Kevin Oleszewski, CFP®, MST, EA, Senior Wealth Planner
Retirement might be fast approaching — leaving you concerned about covering your dream lifestyle. Or it might seem so far off that you’ve decided it’s an issue to think about another day. However, the truth is it’s never too early (or too late) to start saving for your golden years. Not sure where to start your journey? Find out more about two effective classes of investment vehicles that may be right for you.
What to Know About Defined Contribution Plans
The following are answers to some of the most common questions about defined contribution plans. If you have other questions that aren’t answered here, you can contact one of our financial advisors who will help you better understand your options.
What is a defined contribution plan?
Defined contribution plans are employer-sponsored retirement plans that offer tax incentives for both employer and employee. As pensions become increasingly rare, they have been replaced with plans that employees fund themselves, often with matching funds from their employers.
Common defined contribution plans include:
- 401(k) and Roth 401(k)s
- 403(b)s, offered by public schools and some charities
- 457 plans, which are offered to employees of many state and local governments and some nonprofit organizations
How does a defined contribution plan work?
In a defined contribution plan, the employee designates a percentage of their income to be automatically withdrawn from each paycheck and invested for their retirement years. Most plans offer a menu of investment options which participants can choose among.
With a 401(k), an employee funds their account with pre-tax dollars, which effectively lowers their taxable income. For example, if your income is $75,000 and you commit $5,000 to your 401(k), you will only pay taxes on the remaining $70,000. In the future when you take payments from your account, you’ll pay tax on the withdrawals at whatever your tax rate is at that time. 403(b) and 457 plans work similarly.
By contrast, with a Roth 401(k), you make contributions with your after-tax dollars. While that doesn’t lower your tax bill today, it means you’ll withdraw money tax-free when you eventually tap your funds. That can be a benefit if your tax rate is higher than it is now — although, that is an unknown.
One big change is coming in 2025, based on the recently passed Setting Every Community Up for Retirement Enhancement (SECURE) 2.0 Act. Rather than waiting for employees to opt in to a defined contribution plan, employers must automatically enroll employees if they start workplace 401(k) and 403(b) plans. With the automatic enrollment, employees will contribute a minimum of 3% and up to 10% of wages — an amount that increases by 1% per year until they reach at least 10% and not more than 15% of wages — as contributions into the account. Employees may choose to opt out of the auto enrollment or the auto increases, but the hope is that this will spur more consumers to take advantage of this crucial savings opportunity.
What does your employer contribute to your plan?
Defined contribution plans are largely funded by the employee, but in many cases, employers offer to match what the employee has contributed, usually a defined percentage up to a certain amount. For example, they may choose to match half of the first 10% an employee contributes. The great news is that this is essentially “free money.” If you put in 5% of your salary and they match it, you have doubled your money, regardless of market return.
How much can I contribute to a defined contribution plan?
It’s important to note there are limits on how much you can contribute to an employer-sponsored defined contribution plan.
For 2023, the contribution limit for employees who participate in 401(k), 403(b) and most 457s will increase to $22,500. In addition, participants who are age 50 and over can add a “catch-up contribution” of an additional $7,500. Under the SECURE 2.0 Act, catch-up contributions for employees with more than $145,000 in income must be taxed according to Roth rules, which means they would be taxed on the amount when they contribute it, rather than when they take it out.
When can I begin withdrawing from my defined contribution plan?
You can begin withdrawing from your current defined contribution plan without penalty if you leave your employer during or after the year you turn 55. However, if you are trying to access a previous plan, you would need to wait until age 59.5 to avoid a penalty. Otherwise, you’ll owe a 10% early withdrawal penalty, along with the taxes you would otherwise owe.
While those are the ages you can start withdrawing, at age 73 you have to start withdrawing in what’s known as a required minimum distribution (RMD). The amount is determined based on a formula developed by the IRS related to your balance and your life expectancy. (You can find out more and view the worksheets here). Note: The SECURE 2.0 Act removes the RMD requirement from Roth 401(k)s and Roth 403(b)s.
If you don’t withdraw your required minimum, you’ll owe a penalty in addition to the regular income tax. The SECURE 2.0 Act reduces the penalty for missing an RMD from 50% of the amount you were supposed to have withdrawn to 25%, and potentially down to 10% if you correct it by the end of the second year following the year it was due.
What if I need the money in my defined contribution plan now?
Life can be unpredictable, and you might wish you could access the account balance for an emergency you’re facing now. There are some “hardship” exceptions for making a penalty-free withdrawal to satisfy what the IRS calls an “immediate and heavy financial need.” These can include expenses associated with post-secondary education, funerals and medical needs, along with designated costs needed to buy or repair your home or to avoid a foreclosure. Talk with your plan administrator about how to determine if your financial needs qualify.
You can also access your funds as a loan, penalty-free, provided you pay it back within five years (or potentially sooner if you leave your current job). You can borrow up to 50% of your account’s balance, or $50,000, whichever is less. You will also owe interest, but that amount will be applied to your account so it’s as though you are paying yourself.
What to Know About Individual Retirement Plans (IRAs)
Have questions about IRAs? Find answers below. You can also contact one of our financial advisors to learn more about what options might be right for your situation.
What are IRAs?
Individual retirement accounts were created by the U.S. government to encourage people to save for retirement. For that reason, they offer tax benefits similar to a defined contribution plan. There are two kinds of IRAs:
- Traditional IRA – Your contributions are made with before-tax dollars, and you will pay tax on the funds when you withdraw them, much like a 401(k).
- Roth IRA – Your contributions are made with after-tax dollars, which means you won’t need to pay tax when you eventually make withdrawals, much like a Roth 401(k). There are income maximums to be eligible to contribute to a Roth IRA: In 2023 those who are single must have Modified Adjusted Gross Income (MAGI) under $153,000, or $228,000 if married and filing taxes jointly.
Unlike an employer-sponsored plan where contributions are automatically withdrawn from your paycheck, you’ll need to open an IRA on your own with a financial institution or through a financial advisor. Research your fund options to find investment choices that align with your goals and set up a payment schedule.
Many consumers wonder which type of IRA is best for them, and given that investors have different goals, timelines and financial situations, there is not a “one size fits all” best choice. One rule of thumb to consider is that investors currently in a high tax bracket typically realize more tax benefits from a traditional IRA, while those currently in a lower tax bracket typically benefit more from a Roth IRA. However, it’s also important to note that future tax rates are unknown, and today’s marginal tax rates are at historically low levels.
How much can I contribute to an IRA?
You can contribute up to $6,500 to an IRA in 2023, with an extra $1,000 catch-up contribution available to those age 50 and over.
When can I begin withdrawing from my IRA?
As with a defined contribution plan, you can begin making penalty-free withdrawals from your IRA at age 59.5. if you take money out prior to that, you will incur a 10% penalty, along with the taxes you will owe. Again, there are some exceptions, including for a first-time home purchase, unreimbursed medical expenses and some other uses. You can see a complete chart here. And, as with 401(k) plans, you’ll need to start taking RMDs at age 73.
I’m New at Investing: Where Should I Start?
If you’re a beginning investor, the most important thing you can do is start somewhere. The earlier you start investing, the longer the amount has to grow and compound. If nothing else, contribute at least up to an employer match in your defined contribution plan. Then remember to keep a long-term perspective and enjoy the satisfaction of watching your account grow over time.
Want to speak with a qualified professional? A Carson Wealth Advisor can help you think through financial decisions that will help you meet your personal goals. Get matched with a financial advisor today.
Some retirement plans have contribution limitations and tax consequences for early withdrawals. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes. For complete details, consult your tax advisor or attorney.