Making your retirement dreams a reality is no short order. The earlier you can start planning, the better the chances are that you will live out those dreams. Financial planning is a vital aspect of helping you on your long-term journey, especially when it comes to how are you going to fund the post-career lifestyle you envision.
The good news is that there are a multitude of ways to invest for retirement purposes. But, on the other hand, the sheer number of options one has to save for retirement can feel overwhelming. Figuring out what makes the most sense for your individual circumstances and financial goals is the first step.
But before delving into the various ways to invest, it’s important to understand three critical factors that affect different types of plans:
- Tax advantages – Most retirement accounts come with tax advantages to incentivize saving for retirement.
- Tax-deferred means your earnings within the account are not taxed at the end of the year; instead, the tax is deferred until the individual participant retires and starts taking withdrawals.
- Tax-exempt means withdrawals and earnings are totally tax-free.
- Contribution limits – Most retirement accounts have limitations set by the IRS on how much you can contribute every year.
- Minimum distributions – Many plans have required distributions when you reach a certain age (e.g., 70.5 years old). Currently, there are some major changes being considered by Congress, including the required distribution age increasing to 75.
While retirement accounts generally have some common threads, they do contain some varying benefits and requirements. A financial planner can help you navigate the different types of retirement accounts and guide you through your best fit based on variables, including your investment time horizon, risk tolerance, and long-term goals.
Individual Retirement Plans
Let’s dive in to some of the most common types of individual retirement plans. You can start one of these on your own – no employer required (but, generally you do need to have earned income).
- Traditional IRA: Traditional IRAs are a common type of retirement account that allows you to invest in stocks, bonds, or mutual funds. You may be able to deduct contributions to your traditional IRA account from your taxes, while earnings can grow tax-deferred until you withdraw them in retirement. Total contributions are capped at $6,000 per year ($7,000 if you’re 50 or older), or your taxable compensation for the year if it was less than this dollar limit. You’re required to start taking distributions by April 1, following the year in which you turn age 70.5 and by December 31 of later years.
- Roth IRA: This type of retirement account offers a little more flexibility than a traditional IRA with contributions made with after-tax dollars. Any money generated within this type of account is tax-exempt. You can continue making contributions to your Roth IRA account (but not your traditional IRA) even after you turn 70.5 years old and make tax-free withdrawals five years after opening the account. Unlike a traditional IRA, you’re not required to start taking withdrawals at 70.5. However, like a traditional IRA, contributions are capped at $6,000 per year until age 50, at which point they’re capped at $7,000.
- Annuities: These are long-term savings vehicles sold by insurance companies. An annuity can be an IRA, a Roth IRA, or Non-Qualified. Non-qualified annuities allow deposits at any time and offer tax-deferred investment returns until you begin to make withdrawals. They are a good solution once you have maxed out contributions to your other retirement accounts. Unlike regular investment accounts, they may provide income or accumulation guarantees. However, annuities are accompanied by early surrender charges and a penalty tax if you begin withdrawals before turning 59.5.
- Health Savings Accounts(HSAs): HSAs are tax-advantaged accounts used to pay for future health care costs, including copayments and deductibles. Contributions are limited to $3,450 for individuals and $6,900 for families. If earnings are used for an approved list of medical expenses after the age of 65, withdrawals are tax-exempt. You can only use an HSA if you already have a High Deductible Health Plan.
Employer-Sponsored Retirement Plans
The following retirement plans are offered through an employer as a benefit. We’ll cover the essentials to give you an understanding of what these plans offer.
- 401(k): A traditional 401(k) is an employer-sponsored account which allows employees to contribute a portion of their pre-taxed earnings to tax-deferred investments. It reduces the amount of income tax an employee must pay that year. Employers often choose to match employee contributions to a 401(k) – increasing the incentive to make full contributions. Money generated by this type of account grows tax-deferred until you withdraw at retirement, but contributions made out of employee salary is capped at $19,000. These types of plans are designed to discourage you from tapping into your savings before you retire: if you withdraw before the age of 59.5 you could pay a 10% penalty and the withdrawal could be subject to state and federal income taxes.
- Roth 401(k): In contrast, employees pay the taxes up-front with a Roth 401(k). This means an employee contributes money from their paycheck after it has already been taxed. Then, when the time comes, qualified withdrawals can be made tax-free. Like a 401(k), employers can match your contributions to the account. A Roth 401(k) is beneficial for someone who wants to lock in low tax rates from the get-go and take advantage of matching employer contributions. You can invest in both a 401(k) and a Roth 401(k) to diversify your portfolio.
- 403(b): Also known as a tax-sheltered annuity (TSA) plan, a 403(b) is a retirement plan offered by certain 501(c)(3) tax-exempt organizations such as public schools or charitable organizations. Employees are able to contribute to individual accounts, and some come with an employer matching contribution feature. The most an employee can contribute to a 403(b) account out of salary is $19,000. Employees 50 or older can make catch-up contributions of $6,000 through the end of 2019.
- Roth 403(b): Offered to certain 501(c)(3) tax-exempt organizations and with similar characteristics to other types of Roth accounts, a Roth 403(b) retirement account is appealing for a few reasons. Contributions are made on an after-tax basis and some come with an employer matching contribution feature. Money within the account grows tax-deferred and distributions are tax-free. Like a traditional 403(b) account, employee contributions are limited to $19,000. Employees 50 or older can make catch-up contributions of $6,000 through the end of 2019.
- 457(b): Those employed by the government and some nonprofits can open a 457(b) plan, which allows employees of sponsoring organizations to defer income taxes on retirement savings. Contributions to a 457(b) account are limited to $19,000 per year – with a few exceptions. An employer may allow catch-up contributions, which allows employees nearing retirement to contribute an additional $6,000. These types of plans also offer a unique feature, the “Double Limit Catch-Up provision.” This allows participants to compensate for years that they did not make a contribution but were eligible to. Employees who are within three years of retirement are able to, in this particular scenario, double the limit to $38,000.
- Simplified Employee Pension (SEP) IRA: A SEP IRA retirement plan is designed for individuals who are self-employed or small business owners. Contributions can be up to $56,000 or 25% of your income, whichever is less. This allows for bigger contributions than most other types of plans, and the contributions are deductible from your taxed income.
- Profit-Sharing Plan: This type of plan gives employees a share in the profits made by a company, based on the its quarterly and annual earnings. It accepts discretionary employer contributions and is designed for employers who want to support their employees’ retirement account, no matter the size of their business or if there are already other retirement plans in place.
While employer contributions with these types of plans aren’t required by law, they are required to be divided fairly between all qualified employees. They may calculate this through a “comp-to-comp” method, starting with the total sum of all their employees’ compensation. Then, to determine the employees’ allocation, divide their individual compensation by the total compensation and multiply this fraction by the amount of the employers’ contribution. The resulting number is each employees’ individual share.
- Defined Benefit Plan: Defined benefit plans provide a fixed, pre-established benefit for employees once they reach retirement. Employers can open a defined benefit plan whether or not they have other retirement options in effect. Because a specific formula is applied to the account, a defined-benefit plan guarantees a certain amount at retirement. With predictability as a major benefit, these plans accrue benefits faster than some other options, making it appropriate for early retirement. Employees may be required, or have the option, to contribute regularly.
- Money Purchase Plan: Similar to a profit-sharing plan, a money purchase plan builds savings through fixed employer contributions, however the contribution percentage is outlined in the plan, for example, 5% of each eligible employees’ pay. In this case, employers would be need make a contribution of 5% to each eligible employees’ pay to their separate retirement account. Employees can also contribute to their individual accounts. The total benefit is based on the number of contributions to their account, alongside any gains and losses at the time of retirement.
- Employee Stock Ownership Plan (ESOP): An ESOP is an Internal Revenue Code (IRC) Section 401(a) qualified defined contribution plan that can take two forms: as a stock bonus plan, or a combination of stock bonus and a money purchase plan. According to the IRS, an ESOP must invest primarily in qualifying employer securities and meet certain requirements of the IRC and associated regulations.
ESOPs are accompanied by several tax benefits to the employer; contributions of stock are deductible, as well as cash contributions. They’re often used in tandem with other employee savings plans, and as employees earn seniority, they acquire an increasing right to the shares in their account, which is a process called vesting. While ESOPs offer some impressive benefits, they are expensive to set up and are accompanied by some technical caveats of who can use them and how.
Interested in learning more about what retirement plans are available to you and what makes the most sense for your situation and savings goals? You can reach out to a financial planner for guidance on effective ways to save for retirement.
*NOTE: All contribution limits mentioned in this post are current as of July 2019.