Saving for your retirement will most likely be the most important and most expensive endeavor of your lifetime. This means the earlier you start, the better. This is particularly true if your retirement plans include major projects like a world tour, or buying and restoring an old castle in Europe. With the large number of different U.S. retirement plans out there, however, it’s quite easy to make a mistake. Continue reading to learn everything you need to know about retirement accounts.
Defined Contribution Plans
Since they were first introduced about 40 years ago, DC (Defined contribution) retirement plans such as 401(k(, 403(b), and 457(b) have virtually conquered the whole US retirement market. According to the latest data, nearly 86% of Fortune 500 firms now only offer DC plans instead of traditional pensions.
Not all employers offer 401(k) accounts, and those that do might offer different benefits. If you are under the age of 50, the IRS currently allows a maximum contribution of $19,500 per year. This increases to $26,000 if you are 50 or older. You are allowed to deduct your contribution from your taxable income and your employer may make a similar contribution. You have to start making withdrawals when you are 72, but if you withdraw from the fund before the age of 59 1/2 you could incur penalties.
Pros: The contributions can be deducted from your paycheck and invested in various high-return investments, e.g., stocks. You don’t pay tax on the returns before you start withdrawing from the fund. Plus, your employer can match your contributions.
Cons: Should you ever need funds to cover an emergency and you withdraw from the fund, you could face a penalty. Some 401(k) plans, however, allow you to borrow against invested funds for specific reasons. Confirm with your employer.
If your employer is a tax-exempt organization or a nonprofit such as a church, charity, or public school, you may qualify to use a 403(b). It is in many respects similar to a 401(k). If you are under 50, the maximum yearly contribution is $19,500 and if you are 50 or older, it increases to $26,000 per year. You don’t pay taxes on earnings, only when you start to withdraw funds.
Pros: You can have your contributions automatically deducted from your pay check and invested in, e.g., stocks or annuities. You also don’t pay any tax on returns until you start withdrawing funds. Your employer might or might not match your contributions.
Cons: Similar to the 401(k), accessing your money could be difficult unless it’s a qualified emergency. Accessing it without an emergency could mean paying additional taxes as well as a penalty. You can, however, take a loan. Depending on the specific plan to which your employer subscribes, you might not have full control over how your money is invested.
These plans are offered via local and state governments. If you qualify, you will be allowed to contribute a maximum of $19,500 per year if you are under 50, otherwise $26,500 per year. You can start withdrawing money after the age of 59 1/2. Contributions are tax-deductible and you will only pay tax when you start withdrawing.
Pros: The tax benefits make this a popular option. It also offers certain special catch-up savings benefits for older contributors. Another benefit is that you will not face a 10% penalty if you withdraw funds before the age of 59 1/2.
Cons: The average 457(b) plan does not allow your employer to match your contributions. It is also more difficult than with the 401(k) to withdraw funds if you have an emergency.
This is another popular type of retirement plan. There are various options, including a traditional IRA, Roth IRA, spousal IRA, rollover IRA, SEP IRA, and Simple IRA.
This is only available to individuals who earn income. Your contribution can also not exceed your income. Plus there is a maximum contribution of $6,000 for under 50s and $7,000 for those who are 50 or older. Contributions are tax-deductible and you only pay tax when you start making withdrawals (which can’t start later than age 72).
Pros: The tax benefits make this another popular retirement investment option. You can buy a nearly unlimited selection of investments, including real estate, CDs, bonds, and stocks. Plus, you only pay tax when you start withdrawing funds upon retirement.
Cons: If you have an emergency and you need money quickly, it might be difficult to access your funds because of penalties and additional taxes. You are also responsible to invest the money yourself, with or without the help of an investment advisor.
This is in many respects similar to a traditional IRA in, e.g., the tax benefits it provides. You will also not be paying tax on earnings or contributions withdrawn from the account when you retire.
Pros: The biggest pro is that you won’t be taxed on money withdrawn from the account when you retire after 59 1/2. You might even be allowed to withdraw contributions (but not earnings) earlier without facing penalties or additional taxes.
Cons: As is the case with a traditional IRA, you have total control over how your money is invested. For some, this is a major plus. For others, it can be a disaster. Unless you are an investment expert, rather get an experienced adviser to assist you. There are also certain income limits as far as contributions are concerned.
The average 401(k) plan requires employers to go through various non-discrimination tests every year to ensure that high earners are not required to contribute more than their fair share relative to their lower-earning counterparts. These requirements are bypassed by the Simple IRA since all employees receive the same benefits. The employer can choose whether to contribute a 2% (non-elective) share or a 3% match, even if a worker doesn’t make a contribution at all.
Pros: The majority of Simple IRAs are designed around a match, i.e. to allow employees to make tax-deductible contributions that are matched by their employer. From the employer’s point of view, it looks quite similar to a 401(k) plan.
Cons: At the time of writing, the maximum amount a worker can contribute is $13.500 per year, which is less than the $19,500 provided for by many other contribution plans.
These accounts have the same eligibility requirements and maximum contributions as traditional IRAs. The difference comes in with the types of investments the employee is allowed to make. With a self-directed IRA, you can only invest funds in assets such as real estate, precious metals, and cryptocurrencies. The greater levels of autonomy make this type of retirement account a higher-risk, higher-reward option.
Simplified Employment Pension IRA
The Simplified Employee Pension IRA (SEP IRA) was created for small businesses with a mix of self-employed individuals and employees. If you qualify, you will be allowed to contribute the lesser of $58,000 or 25% of your total compensation in any given year. Contributions are not taxed, but you will pay tax once you start withdrawing funds. Withdrawals have to commence before you reach the age of 72 but not before the age of 59 1/2. Otherwise, you will face penalties.
This type of retirement account is created when an IRA or a 401(k) is moved to a new IRA account. The funds are ‘rolled over’ from the first account to the new one, but you will still enjoy the tax benefits of an IRA. A rollover IRA can be created at any institution that will allow this and there is no maximum to the amount that can be transferred.
With a rollover, you will also be able to convert your retirement account from a 401(k) or a traditional IRA to a Roth IRA. Beware of possible tax implications though.
Pros: With a rollover IRA, it is often possible to continue benefitting from certain tax benefits if you, e.g., choose to leave your former workplace’s 401(k) plan. As with all IRAs, you can invest in a wide selection of investments.
Cons: The fact that you will be in charge of investing the funds might be problematic for some individuals. Pay particular attention to the possible tax implications if you are converting your retirement account from a 401(k) or IRA to a Roth IRA.
With this type of retirement account, the spouse of an employee who earns an income is allowed to make contributions to an IRA – provided it’s not more than the taxable income of his or her spouse. Spousal IRAs can be either a Roth IRA or a traditional IRA.
Pros: A spousal IRA allows the non-working spouse of a working employee to benefit from the benefits offered by an IRA.
Cons: As is the case with all IRAs, the contributor will have to make his or her own decisions when it comes to investing the money. Depending on your skills, this can be a pro or a con.
A Health Savings Account can be utilized to save money to help cover the cost of healthcare during your retirement years. To qualify, you must have a high-deductible health insurance plan. At the time of writing, the maximum annual contribution is $3,600 for an individual and $7,200 for a family.
If you are 55 years old or older, the annual maximum contribution is $1,000 higher. The contributions are tax-deductible and, provided they are for qualifying medical expenses, you are not taxed on withdrawals.
Solo 401(k) Plan
Also often referred to as Uni-k, Solo-k, and One-participant (k), these plans are meant for business owners and their spouses. Elective deferrals to a maximum of $19,500 are allowed, as well as a non-elective contribution that doesn’t exceed 25% of total remuneration. The combined maximum is $57,000 p.a.
Pros: If you would like to create your plan as a ROTH, it isn’t allowed with a SEP but it is allowed with a Solo-K.
Cons: It’s more involved to set up and an annual report has to be filed if assets exceed $250,000. It’s also not suitable if you intend to employ workers.
Traditional Pension Plans
This is a kind of defined-benefit plan that is very easy to manage and requires very little employee involvement. Only the employer makes contributions and at retirement, the employee gets a fixed monthly benefit. Less than 14% of Fortune 500 firms are, however, still offering these plans, compared to 59% in 1998.
Pros: This option removes the risk that the employee might run out of money before his or her death.
Cons: The formula used is tied to compensation and years of service, so the highest growth happens toward the end of your career. If your employer terminates the plan before you reach retirement age, benefits might be dramatically reduced.
Guaranteed Income Annuities (GIAs)
Few employers offer these plans, but they can be bought by individuals who want to create their own pension funds. You can, e.g., invest a lump sum when you retire in return for a regular annuity for the rest of your life.
Pros: These are an option for someone who has a large amount of cash and wants to buy an annuity for the remainder of his or her life.
Cons: Not a good solo option. If you expect to receive a large amount of money upon retirement and that doesn’t happen, you might end up with no income during your golden years. You will also receive bond-like returns without the option of getting the potentially higher returns offered by the stock market.
Federal Thrift Savings Plan
This plan can be compared to a high-speed 401(k). It’s available to members of the uniformed services and government workers. If you qualify, you have various options: An S&P 500 index fund, a bond fund, a global stock fund, a small-cap fund, and a fund invested in specially-issued Treasury securities. Federal workers can also select one of various lifecycle retirement funds.
Pros: Federal employees qualify for a 5% contribution by their employer. This includes a non-optional 1% contribution, a 100% match for the next 3%, and a 50% match for the rest. Fees are also very low.
Cons: Similar to defined contribution plans, there’s no certainty about the amount you will be getting upon retirement.
This type of retirement account can be compared to a pension plan or a defined benefit plan. Instead of promising a specific percentage of your income during retirement, you will get a hypothetical account balance that is based on investment and contribution credits. A common setup, for example, is the employer contributing 6% of your pay. Added to that could be a 5% yearly investment credit. The latter is basically only a promise because it isn’t based on any actual contribution credits. If the plan realizes a higher return on assets, the employer could decide to reduce their contributions.
Pros: No worker contribution is required. If you change jobs, the account balance can be transferred to another retirement account. Upon retirement, you can choose from a lump sum or an annuity for life.
Cons: If your employer switches from a more generous retirement plan to a cash-balance plan, you might lose out if you are approaching retirement age. The investment credits are also fairly modest.
Cash-Value Life Insurance Plans
Some firms offer insurance plans as a retirement fund. There are quite a few types available, including variable life, variable universal life, whole life, and universal life. All of these build cash value over time and they also provide death benefits. Upon withdrawing the cash value, the premiums you paid are withdrawn first and are not taxable.
Pros: This is a fairly low-risk option because it provides either a source of income or a death benefit. You also qualify for tax deferral on your investment returns.
Cons: If you make any mistake or the policy lapses, your tax bill could be very high. Once you sign up, you are also in for the long haul. This is not very appealing if the investment products fail to perform as expected.
Only recommended for individuals who are already making the maximum possible contributions to other retirement savings accounts such as an IRA and a 401(k).
Non-Qualified Deferred Compensation (NQDC) Plans
These plans are typically only available to top executives. There are 2 main types: one is 100% funded by the employer, the other one is similar to a 401(k) plan with an employer match and salary deferrals.
Pros: You are able to save funds on a tax-deferred basis but your employer is not allowed to deduct its contributions before you start withdrawing and paying income tax on those withdrawals.
Cons: The level of security offered by these plans is not very high since the promise to pay in the future depends on the company’s solvency.
There are loads of investment account options for U.S. investors. The right mix will depend on your eligibility for a particular plan, as well as your savings objective. Keep in mind the level of income you expect to derive from your retirement holdings as this will play a big influence in your decision on what retirement accounts to use.