Additionally, investors should always plan for the effect inflation can have on their purchasing power over time. The government has created several retirement plans to help lessen the impact of inflation on assets, and to help investors achieve their retirement goals. Most of these plans are tax-deductible and tax-deferred.

The government has also recognized the need for college savings plans. As inflation erodes retirement savings at roughly 2-4% per year, the cost of a four-year undergraduate program has steadily risen at a rate of 5-6% or more per year. While college savings plans help to alleviate costs associated with college, they also provide investors with several other incentives. Before discussing these, we will first take a look at the different types of retirement plans.

EMPLOYER-SPONSORED RETIREMENT PLANS

The two main categories of employer-sponsored retirement plans are qualified and non-qualified. Both follow the guidelines of the Employee Retirement Income Security Act of 1974 (ERISA). ERISA is also known as the Pension Reform Act. Although it regulates most employee benefit plans and non-pension based personal retirement plans, its main function is to protect retirement plan participants against the abuse and misuse of funds. ERISA outlines several basic tenets.

Fiduciary responsibility describes a fiduciary's duty to strictly monitor and responsibly manage the assets, plans, and investments of his clients. The fiduciary must follow stringent rules and always act in the best interest of his clients.

Eligibility describes the ability to be able to participate in a plan. Age and years of service with the same employer are two huge factors that determine eligibility. Qualified retirement plans cover all employees who are 21 and older if they have worked for the employer for at least two years {one year for 401(k) plans}. However, if the plan requires employees to work more than one year to be eligible to participate in the plan, then the plan cannot require the employee to complete more than two years of service before he is 100% vested. Employees under age 21 or who have not completed the required number of years of service may be excluded from participating in the plan. Otherwise, they must be allowed to participate.

The years of service requirement is established by the retirement plan, but it cannot exceed two years. In other words, the employer can choose if he wants an employee to work from zero to two years before becoming eligible to participate. If an employer chooses a requirement of one year of service or less, he can choose to have the contributions vested over time (within the statutory limits). If the employer chooses an eligibility service of more than one year, all contributions must immediately be 100% vested.

Vesting states that all plan participants must be fully vested after three years of employment. Otherwise, they must be 20% vested after three years and 100% vested after six years.

Communication requires that a retirement plan must be available for review in writing, and employees must receive regular information on plan benefits, vesting procedures, account status, and availability. Most companies adopt a template plan designed by a financial institution or investment company that meets the ERISA and IRS standards.

QUALIFIED EMPLOYER-SPONSORED RETIREMENT PLANS

Under a qualified employer-sponsored retirement plan, all contributions grow tax-deferred. Employees are not taxed on income, dividends, or capital gains within the plan until they begin taking distributions from it. In addition, an employer may deduct all contributions that are made to the plan on behalf of its employees. Qualified employer-sponsored retirement plans can be established as either defined-benefit or defined-contribution.

Defined-benefit plans are rare today. A defined-benefit plan provides a fixed monthly income to the employee at retirement. The monthly amount is determined by the employee's length of service, age, and annual salary. The employer is responsible for financing the plan and bears all the investment risk if its assumptions fall short of the mark. The employer is obligated to pay the employee's defined-benefits no matter how successfully it financed the plan.

Defined-contribution plans have become the norm in the last decade. Since employees contribute to this type of plan, they bear all the investment risk. An employee's retirement benefits depend on the amount he has contributed to the plan. The benefits also depend on the performance of the chosen investments within the employee's account. The three most common defined-contribution plans are 401(k) plans, 403(b) plans, and profit-sharing plans.

The 401(k) plan is the most common type of defined-contribution plan. It allows an employee to make contributions (before tax) from his paycheck into the plan. The employee decides which investment choices to make from a list of mutual funds or employer stock. These contributions grow tax-deferred until the employee starts taking distributions from the account. While employees are always fully vested in their own contributions, the employer does have the option to establish a vesting schedule for matching contributions. 401(k) plans have annual and "catch-up" contribution limits. Contribution amounts are indexed for inflation. As of 2016, only $18,000 may be contributed to the plan each year, and catch-up contributions up to $6,000 are allowed.

Although similar to the 401(k) plan, the 403(b) plan is exclusively for employees of certain nonprofit organizations with tax-exempt status (i.e. public schools, state colleges and universities, churches, hospitals, etc). 403(b) plans have the same tax advantages and eligibility requirements as 401(k)s. A 403(b) plan is also called a tax-sheltered annuity (TSA) because participants are contributing to annuities or mutual funds.

Profit-sharing plans were established to reward employees for their roles in making a business profitable. An employer has the option to contribute to the plan, depending on how well the business is doing. During trying years, the employer might not contribute at all to the plan. During a profitable year, the employer might contribute a certain percentage to the plan. The contribution percentage is determined at the plan's inception. Employers may deduct any contributions made up to a maximum of 25% of the employee's salary or (as of 2017) $54,000 per year (whichever is less).

Although 401(k), 403(b), and profit-sharing plans are the most common, there are still other employer-sponsored plans that exist.

A simplified employee pension is known as a SEP or a SEP IRA (individual retirement account). A SEP IRA is a simpler alternative to the profit-sharing plan. SEP IRAs are easy to establish and run. Employers may also change their contribution amounts from year-to-year. The annual contribution limit is the same for the SEP as the profit-sharing plan. Under SEP rules, the employer must include all employees who are 21 and older. The employer must also include employees who have worked with the company for three to five years. An employer may contribute up to 25% of the employee's salary or (as of 2017) $54,000, whichever is lowest, to the employee's individual SEP IRA account.

A savings incentive match plan for employees is known as a SIMPLE plan or a SIMPLE IRA. These plans are available for any small employers with 100 or less eligible employees (who make at least $5,000 per year), as long as the employer does not sponsor any other retirement plans for its employees. The SIMPLE contributions may be made either to an IRA or a 401(k). SIMPLE plans also have annual and "catch-up" contribution limits. For participants older than age 50, catch-up contributions up to $3,000 are allowed as of 2015. Additionally, the employer must contribute either a matching amount up to 3%, or a non-elective contribution of at least 2%. In accordance with their name, SIMPLE plans are low-cost, and require much less paperwork and administrative testing than other employer-sponsored retirement plans.

Like 403(b) plans, 457 governmental plans are available to governmental organizations (state, county, and municipal employers). With 457 plans, employees make contributions via salary deferral. The maximum salary deferral limits are the same as the 401(k) limits.

Keogh plans (originally called HR 10 plans) were introduced in 1962 to give tax-deductible retirement benefits to self-employed individuals and owner-employees of unincorporated businesses or professional practices. As with all qualified plans, only earned income can be considered for contribution eligibility. So, if a business is not profitable, no contribution is allowed.

A self-employed individual can contribute to a Keogh plan even if he is also an employee of a corporation with a qualified employer-sponsored retirement plan. However, the employee can only base his contribution amounts (to the Keogh plan) on the income from his self-employment activities.

Employees of a self-employed person who participate in the Keogh plan are subject to the following eligibility rules:

•must be 21 or older
•must have completed one or more years of continuous employment or have been employed on a continual
  basis from the date the plan began (if less than three years has elapsed)
•must be fully vested in employer contributions if has worked for five years
•must receive compensation for at least 1,000 hours of work per year (if full-time employee)
•maximum contribution of 25% of self-employment earned income or (as of 2017) $54,000 (whichever is less)

WITHDRAWAL RULES FOR QUALIFIED RETIREMENT PLANS

The taxation on withdrawals is similar to that of an IRA. Withdrawals before age 59 1-2 are subject to ordinary income taxes and a 10% tax penalty. There may be an exception to the 10% penalty if one of the following occurs:

• The taxpayer becomes disabled
• The employee retires after age 55 (applies only to withdrawals from the current company's plan, not a previous
  employer's plan and not an IRA)
• The employee needs money to cover medical expenses that exceed 7.5% of adjusted gross income
• The withdrawals are made during a divorce as part of a "qualified domestic relations order" (QDRO)
• The withdrawals are made in a series of "substantially equal periodic payments" (SEPP) over the course of the
  owner's life expectancy
• The beneficiary withdraws funds from the plan after the employee's death


Funds in a qualified retirement plan may be transferred or rolled over to another retirement plan or IRA without taxation. In a direct transfer or rollover, the money is sent directly from the custodian of the plan to the custodian of the new plan. No income taxes are withheld. However, if the employee withdraws the funds directly, there is a mandatory 20% income tax withholding. So, if the employee chooses to roll the funds over to another plan, he should have the money to deposit that additional 20%. Otherwise, he must pay taxes on the 20% that was not rolled over. He will also have to pay the 10% tax penalty if he is under the age of 59 1/2.

DISTRIBUTION RULE FOR QUALIFIED RETIREMENT PLANS

The IRS states that qualified plan and IRA distributions must begin by April 1 the year after a person turns 70 1/2. This is the required minimum distribution rule. The amount that must be withdrawn is calculated by dividing the account balance by the life expectancy factor. A 50% tax penalty will be applied to plans that are not withdrawn by age 70 1/2. The minimum distribution rule does not apply to people who are still working. This applies only to their current employer's plan and not a previous employer's plan or an IRA).

NON-QUALIFIED EMPLOYER-SPONSORED RETIREMENT PLANS

Non-qualified employer-sponsored retirement plans are not required to meet specific guidelines regarding contribution limits, vesting, and employee coverage. However, contributions to these types of plans do not grow tax-deferred. The two types of non-qualified employer-sponsored retirement plans are deferred-compensation and payroll deduction.

Deferred-compensation plans are contracts between employers and certain employees. An employer agrees to pay a certain amount of compensation to an employee at retirement, termination, disability, or death. A deferred-compensation plan can be funded or unfunded. Funded plans are backed by specific employer assets that are not accessible to creditors, while unfunded plans are backed only by the promise of the employer.

A payroll deduction plan is a product-purchase service set up by an employer to provide his employees with cheaper life insurance, mutual funds, variable annuities, and other benefits. An employee purchases these special products and services by deducting them (after-tax) from his paycheck. An employer might match a certain percentage of an employee's contributions, but is not required to do so.


TRADITIONAL AND ROTH IRAs

An individual retirement account (IRA) is basically a savings account with big tax breaks. An IRA itself is not an actual investment, it is just the "basket" in which investments are kept. The most common types of IRAs are traditional, Roth, SEP and SIMPLE. Traditional and Roth IRAs are available to all individuals, SEP IRAs are available to anyone who is self-employed, and SIMPLE IRAs are available to most small business owners. Each type of IRA has different eligibility and tax rules. Just an "IRA" by itself is not a qualified plan, because it is not offered by an employer.

A traditional IRA is an individual retirement account to which a person may contribute pre-tax or after-tax dollars, giving immediate tax benefits if the contributions are tax-deductible. For traditional IRAs to be tax-deductible, the following conditions must be met:

•the investor may only contribute up to $5,500 to his traditional IRA account each year; this amount might increase in $500 increments per year (it is changed according to the cost-of-living adjustment or "COLA")
•there is a required minimum distribution (RMD) for a traditional IRA, and investors not withdrawing by the age of 70 1/2 will incur a tax penalty; the individual who owns the IRA must take RMDs by April 1 of the year after he turns 70 1/2

•the IRA owner may not be covered by an employer-sponsored retirement plan (a partial deduction might be possible)
•the account holder must meet modified adjusted gross income (AGI) requirements below a certain salary amount (depending on whether he is single or married)
      NOTE: The deduction excludes married couples who have access to a qualified employer-sponsored retirement plan and reach certain combined levels of AGI.

Although not one of the common types of IRAs, a spousal IRA is a type of IRA used when one person in a married couple does not work, and the working spouse earns at least $11,000 a year. In this case, the married couple can open two IRAs and contribute $5,500 to each account. The IRA owned by the non-working spouse is called the spousal IRA.

The Roth IRA is a retirement account that is not generally taxed as long as certain conditions are met. In other words, taxes are paid on the money going into the account, but all future withdrawals after five years are tax-free. RMD rules do not apply to Roth IRAs. Additionally, it was introduced by the Taxpayer Relief Act of 1997.

There are certain income limitations on Roth IRAs. As of 2017, a single person with an AGI of $118,000 or less is able to start a Roth IRA (the phase-out of contributions must be between $118,000 and $133,000). The AGI limit for married couples filing jointly is less than $186,000, with the phase-out of contribution eligibility occurring between $186,000 and $196,000. It does not matter if the investor participates in an employer-sponsored retirement plan. If a married couple lives together but files separately, their AGI must be less than $10,000, with the phase out occurring between $0 and $10,000.

RULES AND REGULATIONS FOR IRAs

Rollovers and Transfers

The IRS allows investors to transfer funds between IRAs without incurring taxes. For example, a client may transfer funds from a traditional IRA at Bank A to a traditional IRA at Broker B without any tax consequences. Investors may also rollover distributions from qualified retirement plans into Traditional IRAs without any tax consequences. For example, an investor may withdraw a portion of funds from the account and deposit all or part of it into another IRA or qualified plan within 60 days. Rollovers are allowed only once a year, while transfers are unlimited.

Conversions

Whether single or married, an investor with an AGI of $100,000 or less can convert a traditional IRA to a Roth IRA. He does not have to pay the early withdrawal 10% tax penalty, but he must pay ordinary income taxes on the amount he converted to the Roth IRA. The "cost" of conversion depends on the following factors:

• the investor's anticipated tax bracket at retirement
• the length of time until withdrawals from the IRA begin
• the cash availability to pay taxes that are due at the time of conversion
• the effect of the eventual IRA distribution on Social Security benefits

Contribution Catch-Ups

As of 2013, traditional and Roth IRA owners age 50 and above were allowed to contribute an extra $1,000 per year. To qualify for the catch-up contribution, the investor must have reached age 50 by the end of that specific contribution year.

Penalties for Excess Contributions and Early Withdrawals

If an individual over-contributes to an IRA, a 6% penalty is assessed.

Recall the "withdrawal rules" earlier in this section. Remember that early withdrawals are subject to ordinary income taxes and a 10% tax penalty. However, certain exceptions do apply. Aside from the exceptions already listed earlier in this section, the following are also reasons a person may be exempt from an early withdrawal penalty:

• if the IRA funds (limited to $10,000) are used towards the purchase of a first home
• if the IRA owner or a member of his immediate family need money to cover higher-education expenses (tuition, books, room and board, etc).

A notable difference between a traditional and Roth IRA is that the withdrawals from a Roth IRA are made from the contributions first. Therefore, penalties and restrictions apply only to the Roth IRA's earnings.

COLLEGE SAVINGS PLANS

Section 529 Plan-- A 529 is an education savings plan that is sponsored by a state or educational institution. Any account earnings are free from federal taxes. Contributions into the account are subject to federal taxes, but might be free from state taxes. This is determined individually by each state. Each state also determines which investment choices are available for the account, as well as how much can be contributed to an account. Some states allow a lifetime contribution limit of $255,000 per child.

529 plans are also known as Qualified Tuition Programs (QTPs) and are the most popular way people save for the future education of their children. The main advantage of a 529 plan involves account ownership and the ability to change the beneficiary. For example, a parent can open a 529 account for a child, and a specific age does not need to be reached before funds can be used. Additionally, if that child decides not to go to college, the parent can name another child as the beneficiary in order to pay for his college expenses. However, any withdrawals from the plan that are not used for educational purposes will be taxed as ordinary income and assigned a 10% penalty.

There are two types of 529 plans--prepaid tuition plans and college savings plans. If a parent chooses the prepaid tuition plan, he locks in the current tuition rate for all public colleges in the state. This is guaranteed by the state, and the parent will not have to worry about the rising cost of tuition. By the time the child enters college, the plan will cover all college costs. On the contrary, a college savings plan is not guaranteed by the state and is not usually sufficient in covering all college expenses. However, since the investments in the account are subject to market conditions, there is an opportunity for greater returns with this type of plan.