already funding a Roth IRA and there is a limit to how much I can contribute. This is a common misconception about Roths. The good news is contribution rules for funding your Roth IRA has no impact on funding your Roth 401k, they are two completely separate plans.
An even better strategy is to use the ‘catch-up contribution’ rules available to those over the age of 50! You will be able to sock away even more to the highly coveted Roth 401k. Using this catch-up provision will help you quickly work toward a more balanced pool of retirement sources to draw upon when supplemental income is needed during retirement.
Even if you’re the most dedicated employee, you’ve likely held more than one job throughout your working career. In fact, according to data from the Bureau of Labor Statistics, people born between 1957 and 1964 have gone through nearly 12 jobs on average over their lifetime.5
Multiple jobs often means multiple retirement accounts. Rather than keeping track of separate plans simultaneously, it may be possible to consolidate those prior plans into one retirement account. In some cases, you may even be able to roll those previous plans into your current employer-sponsored retirement plan.
Make sure to do your homework before making that decision, however. Plans may sound somewhat standardized, but costs and tax obligations between plans can vary and you will want to compare costs with the features and benefits of these options before you make any decision.
The most significant benefit of consolidating your accounts is simplifying your financial life. There will be one account to monitor and access, change investments, rebalance your portfolio, or satisfy required minimum distributions (more on that later).
A similar consideration to consolidation is whether you should leave your retirement plan in place through your employer (even after you retire) or roll it over into an IRA.
Again, convenience is something you should consider. An IRA can sometimes be easier to manage and get professional help with than an employer-sponsored retirement account.
You’ll also likely have access to a more comprehensive selection of investment options through an IRA. How big of a benefit this will be, depends on what is available in your workplace plan. Again, be sure to due your homework.6
If you’re considering a rollover, take a look at the fund choices in your employer’s plan. Consider whether the options available allow you to create a properly diversified portfolio. If you aren’t satisfied with the limited investment choices with your workplace, then rolling over to an IRA could be a way to expand your options.
Some additional considerations to ponder when making this decision are:
Another factor to help you determine if a rollover makes sense is the plan's fees. You will need to do your homework here as well, but your employer is obligated to disclose all the relevant retirement plans costs when you ask for them. Then compare that with what it would cost to move it into a self directed IRA or new employer 401k plan. If the costs in your old employer-sponsored plan are especially high compared to what you could do elsewhere, this should be a strong consideration in your decision to roll out your old retirement plan.
As you approach retirement, it’s also a good time to start thinking about how your tax bill will look once you start taking withdrawals from your accounts.
As I indicated earlier, tax deferral is a nice perk when saving with a workplace plan. But if all your money is in tax-deferred accounts, then every dollar you withdraw is subject to taxation. You’ll be at the mercy of the IRS and changing tax laws throughout retirement.
Roth conversions are another way to protect yourself from potentially higher taxes in the future. With a Roth conversion, you simply take a portion of your traditional retirement account and roll it into a Roth IRA. While you’ll owe taxes on the converted amount, your funds can continue to grow tax free. When you’re finally ready to withdraw, you can do so entirely tax-free as well.7 Note, you may need to maintain the Roth IRA for at least five years and meet other requirements.
Unlike Roth contributions, there is no limit on the amount you can convert.8 But be cautious not to push yourself into another tax bracket. One common recommendation is to “fill up” at least the minimum tax bracket you expect to be in during retirement. For example, if your Social Security and tax-deferred withdrawals will place you in the 24% tax bracket, then it may make sense to convert enough to get you to the top of that bracket.
You don’t have to delay your Roth conversions until you retire, either. If you are in the same or lower tax bracket now as you will be in retirement, it may make sense to start annual conversions right away. As long as you deposit the money you remove from your workplace plan into a Roth IRA within 60 days, then it is not considered a withdrawal, so you won’t be subject to the 10% penalty if you are under 59½.
The IRS requires you to withdraw a ‘minimum’ amount from your tax-deferred retirement accounts every year starting the year you turn 72 — this is known as your required minimum distribution (RMD).9 This required amount is loosely based on your life expectancy and designed so you withdraw the remaining balance by the time of your expected mortality age.
Required Minimum Distributions (RMD’s) is the IRS way to make sure they eventually get their tax dollar and prevent you from leaving tax deferred accounts growing forever into future generations. The IRS offers an RMD Worksheet that can help you calculate your necessary withdrawals.
Please take RMD rules seriously because penalties are steep. Failure to take your RMD each year results in a 50% tax on the amount you should have taken but didn't.10
There’s IS good news: The RMD rules apply to both traditional and Roth 401k’s, but not to Roth IRAs.11 That means a Roth IRA conversion might also be your biggest tool to reduce your required withdrawal amounts later. Any money you move from your workplace retirement plan to a Roth IRA not only grows tax-free but is also protected from the RMD rules.
Some companies offer the benefit of employees owning stock in the employer company. If you have been granted company stock as part of your compensation, make sure you understand what you have, how they vest, and how they impact your taxes.
Most of the time these shares of stock are held inside a tax qualified retirement plan. Once retired, distributions from these tax-deferred accounts are treated as ordinary income, including all of the company stock value.
The problem is, if the stock were held outside a tax deferred retirement plan, investors would only have to pay tax at the much lower long term capital gains tax rates. To remedy this issue, the IRS offers an exception called NUA (Net Unrealized Appreciation). This allows for employer stock inside retirement plans to be taxed at the more favorable capital gains rate.
In short, the net unrealized appreciation (NUA) is the difference in value between the average cost basis of shares of employer stock and the current market value of the shares. Most participants are not going to know how to navigate these rules on their own and should seek professional advice from their accountant or financial advisor.
Understanding how to take advantage of your workplace retirement benefits can make a dramatic difference in your retirement plan. Educate yourself, stay informed, review regularly, and work with a professional. Now is the time to get serious about planning, and working with an experienced retirement advisor can help you be prepared for retirement ahead of time.
To learn how retirement planning can help ensure a smooth transition into and through retirement, watch for additional posts and planning tips in the weeks ahead, or contact us any time to discuss your planning needs.
In February 2022, the IRS issued proposed regulations that interpret the revised RMD rules. Unless these proposals are amended, some beneficiaries could be subject to annual required distributions as well as a full distribution at the end of a 10-year period. Account owners and their beneficiaries may want to familiarize themselves with these new interpretations and how they might be affected by them:
At first glance, automatic enrollment sounds like a no-brainer. Without doing anything, you're on your way to saving for retirement. But don't just assume that the investment decisions your employer has made on your behalf are right for you. Instead, take charge of your own retirement savings right now by following these four steps.
When saving for retirement, it often makes sense to contribute to employer-sponsored retirement plans to take advantage of any available employer match opportunities. However, not everyone has access to an employer-sponsored plan. Even if you do, there are reasons you may want to consider using Traditional and/or Roth IRAs to supplement your retirement savings.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal advisor.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.