According to some studies, as many as two-thirds of Americans are failing in their retirement preparations. Unfortunately, another worrying statistic is that around half of Americans are happy to rely on Social Security and aren’t actively trying to improve their financial position.
Why is this a bad thing? Well, it’s thought that Social Security only replaces 40% of pre-retirement income. Considering that most seniors need 80% of pre-retirement income to survive, these are worrying numbers.
During retirement, the cost of living generally decreases due to a lack of commuting to and from work, no payroll taxes, and less spending on dry cleaning and other work-related tasks. However, experts still predict that we need 80% of pre-retirement earnings during retirement, which is double the amount provided by Social Security alone.
If you want a comfortable retirement, it’s no secret that planning is required as early as possible. Without careful planning, you could face a retirement plagued with concerns over finances. This isn’t exactly a new problem, and half of Americans worry less about their health during retirement than their money. The more we worry about money, the more likely we are to experience health problems, and this is at an age where health expenses increase anyway.
This last point will scare some: they believe that Medicare eligibility means reduced healthcare costs. In reality, a healthy couple can spend upwards of $600,000 on healthcare during retirement. If you aren’t planning your retirement already, we hope you’re thinking about it more seriously now.
Retirement Plan Types
To start your planning journey, we want to go through some of the most popular retirement plans. From here, you have a stronger understanding of what they do and what you need!
1. IRA (Individual Retirement Account)
There are four main types of IRA:
• Roth IRA
• Traditional IRA
• SIMPLE IRA
• SEP IRA
Although they have differences, one thing these plans have in common is that they’re investment-based and tax-advantaged. It’s possible for those with experience in investing to choose your investments with Roth and traditional IRAs; this includes options in mutual funds, stocks, bonds, and ETFs. If you aren’t comfortable selecting investments, better options are SIMPLE and SEP IRAs.
When contributing to a traditional IRA, this is normally tax-deductible. As an example, your taxable income decreases by $10,000 when contributing the same amount into an IRA. However, this doesn’t mean that you avoid tax. Instead, it’s charged at the point of withdrawal. The advantage of delaying tax in this way is that you might be in a lower tax bracket in retirement, and this means paying less.
On the other hand, a Roth IRA works oppositely. In other words, you’ll pay tax when contributing to your retirement account (it’s not tax-deductible) and can withdraw during retirement without worrying about this additional cost.
How does a SIMPLE IRA work? In the same way as a traditional IRA. The difference is that your employer needs to make tax-deductible contributions. With a SIMPLE IRA, the limit is set to $13,500 for employee contributions.
Again, the tax rules for a SEP IRA are identical to a traditional IRA, but the whole scheme is devised for freelance workers, self-employed, and those with small businesses. Therefore, contributions from employees aren’t allowed. If you’re an employer, you can’t deduct contributions when setting up a SEP IRA for employees. Depending on which is less, contribution limits are set to $58,000 or 25% of pay per year.
2. 401(k) Plan
This is one you’re likely to have seen before, and this is because it’s a common option. Essentially, the employer sponsors the retirement account, and the employee can make tax-advantaged contributions. Normally, contributions are taken straight from a paycheck, and the employer matches the amount. If you have a 401(k), we recommend checking the summary description of your plan to learn how it works (too many people are unaware of how their own 401(k) works!).
The key thing to remember with 401(k) accounts is the principle of compounding interest. The quicker you start building funds, the more it will grow because it has time to multiply. For those involved in a 401(k), please don’t ignore the additional features that it provides. Also, withdrawing before 591/2 will lead to penalty fees (be careful!).
3. 403(b) Plan
Similar in name and similar in nature to the 401(k) plan, the 403(b) is designed for those in public employment; this includes public schools and other institutions (not all tax-exempt institutions are included). Two reasons you might choose a 403(b) plan are the catch-up contributions and quicker vesting options. On the other hand, some people stay away from this plan because it lacks REITs and stocks.
4. Payroll Deduction IRA
Just like the first group of IRAs, there are different types of payroll deduction IRAs. The two main types are as follows:
• Roth – Your contributions are taxed.
• Traditional – Money goes into the account before tax.
The account you choose depends on your preferences and tax brackets both now and in the future. While some prefer to pay tax and allow funds to grow knowing that tax is paid, others wait to pay tax because they expect a lower bracket in the future.
In terms of contribution limits, they’re the same as Roth and traditional IRAs. Yet, it would help if you kept in mind that the employer doesn’t need to file for tax; employees make all contributions.
5. SARSEP (Salary Reduction Simplified Employee Pension)
As a defined benefit plan, this one is used by small businesses where employees make contributions from their salary. Over the years, this option has slowly become less popular because the 1996 Small Business Job Protection Act led to the plan being repealed. The only plans that still exist are the ones created before 1997.
Even in the 1990s, it still struggled for attention in certain groups due to the strict application rules. For example, only those who had been working for their employer for three of the last five years had access. As we’ve seen with other retirement plans, it came with a penalty for early withdrawals, and contributions were limited to the lower of $58,000 or 25% of salary.
6. Profit-Sharing Plan
As the name suggests, this plan allows companies to give a percentage of company earnings (either annually or quarterly). Unfortunately, due to the nature of the plan, only employers can contribute to profit-sharing plans. Typically, the company chooses the percentage given to staff; some years will see no contributions as a result of the adjustable rate. The limit is the lower of $58,000 and 25% of salary as we’ve seen before.
7. Money Purchase Plan
You’ll see suggestions that a money purchase plan is like 401(k) and 403(b) accounts; this is true, but it’s also a defined-contribution plan where the employer contributes a specific amount each year. As we’ve seen before, this is based on the salary of the individual. Depending on the circumstances, the employee may be entitled to contribute too.
Two standout features of a money purchase plan are the annual deposits and the tax benefits for both the employee and the employer. For employees, they’re often worried about their employer and the reliability of contributions. Fortunately, a money purchase plan comes with a minimum funding standard; if this isn’t met, the company is hit with an excise tax.
8. Defined Benefit Plans
You might know this option as a pension, and it’s another that used to be tremendously popular. Again, it has dropped in popularity, but this time because of the 401(k) plan. Although both are employer-sponsored retirement plans, a defined benefit plan guarantees a benefit in retirement. Since the calculation is always the same, you can easily work out the amount you’ll receive after leaving the workforce.
For calculation, years of employment and salary are considered. Once a pension factor is added, you’ll get an annual amount from the plan. What if you earn $77,000 per year, the company’s pension factor is set to 3%, and you have 30 years of experience with the company? In this case, $69,300 would be the annual pension amount before federal income tax.
One of the benefits of this plan is that the recipient decides how they wish to receive their benefit:
Single-Life Annuity – With this first option, it’s designed to offer individuals a fixed monthly amount until death.
Lump-Sum Payment – Elsewhere, some participants prefer to receive their money as one lump sum. Not only do you have to navigate the tax burden, but you also need to think about managing this amount and making it last throughout retirement.
Qualified Joint and Survivor Annuity – Although essentially the same as a single-life annuity, this one pays benefits to surviving spouses after death. After you pass away, your loved one should receive a minimum of 50% of the historical monthly benefits.
9. Deferred Compensation 457 Plans
You may have seen the 457(b) and 457(f) plans under this umbrella. Depending on the circumstances, those with a 457 plan may be limited to $19,500 for contributions (the elective deferral limit) or contribute more. As a tax-advantaged plan, you’ll only worry about tax when you withdraw later in life.
How do the two variations differ? It comes down to the qualification rules. The 457(f) isn’t widely adopted because it’s used for highly compensated nongovernment and government employees (and a select group at that!). Meanwhile, most local and state government employees have access to 457(b) plans; this includes many non-profit employees.
Despite the limitations, you might choose this plan because participants can withdraw before 591/2 without the normal penalty that comes with it. Though you will pay tax on the withdrawal, this happens anyway with other retirement plans. If you think you might need or want early withdrawals, this is the best way to get them without paying penalty fees.
10. ESOP (Employee Stock Ownership Plans)
You may not have realized there were so many retirement options, but we’re now at the tenth, and it’s an interesting one with ESOPs. Similar in nature to the profit-sharing plan, the main difference is that employees get shares of stock. For safety and growth, some companies choose a trust to hold their shares. As an employee, the number of shares you earn depends on the years of experience you have with the company. Then, the company has an opportunity to buy back the shares when you either resign or retire.
Don’t worry, this doesn’t mean you receive all funds at once. If chosen, you’ll receive the payment in chunks over time. Unfortunately, you won’t have the option to keep shares after leaving the company.
Summary
The list goes on. As well as the IRS-approved retirement plans in this guide, you’ll also find plenty of other retirement plans and ways to save for the end of your working career. For some, they invest in stocks and bonds and prefer this to an employer-sponsored program. For others, they’re lucky enough to invest in real estate.
The route you choose depends on your needs, proximity to retirement, expected lifestyle in retirement, and more. If you have a strategy, it’s easier to stay on the right track. Of course, don’t be afraid to contact a financial professional if you need help!
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