Welcome back. During the course of employment,

individuals have opportunities to fund retirement plans,

and invest in individual retirement accounts or IRAs.

In the next set of videos,

we'll examine how these investments work.

In this video, I'll introduce you generally,

to the various retirement plans and investment vehicles available to individuals.

First, broadly speaking, retirement plans can be classified into two groups;

a defined benefit plan and a defined contribution plan.

A defined benefit plan is a retirement benefit that's

based on a pre-determined or predefined formula.

For example, an employer will make it clear that given the number of years you

worked and given the average last three or five years with a salary,

the employer will pay you some defined amount every month in retirement.

Therefore, the benefit is defined and set upon retirement.

This is like a traditional pension plan,

where the employee receives a pension check from the former employer.

Here because the employer is the one promising the benefits,

the employer bears the risk in making sure it

has enough funds to cover the retirement obligations.

Of course the risk is on the employer,

if one assumes the employer will exist in the future.

If an employer goes bankrupt,

and it has promised specific retirement benefits to his employees,

then the employees will suffer greatly because they did

not expect to lose their promised pension.

The second group is a defined contribution plan.

Here the benefits upon retirement are not defined,

but the contribution is defined.

That is, the individual will define how large of

a contribution he or she will put into the retirement funds.

But, the benefits are dependent on how well the employee managed their retirement funds.

This is like a self-directed retirement plan.

The employee contributes to the fund,

the employee manages the investments within the fund,

and thus, the employee bears the risk.

If the employee is savvy or lucky and the investments do well,

the employee might be able to retire early.

If the investments do poorly,

then there is really no other backup provided by the employer.

And so, the employee is stuck with what he or she has upon retirement,

or decides to work longer.

Among other reasons, because the risk of investing is pushed onto the employee,

the defined contribution plan is becoming far more

popular with companies than defined benefit plans.

A specific type of defined contribution plan that's very popular in the U.S.,

is the 401(K) plan.

Here the employer can contribute up to some defined amount per year.

There's also an additional catch up contribution allowed,

that can be added to the base contribution limit if the person is age 50 or over.

The individual's contributions to the 401(K) are pretax,

meaning that a part of the person's wages are directed into the 401(K) directly,

and not included in the person's gross income for the year.

Furthermore, the contributions are 100 percent vested,

meaning they are owned and technically available to

the employee if he or she chooses to access the funds.

Also, what happens is sometimes the employer will

match what the employee contributes to the 401(K).

So for example, for every dollar an employee contributes to the 401(K),

the employer will also contribute

a dollar up to a certain percent of the employee's salary.

Here the employer contributions do not count towards the limits,

and they are tax deferred just like the employee's contributions.

That is, the employee does not have to pay tax

on the contributed portion into the 401(K),

until the employee withdraws the funds.

Also what happens within the 401(K),

is that the individual can invest in a variety of funds,

say stock index funds or bond funds,

or keep the money in cash.

To the extent, there are earnings generated by these funds within the 401(K),

whether due to the employees or the employer's contributions,

the earnings are also tax deferred.

Meaning they grow tax free within the fund,

but they are taxed when the employee withdraws the funds.

So, now lets talk about individual retirement accounts or IRAs.

There are three types of IRAs,

we have traditional or deductible IRAs,

we have nondeductible IRAs and we have Roth IRAs.

Offers talk about traditional or deductible IRAs.

Here is a name with suggests,

contributions into a traditional IRA are deductible.

This means that the taxpayer is basically making

pretax contributions into the IRA and the both the contributions.

And the earnings generated within the IRA are tax deferred,

until the individual withdraws the funds for retirement.

In this broad sense,

the traditional IRA looks exactly the same as a 401(K).

However, where IRAs are different are in the limits.

Here the limits are considerably smaller for IRAs than for 401(K) case.

The limit is the smaller of some amount set by the IRS each year,

doubled if one adds in the spouse,

if the taxpayer is married filing jointly or 100 percent of

combined compensation of the individual and spouse, if there is a spouse.

What compensation means here,

is that an individual can only contribute earned income such as wages into the IRA.

The individual cannot count on earned income like interest and dividends,

towards the combined compensation limit because

interest and dividends are not compensation, but wages are.

Also, the combined part of the combined compensation clause,

allows a working spouse to contribute to

a non-working spouses or little working spouses, spousal IRA.

This effectively does not punish non or

little-working spouses by preventing them from funding a retirement account.

Note as well, the taxpayers over age 50 can make

an additional catch up contribution on top of the base contribution limits.

Now, what might happen is that an employee is both investing in their 401(K) at work,

and also interested in investing in a deductible IRA.

But, this would essentially provide lots of tax benefits to the employee,

because the 401(K) contributions would be escaping taxes in the current year,

as what the contributions to a deductible IRA.

Essentially, both types of plans provide for deductible contributions.

Therefore, what the tax law says is that,

if a taxpayer is an active participant in another qualified plan such as a 401(K),

then the IRA deduction amount is phased out proportionately to the AGI.

This slide shows the limits for the current year.

Notice that for the married filing joint range,

if one spouse is not an active participant

and a qualified retirement plan but the other spouse is,

then the taxpayer can still contribute up to

the limit to the non active spouse's deductible IRA.

In the phase out of that deduction,

begins at a much higher point of AGI.

So, putting a little bit more structure on the calculation.

If a taxpayer there's an active participant falls within the phase out range,

then the nondeductible amount is shown here.

First, the taxpayer sees how much higher is his or her AGI,

then the applicable threshold for the filing status.

Then, the taxpayer divides that excess amount by the range of the phase out.

Then multiply this proportion by the contribution limit.

This will give the nondeductible amount.

Therefore, the deductible amount is the greater of $200 or

that year's contribution limit minus the nondeductible amount calculated above.

If the person's AGI falls below the lower number in the phase range,

then the individual is entitled to the maximum allowable deduction for the year.

If the person's AGI falls above the higher number in the phase out range,

then the individual is not entitled to receive any IRA deduction for the year.

Therefore, the calculation only applies to taxpayers that fall within

the range and that are active participants in another qualified retirement plan.

Finally, note that if the person is

not an active participant in a qualified retirement plan,

then the phase outs are not considered at all.

The taxpayer can get the maximum allowable deduction regardless of AGI.

In all, retirement plans come into general flavors;

defined benefit and defined contribution.

401(K) plans and IRAs are defined contribution plans.

Contributions into these plans are deductible,

earnings grow tax free within the plans,

and taxes are only paid when the funds are accessed by the individual.

If a person has a 401(K) plan at work and has sufficiently high AGI,

then the deduction for the IRA will be phased out.

Note that in a later video I'll discuss

other eligibility requirements surrounding IRAs namely;

age rules and how the IRAs are taxed.

Retirement Plans and Traditional IRAs

Federal Taxation I: Individuals, Employees, and Sole Proprietors

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