Chapter 12: Tax-Advantaged Accounts & Products

Tax-Deferred Growth

The tax treatment under which investment earnings (interest, dividends, and capital gains) are not taxed in the year they are earned. Taxes are deferred until funds are distributed from the account. This allows full reinvestment of earnings and faster compounding.

Ordinary Income Taxation

The method by which retirement plan and annuity distributions are taxed. Distributions are taxed at the individual’s marginal income tax rate, not capital gains rates. All taxable retirement distributions are taxed as ordinary income.

Corporate Retirement Plan

An employer-sponsored plan designed to help employees save for retirement, offering tax advantages and governed by specific federal rules.

Qualified Corporate Retirement Plan

A retirement plan that meets ERISA requirements. Contributions are made with pre-tax dollars, earnings grow tax-deferred, and all distributions are taxed as ordinary income.

Non-Qualified Corporate Retirement Plan

A retirement plan that does not meet ERISA requirements. Contributions are made with after-tax dollars, earnings grow tax-deferred, and only the earnings portion is taxed upon distribution.

Employee Retirement Income Security Act (ERISA)

A federal law passed in 1974 that regulates private-sector employer retirement plans. It sets standards for participation, vesting, fiduciary responsibility, and nondiscrimination.

ERISA Fiduciary

A person legally required to act solely in the best interest of plan participants and beneficiaries.

Eligibility Requirement (ERISA)

Qualified plans must be offered to all full-time employees age 21 or older with at least one year of service. Part-time employees with 500 hours per year for three consecutive years must also be eligible.

Vesting

The process by which employees gain ownership rights to employer contributions. Employee contributions are always 100% immediately vested. Employer contributions must be fully vested after no more than five years.

Vesting Schedule

A timetable specifying how much of employer contributions an employee owns based on years of service.

Defined Benefit Plan

A retirement plan funded entirely by the employer that promises a specific retirement benefit based on salary, age, and years of service. The employer bears all investment risk.

Pension Plan

A common example of a defined benefit plan.

Actuary

A professional hired by employers offering defined benefit plans to calculate required contributions needed to meet future benefit obligations.

Underfunded Pension Plan

A defined benefit plan with insufficient assets to meet promised retirement benefits.

Defined Contribution Plan

A retirement plan in which both employer and employee may contribute. Retirement income depends on contributions made and investment performance. Employees bear investment risk.

401(k) Plan

A defined contribution plan allowing employees to defer a portion of salary into the plan on a pre-tax basis. Employers may offer matching or profit-sharing contributions but are not required to.

Elective Deferral

The portion of an employee’s salary voluntarily deferred into a retirement plan such as a 401(k).

Employer Matching Contribution

An optional employer contribution that matches a percentage of an employee’s deferral.

Roth 401(k)

An optional feature of a 401(k) plan allowing employees to contribute after-tax dollars. Qualified distributions are tax-free. Employer contributions always go into the traditional 401(k) portion.

Profit-Sharing Plan

A defined contribution plan allowing employers to make discretionary contributions based on company profits. Contributions must be allocated uniformly as a percentage of compensation.

Keogh Plan (HR-10 Plan)

A qualified retirement plan for self-employed individuals and unincorporated business owners. Primarily a defined contribution plan.

SEP-IRA (Simplified Employee Pension IRA)

An employer-sponsored plan typically used by small businesses. Only employers contribute, and contributions are made directly into employees’ IRAs.

SIMPLE IRA

A retirement plan for small businesses with 100 or fewer employees. Requires employer contributions and allows employee salary deferrals.

403(b) Plan

A tax-sheltered annuity plan for nonprofit organizations, educational institutions, and certain religious organizations.

457(b) Plan

A deferred compensation plan for state and local government employees and certain tax-exempt organizations. Similar to a 401(k) in structure and taxation.

Deferred Compensation Plan

A non-qualified plan in which compensation is set aside for future payment. Contributions are after-tax and earnings are taxed when distributed.

Credit Risk (Non-Qualified Plans)

The risk that benefits may be lost if the employer becomes insolvent, since plan assets are subject to claims by creditors.

Individual Retirement Account (IRA)

A personal retirement account opened by an individual with earned income, independent of employer plans.

Earned Income

Compensation such as wages, salary, or commissions. Required for IRA contributions. Investment income does not qualify.

Traditional IRA

An IRA allowing pre-tax or after-tax contributions, tax-deferred growth, and taxable distributions.

Contribution Limit (Traditional IRA)

The lesser of $7,000 or 100% of earned income (plus $1,000 catch-up for individuals age 50 or older).

Catch-Up Contribution

An additional contribution allowed for individuals age 50 or older.

Spousal IRA

An IRA contribution made for a non-working spouse using the working spouse’s earned income.

Prohibited Investments (IRAs)

Life insurance, antiques and collectibles, uncovered options, and directly owned real estate.

Tax-Deductible Contribution

A pre-tax IRA contribution allowed when income thresholds are met.

Non-Deductible Contribution

An after-tax IRA contribution made when income exceeds limits but still allows tax-deferred growth.

Early Withdrawal

A distribution taken before age 59½, subject to a 10% penalty unless an exception applies.

Early Withdrawal Penalty Exceptions

Disability, education expenses, first-time home purchase (up to $10,000), medical expenses, death, birth or adoption, terminal illness, and certain disaster-related distributions.

Rollover

The transfer of IRA assets from one custodian to another within 60 days to avoid taxes and penalties.

Required Minimum Distribution (RMD)

The minimum amount that must be withdrawn annually from a traditional IRA starting at age 73.

Required Beginning Date (RBD)

April 1 of the year following the year the account owner turns 73.

RMD Penalty

A 25% excise tax on the amount not distributed (reduced to 10% if corrected within two years).

Roth IRA

An IRA funded with after-tax dollars that allows tax-free growth and tax-free qualified distributions.

Income Limits (Roth IRA)

Only individuals below certain income thresholds may contribute.

Five-Year Rule (Roth IRA)

The requirement that at least five tax years must pass since the first Roth contribution for earnings to be tax-free.

Qualified Roth Distribution

A distribution taken after age 59½ and after the five-year requirement, resulting in no taxes on contributions or earnings.

RMD Rules (Roth IRA)

No required minimum distributions during the owner’s lifetime.

Annuity

An insurance contract designed to provide lifetime income and protect against outliving assets.

Annuitant

The individual whose life expectancy determines annuity payments.

Deferred Annuity

An annuity that accumulates earnings before payments begin.

Immediate Annuity

An annuity that begins paying income shortly after purchase.

General Account

The insurer’s account used for fixed products, invested conservatively, and guaranteeing returns.

Separate Account

The insurer’s account used for variable annuities, invested in market-based subaccounts, with risk borne by the investor.

Guaranteed Investment Contract (GIC)

A general account product offering guaranteed principal and interest.

Fixed Annuity

An annuity providing guaranteed principal and a fixed rate of return. Not considered a security.

Purchasing Power Risk

The risk that fixed payments will lose value due to inflation.

Variable Annuity

An annuity with returns based on market performance through separate account investments. Considered a security.

Accumulation Phase

The period during which contributions are made and accumulation units are purchased.

Accumulation Units

Units representing ownership in the separate account during the accumulation phase.

Guaranteed Death Benefit

A feature ensuring beneficiaries receive the greater of account value or total contributions if death occurs during accumulation.

Annuitization Phase

The phase when accumulation units are converted into annuity units and income payments begin.

Annuity Units

Units determining the amount of periodic income payments during annuitization.

Straight Life (Life Annuity)

Pays income for life only, with no beneficiary payments.

Life with Period Certain

Pays for life with guaranteed payments for a minimum period.

Joint with Last Survivor

Pays income until the death of the second annuitant.

Surrender Charge

A back-end sales charge applied when withdrawals occur during the surrender period.

1035 Exchange

A tax-free exchange of one annuity for another, though surrender charges may still apply.

529 Plan

A state-sponsored, tax-advantaged account for education expenses with tax-free growth and distributions.

Adviser-Sold Plan

A 529 plan sold through a financial professional.

Direct-Sold Plan

A 529 plan purchased directly from the state.

Qualified Education Expenses

Tuition, fees, books, supplies, technology, internet, and room and board (if half-time or more).

ABLE Account

A tax-advantaged savings account for individuals with disabilities that began before age 26

Achieving a Better Life Experience (ABLE) Act

The 2014 law authorizing ABLE accounts.

Coverdell Education Savings Account

A tax-advantaged education account with a $2,000 annual contribution limit and age restrictions.