Retirement Accounts in the US

If you are like my family, you will have some relatives who have moved to the United States for work. This is a topic of mind for me right now because my wife and I just returned from a visit to some of those relatives. We seem to have returned just before the re-tightening of measures due to the rise of the Omicron variant of COVID-19. I can say, though, that the PCR test needed to board a plane back to Canada was a painless process, both in terms of its execution and the cost. At the boarding gate, everyone had to have their documents reviewed: passport, boarding pass, proof of vaccination, and proof of a negative PCR test. Masks were everywhere inside the airport. It felt safer than going into a supermarket here in London, ON.

 

To the topic at hand. There are three account types that I am going to discuss, the 401(k), the Traditional IRA, and the Roth IRA. There are a few other account types, but these are the basics.

 

The 401(k)

The 401(k) is a retirement account offered by many employers in the US. It is similar to a defined contribution registered pension plan in Canada. Contributions are made by the employee which the employer often matches. These contributions are made on a “pre-tax” basis so that income tax is calculated after the contributions have already been deducted. An employee under age 50 could contribute up to $19,500 in 2021 and $20,500 in 2022. Employees over age 50 can add $6,500 to those figures. In 2021 the combined employee-and-employer contribution amount was capped at $58,000 or 100% of employee compensation, whichever is less, or $64,500 ($6,500 more) if the employee is over 50. For 2022, the respective limits will be $61,000 if under 50, and $67,500 if 50 or older.

 

The advice often heard from US retirement experts is for the employee to contribute enough to maximize the employer contribution. This makes sense as it is essentially free money.

 

As is the case with defined contribution plans in Canada, the employee is typically given a list of mutual funds from which to choose their investments within the plan.

 

What are your options when you leave your employer?

Withdraw the money

Unlike a Canadian defined-contribution plan, you can withdraw your money from a 401(k) if you leave your employer. However, the entire amount would be taxable in the year in which it is withdrawn. Unless you are experiencing financial hardship, this is usually not a good idea.

 

Roll the 401(k) into an IRA

In Canada, this would be akin to transferring your pension plan into a locked-in retirement account (LIRA). An IRA, or Individual Retirement Account, is similar to the Canadian Registered Retirement Savings Plan (RRSP). The employee has 60 days to make a qualified rollover in order to avoid tax consequences.

 

Leave the 401(k) with your employer

If you change employers but are satisfied with the available investment options, you may wish to leave your existing 401(k) with your employer. The potential problem, though, is if you change jobs relatively frequently, and move periodically, you may lose track of your various plans and your former employer may not know how to contact you.

 

Transfer your 401(k) to your new employer

If withdrawing from the plan isn’t smart, and you don’t feel confident about managing your accounts or keeping track of old 401(k)s, then making a qualified transfer to your new employer may make the best sense.

 

The Traditional IRA

You can use an IRA even if you have a 401(k) but an IRA is especially relevant if you don’t have a company pension plan or 401(k). The traditional IRA is like an RRSP in Canada in many ways. You need to have qualifying earned income, you can invest in a wide range of products from savings accounts to individual stocks and even certain options strategies. Also like an RRSP, contributions are tax-deductible, within limitations, and the investments grow tax-deferred inside the account. Taxes are only assessed at withdrawal.

 

There are some limitations based on income to consider, though. Modified Adjusted Gross Income (MAGI) is a calculation that is used to determine whether you can deduct all, only a portion, or none, of your IRA contributions from your taxes. If you are curious to read more about MAGI, please take a look at this Investopedia article here. If you don’t have a retirement plan, your IRA contributions are generally fully deductible.

 

If you previously lived in Canada and contributed to an RRSP, one thing that may surprise you is that IRA contributions do not accumulate. If you have gone through several years of not contributing to your RRSP, you may see on successive Notices of Assessment that your contribution limit has grown over time. The IRA in the US has an annual contribution limit of $6,000 ($7,000 if you are over 50), but it does not accumulate over time.

 

Withdrawing from your IRA

Under Age 59½

The US government, to encourage saving for retirement, has penalties for withdrawals that are taken before age 59½. In addition to your regular tax rate, you will be assessed a 10% tax penalty on the amount withdrawn.

 

Over Age 59½

You are not obligated to withdraw from your IRA after you reach age 59½, but neither are you penalized. You are simply taxed at your ordinary tax rate.

 

At Age 72

Once you reach age 72, you must begin to take Required Minimum Distributions (RMDs), which are based on the account size and the person’s life expectancy. Marital status and beneficiary age are additional factors in calculating the RMD. Failure to take your RMD is not a trifling matter. The tax penalty could be as high as 50% of the amount of the required distribution.

 

Note that, unlike in Canada, where you need to convert your RRSP into a RRIF no later than in the year you turn 71 so that you can begin making Annual Minimum Payments (AMPs), there is no need to convert your IRA into some other account type to make withdrawals. You simply start pulling the money out of the same account.

 

The Roth IRA

The closest equivalent to the Roth IRA in Canada is the Tax-Free Savings Account (TFSA). Contributions to a Roth IRA do not generate a tax deduction, but assets grow tax-free within the account and distributions are tax-free, within certain rules.

 

Income limits may prevent you from receiving a deduction for traditional IRA contributions, as noted above. However, if your income is too high, you may be prevented from contributing to a Roth IRA altogether. In 2022, a single person can make full contributions of $6,000 (below age 50) if his or her MAGI is less than $129,000. Partial contributions are available above that amount but will phase out entirely at $144,000.

 

Unlike the case with a TFSA in Canada, a Roth IRA can only be funded from earned income, e.g., wages, commissions, self-employed net earnings, etc.

 

Withdrawing from your Roth IRA

Withdrawing contributions

You may withdraw contributions from your Roth IRA free of taxes or penalties. For example, if over the years you had contributed $10,000 and thanks to your investing acumen, the account was now worth $20,000, you may withdraw the accumulated contributions of $10,000 at any time.

 

Withdrawing growth and income

To avoid taxes and penalties, certain criteria must be met.

 

The 5-year rule

Withdrawals of earnings may be subject to taxes and/or a 10% penalty if you did not establish and fund your first Roth IRA at least five years before the withdrawal.

 

If you don’t meet the 5-year rule

If you don’t meet the 5-year rule and are under age 59½, you may be able to avoid the penalty – but not the taxes – if the money is used: a. for a first-time home purchase (lifetime maximum of $10,000); b. for qualified education expenses; c. for medical expenses; d. if you have a permanent disability; or e. if you die and your beneficiary takes the distribution.

 

If you are over age 59½, a withdrawal of earnings from the Roth IRA is taxed but there aren’t any penalties.

 

If you meet the 5-year rule

If you are under age 59½ earnings are subject to taxes and penalties. You may be able to avoid taxes and penalties if the money is used: a. for a first-time home purchase (lifetime maximum of $10,000); b. if you have a permanent disability; or c. if you die and your beneficiary takes a distribution.

 

If you are over age 59½, there are no taxes or penalties.

 

FIFO withdrawals

Roth IRA withdrawals are made on a FIFO (First In, First Out) basis so that any withdrawals are considered to have come from contributions first. Therefore, no earnings are considered touched until all contributions have been taken out.

 

Which Account Type Should You Choose?

If you move to the US and have the option of an employer-sponsored 401(k), it probably makes the most sense to maximize the matching portion from your employer. Once that is achieved, if you have extra money available to save for retirement, then investing in a traditional IRA or a Roth IRA depends on your current marginal tax rate and your expected tax rate in retirement. This question is similar to the question Canadians need to answer regarding the choice to invest in an RRSP or a TFSA. Note, however, that investors in IRAs are capped annually at $6,000 (or $7,000 if age 50 or older), if eligible at all, between the traditional and Roth options.

 

In a future blog post, I intend to write about Canadians who return to Canada after working in the US and accumulating retirement assets in these accounts.

 

In the meantime, Merry Christmas, Happy Holidays, and a Happy (and less viral?) New Year.

 

This is the 128^th blog post for Russ Writes.

 

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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.