IRAs, 401(k)s and More: Making Sense of the Alphabet Soup of Retirement Accounts
Consumers and small business owners are fortunate to have a variety of retirement savings opportunities available to them — from IRAs and SEPs to 401(k)s and 403(b)s — that can be used to save for retirement and save on some taxes. These options are especially important now that traditional pensions and other employer-funded retirement plans have become increasingly rare. One big challenge, though, is determining which retirement savings vehicles may be right for you.
"Every day, the FDIC receives questions from individual consumers about the deposit insurance coverage of their retirement accounts but they also have important concerns about tax issues and other matters," noted Martin Becker, an FDIC Senior Deposit Insurance Specialist. "It's clear that many people would appreciate and need help understanding fundamental concepts regarding retirement plans, which could be their most important savings for their future."
While the FDIC can't advise you on where to put your money, we can help you understand the basic characteristics of different types of retirement options available from banks and other institutions so that you, perhaps in consultation with a financial or tax advisor, can make the right choices.
Here are a few issues to consider for the most common types of retirement plans that are self-directed, meaning that the consumer chooses how and where the money is deposited or invested. (Note: We use "retirement plan" to refer to one of several types of savings programs offered by a financial institution or an employer, and "retirement account" for an individual's funds within a retirement plan.)
In general there are two kinds of self-directed retirement plans: those that are tax-deferred and those that are after-tax.
Tax-deferred retirement plans, which include traditional Individual Retirement Accounts (IRAs) and employer-sponsored 401(k)s, allow you to reduce your taxable income by the amount of the deposits or investments made each year. "That's the main advantage — your contribution reduces your income tax bill for that year," explained Calvin Troup, a Senior Consumer Affairs Specialist at the FDIC. "In addition, you hope that the account will increase in value over the years through appreciation and any interest or dividend earnings, and that growth would be tax-deferred. Another advantage with IRAs and other self-directed plans is you have a say as to where your funds will be invested."
Tax-deferred retirement accounts may be best suited for people who anticipate their income tax rate will be lower after retirement than before retirement. What's the disadvantage of tax-deferred retirement plans? "As the title implies, taxes must be paid at some point in the future," said Troup.
And by law, you must start paying taxes on the funds you withdraw from the account. Withdrawals after age 59½ are taxed as ordinary income and are not subject to the 10 percent tax penalty imposed on early withdrawals (those taken before age 59½). For many people, withdrawals usually start April 1 of the year following the year in which they turn 70½ years old, which is when a "required minimum distribution" (RMD) must be taken.
After-tax retirement plans, which include Roth IRAs and employer-sponsored Roth 401(k)s, enable a consumer to make contributions using after-tax dollars. This means the consumer has already paid income taxes on the funds that will be used for the deposits or investments. "However, one advantage is that, if certain conditions are met, you will not have to pay income tax on withdrawals, so your interest or dividend earnings and the appreciation in the account will grow tax-free," Troup said. And what could trigger income taxes on withdrawals? Common examples include the IRA owner taking distributions prior to age 59½ or a beneficiary not following Internal Revenue Service requirements for distributions after the account owner's death.
Another advantage of after-tax retirement plans is that there is no requirement that you have to take distributions when you reach 70½. That flexibility makes these plans good for estate-planning purposes because it's possible to build a large sum of money to leave to beneficiaries and heirs without them having to pay taxes on that money.
Roth IRAs and other after-tax retirement accounts make sense primarily for consumers who (a) expect that they will be in a higher tax bracket in retirement, so that it is more advantageous to be taxed on their contributions before they retire instead of on their withdrawals later, or (b) want to use these accounts for estate-planning purposes, meaning to leave funds directly to their children and other beneficiaries.
Ways to Invest
Both tax-deferred and after-tax retirement plans also provide you with the opportunity to widely diversify the assets in your account. "Many financial planners suggest adding stocks and mutual funds to your retirement mix, which can provide opportunities for growth, and adding bonds to provide income. But remember, these investments can increase and decrease in value and they are not protected by FDIC insurance against loss, even if they are purchased from an insured banking institution," Troup said.
"One common strategy that financial advisors also recommend," he added, "is to invest a large percentage of your retirement funds in growth-oriented stocks and stock mutual funds early in your working years, and then start moving the funds to more conservative, income-generating investments, such as bonds, bond mutual funds, and insured bank certificates of deposit (CDs), as you get closer to retirement."
Deposit Insurance Coverage
As Becker noted, "Retirement funds that you want to be safe and secure can be placed in CDs or other interest-bearing deposit accounts at FDIC-insured institutions." The deposit insurance coverage is up to $250,000 for the combined balance of all self-directed retirement accounts owned by the same person in the same insured bank.
Here are some key points to remember: First, adding beneficiaries does not increase the maximum deposit insurance coverage of $250,000 for self-directed retirement accounts.
Also, when an IRA depositor passes away, if the account continues to be held in the name of the deceased depositor (in accordance with IRS rules), that money will continue to be separately insured from any IRA deposits at the same bank that were established by any beneficiaries. For example, if Jane Smith has an IRA naming her daughter Sally as the beneficiary, and Jane dies, that money will be insured separately from any retirement accounts that Sally has established at the same bank provided that the mother's account continues to be held as an IRA in Jane's name.