If you have young kids or you’re still building your
career, retirement may not be top of mind at this point in
your life. But someday, if you’re lucky and save on a
regular basis, it will be.
To help ensure you have a financially secure retirement,
it’s wise to create a plan early in life — or right now if
you haven’t already done so. By diverting a portion of
your paycheck into a tax-advantaged retirement savings
plan, for example, your wealth can grow exponentially to
help you achieve peace of mind for those so-called golden
years.
Yet only about half of current employees understand the
benefits offered to them, according to a 2019 survey from
the Employee Benefit Research Institute.
“One company’s benefit formula may not be as generous as
others,” explains David Littell, retirement planning
expert and professor emeritus of taxation at The American
College of Financial Services. “It’s really important that
you read the summary plan description that is provided to
all participants so that you can understand the design of
the plan.”
By understanding your retirement plan options, you’ll be
better equipped to max out your benefits and actually
achieve the retirement you want.
Key plan benefits to consider
Virtually all retirement plans offer a tax advantage,
whether it’s available upfront during the savings
phase or when you’re taking withdrawals. For example,
traditional 401(k) contributions are made with pre-tax
dollars, reducing your taxable income. Roth 401(k)
plans, in contrast, are funded with after-tax dollars
but withdrawals are tax-free. (Here are other key
differences between the two.)
Some retirement savings plans also include matching
contributions from your employer, such as 401(k) or
403(b) plans, while others don’t. When trying to
decide whether to invest in a 401(k) at work or an
individual retirement account (IRA), go with the
401(k) if you get a company match – or do both if you
can afford it.
If you were automatically enrolled in your company’s
401(k) plan, check to make sure you’re taking full
advantage of the company match if one is available.
And consider increasing your annual contribution,
since many plans start you off at a paltry deferral
level that is not enough to ensure retirement
security. Roughly half of 401(k) plans that offer
automatic enrollment, according to Vanguard, use a
default savings deferral rate of just 3 percent. Yet
T. Rowe Price says you should “aim to save at least 15
percent of your income each year.”
If you’re self-employed, you also have several
retirement savings options to choose from. In addition
to the plans described below for rank-and-file workers
as well as entrepreneurs, you can also invest in a
Roth IRA or traditional IRA, subject to certain income
limits, which have smaller annual contribution limits
than most other plans. You also have a few extra
options not available to everyone, including the SEP
IRA, the SIMPLE IRA and the solo 401(k).
1. Defined contribution plans
Since their introduction in the early 1980s, defined
contribution (DC) plans, which include 401(k)s, have all
but taken over the retirement marketplace. Roughly 86
percent of Fortune 500 companies offered only DC plans
rather than traditional pensions in 2019, according to a
recent study from insurance broker Willis Towers Watson.
The 401(k) plan is the most ubiquitous DC plan among
employers of all sizes, while the similarly structured
403(b) plan is offered to employees of public schools
and certain tax-exempt organizations, and the 457(b)
plan is most commonly available to state and local
governments.
2. IRA plans
An IRA is a valuable retirement plan created by the U.S.
government to help workers save for retirement.
Individuals can contribute up to $6,000 to an account in
2020 and 2021, and workers over age 50 can contribute up
to $7,000.
There are many kinds of IRAs, including a traditional
IRA, Roth IRA, spousal IRA, rollover IRA, SEP IRA and
SIMPLE IRA.
3. Solo 401(k) plan
Alternatively known as a Solo-k, Uni-k and
One-participant k, the Solo 401(k) plan is designed for
a business owner and his or her spouse.
Because the business owner is both the employer and
employee, elective deferrals of up to $19,500 can be
made, plus a non-elective contribution of up to 25
percent of compensation up to a total annual
contribution of $57,000 for businesses, not including
catch-up contributions.
4. Traditional pensions
Traditional pensions are a type of defined benefit (DB)
plan, and they are one of the easiest to manage because
so little is required of you as an employee.
Pensions are fully funded by employers and provide a
fixed monthly benefit to workers at retirement. But DB
plans are on the endangered species list because fewer
companies are offering them. Just 14 percent of Fortune
500 companies enticed new workers with pension plans in
2019, down from 59 percent in 1998, according to data
from Willis Towers Watson.
Why? DB plans require the employer to make good on an
expensive promise to fund a hefty sum for your
retirement. Pensions, which are payable for life,
usually replace a percentage of your pay based on your
tenure and salary.
A common formula is 1.5 percent of final average
compensation multiplied by years of service, according
to Littell. A worker with an average pay of $50,000 over
a 25-year career, for example, would receive an annual
pension payout of $18,750, or $1,562.50 a month.
5. Guaranteed income annuities (GIAs)
GIAs are generally not offered by employers, but
individuals can buy these annuities to create their own
pensions. You can trade a big lump sum at retirement and
buy an immediate annuity to get a monthly payment for
life, but most people aren’t comfortable with this
arrangement. More popular are deferred income annuities
that are paid into over time.
For example, at age 50, you can begin making premium
payments until age 65, if that’s when you plan to
retire. “Each time you make a payment, it bumps up your
payment for life,” says Littell.
You can buy these on an after-tax basis, in which case
you’ll owe tax only on the plan’s earnings. Or you can
buy it within an IRA and can get an upfront tax
deduction, but the entire annuity would be taxable when
you take withdrawals.
6. The Federal Thrift Savings Plan
The Thrift Savings Plan (TSP) is a lot like a 401(k)
plan on steroids, and it’s available to government
workers and members of the uniformed services.
Participants choose from five low-cost investment
options, including a bond fund, an S&P 500 index fund, a
small-cap fund and an international stock fund — plus a
fund that invests in specially issued Treasury
securities.
On top of that, federal workers can choose from among
several lifecycle funds with different target retirement
dates that invest in those core funds, making investment
decisions relatively easy.
7. Cash-balance plans
Cash-balance plans are a type of defined benefit, or
pension plan, too.
But instead of replacing a certain percentage of your
income for life, you are promised a certain hypothetical
account balance based on contribution credits and
investment credits (e.g., annual interest). One common
setup for cash-balance plans is a company contribution
credit of 6 percent of pay plus a 5 percent annual
investment credit, says Littell.
The investment credits are a promise and are not based
on actual contribution credits. For example, let’s say a
5 percent return, or investment credit, is promised. If
the plan assets earn more, the employer can decrease
contributions. In fact, many companies that want to shed
their traditional pension plan convert to a cash-balance
plan because it allows them better control over the
costs of the plan.
8. Cash-value life insurance plan
Some companies offer insurance vehicles as a benefit.
There are various types: whole life, variable life,
universal life and variable universal life. They provide
a death benefit while at the same time building cash
value, which could support your retirement needs. If you
withdraw the cash value, the premiums you paid – your
cost basis – come out first and are not subject to tax.
What it means to you: These products are for wealthier people who have already maxed out all other retirement savings vehicles. If you’ve reached the contribution limits for your 401(k) and your IRA, then you might consider investing in this type of life insurance.
9. Nonqualified deferred compensation plans (NQDC)
Unless you’re a top executive in the C-suite, you can
pretty much forget about being offered an NQDC plan.
There are two main types: One looks like a 401(k) plan
with salary deferrals and a company match, and the other
is solely funded by the employer.
The catch is that most often the latter one is not
really funded. The employer puts in writing a “mere
promise to pay” and may make bookkeeping entries and set
aside funds, but those funds are subject to claims by
creditors.
What it means to you: For executives with access to an NQDC plan in addition to a 401(k) plan, Our advice is to max out the 401(k) contributions first. Then if the company is financially secure, contribute to the NQDC plan if it’s set up like a 401(k) with a match.
Which retirement plan is best for you?
In many cases you simply won’t have a choice of retirement plans. You’ll have to take what your employer offers, whether that’s a 401(k), a 403(b), a defined-benefit plan or something else. But you can supplement that with an IRA, which is available to anyone regardless of their employer.
Here’s a comparison of the pros and cons of a few retirement plans.
Employer-offered retirement plans
Defined-contribution plans such as the 401(k) and 403(b) offer several benefits over a defined-benefit plan such as a pension plan:
- Portability: You can take your 401(k) or 403(b) to another employer when you change jobs or even roll it into an IRA at that point. A pension plan may stick with your employer, so if you leave the company, you may not have a plan.
- Potential for higher returns: A 401(k) or 403(b) may offer the potential for much higher returns because it can be invested in higher-return assets such as stocks.
- Freedom: Because of its portability, a defined-contribution plan gives you the ability to leave an employer without fear of losing retirement benefits.
- Not reliant on your employer’s success: Receiving an adequate pension may depend a lot on the continued existence of your employer. In contrast, a defined-contribution plan does not have this risk because of its portability.
While those advantages are important, defined-benefit plans offer some pros, too:
- Income that shouldn’t run out: One of the biggest benefits of a pension plan is that it typically pays until your death, meaning you will not outlive your income, a real risk with 401(k), 403(b) and other such plans.
- You don’t need to manage them: Pensions don’t require much of you. You don’t have to worry about investing your money or what kind of return it’s making or whether you’re properly invested. Your employer takes care of all of that.
So those are important considerations between defined-contribution plans and defined-benefit plans. More often than not, you won’t have a choice between the two at any individual employer.
Retirement plans for self-employed or small business owners
If you’re self-employed or own a small business, you have some further options for creating your own retirement plan. Three of the most popular options are a solo 401(k), a SIMPLE IRA and a SEP IRA, and these offer a number of benefits to participants:
- Higher contribution limits: Plans such as the solo 401(k) and SEP IRA give participants much higher contribution limits than a typical 401(k) plan.
- The ability to profit share: These plans may allow you to contribute to the employee limit and then add in an extra helping of profits as an employer contribution.
- Less regulation: These retirement plans typically reduce the amount of regulation required versus a standard plan, meaning it’s easier to administer them.
- Investible in higher-return assets: These plans can be invested in higher-return assets such as stocks or stock funds.
- Varied investment options: Unlike a typical company administered retirement plan, these plans may allow you to invest in a wider array of assets.
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