Contributions to tax-deferred retirement accounts are made with pretax dollars resulting in a lower income that is subject to tax. No taxes are paid until the money is withdrawn, which typically occurs during retirement age. At that time many investors are in a lower tax bracket. Several types of tax-deferred retirement accounts exist, and understanding the eligibility requirements and rules of each account can help you better plan for your retirement.
A common type of tax-deferred retirement account is a traditional 401(k). To participate in a traditional 401(k), you must enroll in a plan offered by your employer. The plan is backed by underlying assets made available to you by your employer.The contributions made into your 401(k) plan are deducted from your paycheck on a pretax basis. Your employer can also contribute to your retirement account. The contributions deducted from your paycheck are not subject to income tax, but you must pay Social Security and Medicare taxes on them. You must abide by the contribution limits established by the IRS.
Employees who work for nonprofit organizations covered under section 501(c)(3) of the Internal Revenue Code can possibly take advantage of a 403(b) retirement plan. This plan is also referred to as tax-sheltered annuity plan. The IRS prohibits you from setting up a 403(b) account. Only eligible employers can establish accounts on their employee’s behalf. Three types of contributions exist for this retirement account – elective deferrals, non-elective contributions and after-tax contributions. Elective deferrals are approved contributions taken from your paycheck by your employer. Non-elective contributions are made by your employer and are not taken from your paycheck. After-tax contributions are made after income taxes are taken from your paycheck. You must report the income on your tax return. The investment options for a 403(b) plan are limited compared to other retirement accounts.
IRC 457(b) Plan
Certain state and local government entities as defined in IRC 457 and nonprofit organizations as defined in IRC 501 can offer employees the ability to contribute to an IRC 457(b) plan. This retirement account is considered a non-qualified, tax-deferred plan. A non-qualified account is any plan that does not fall under the Employee Retirement Income Security Act.
You can establish a traditional IRA without the sponsorship of an employer. According to the IRS, you are able to deduct your contributions in full if you are not covered by an employer-sponsored retirement plan. The maximum amount you can contribute to your IRA each tax year is regulated by the IRS, with a higher maximum contribution limit for those aged 50 and over. You cannot make additional contributions above the limits without facing a 6-percent excess contribution tax. You are required to take distributions at age 70 1/2, but you can start receiving approved distributions as early as age 59 1/2. You can withdraw money at any time from your IRA but you will incur a 10-percent tax penalty on unapproved early withdrawals.
Video of the Day
- Internal Revenue Service: 401(k) Resource Guide – Plan Participants – Limitation on Elective Deferrals
- Internal Revenue Service: 401(k) Plans
- Internal Revenue Service: Retirement Topics – IRA Contribution Limits
- Internal Revenue Service: IRC 457(b) Deferred Compensation Plans
- Internal Revenue Service: 403(b) Plan Basics