The Best Retirement Plans (and When to Use Them)
To help ensure a comfortable retirement, it’s wise to have a solid gameplan. Putting a portion of your income into a tax-advantaged retirement plan allows your nest egg to grow exponentially. Here’s how to save for retirement efficiently using the best retirement plans available:
Why not just use a savings account?
Savings accounts may seem like a secure place to store your retirement funds, but there are many reasons why retirement plans are a better option:
- Retirement plans offer tax advantages: Unlike a savings account, contributing to a retirement plan can reduce your taxable income or allow for tax-free withdrawals (we’ll elaborate on these advantages below)
- Retirement plans allow for employer contributions: Many employers offer retirement contribution matching (up to a specified percentage of your monthly pay) as an employee benefit. This allows your retirement funds to grow more rapidly.
- Retirement plans have greater returns: Investing your money yields higher growth than putting it into Certificates of Deposit (CDs) or savings accounts.
What are the best retirement plans?
Defined Contribution Plans: This type of retirement plan is tax-deferred, meaning income tax on these funds will be paid at the time of withdrawal during retirement rather than at the time of contribution. The idea is that the taxation will occur when you are in a lower tax bracket rather than when your earnings are at their peak.
Employers may add funds to their employees’ defined contribution plans, but limitations are enforced on when and how an employee can withdraw their money. There are also limits to how much you can contribute each year. Here are two popular contribution plans:
- 401(k) plans: Offered by employers and allows employees to have contributions automatically withdrawn from their paychecks. You can choose where your funds are invested, selecting from aggressive options, conservative plans, and everything in between.
Early withdrawals are penalized heavily, so it’s important to save outside your 401(k) as well to cover any emergencies that arise.
- 457(b) plans: State and local employees, such as government officials, teachers, and civil servants, usually have access to a 457(b) plan. This type of retirement plan is a lot like a 401(k), except that you won’t pay a fee if you need to withdraw funds before retirement.
Another benefit is that those with both a 401(k) plan and a 457(b) plan can make maximum contributions to BOTH plans if they desire, reducing their taxable income significantly.
Individual Retirement Plans
If you don’t have access to an employer-sponsored 401(k) or 457(b) plan, or would like to save in addition to those plans, you can set up an Individual Retirement Account (IRA). IRAs allow investors to make tax-advantaged contributions that are earmarked for retirement. Early withdrawal fees, income limits, and contribution limits apply.
Here are the three most common types of IRAs:
- Traditional IRA:. Annual contribution limits in 2020 are $6,000 for those under 50 and $7,000 for those over 50. Contributions to this type of IRA are usually tax-deductible, unless you also have a 401(k) AND make more than the income threshold.
At age 70½ (yes, it’s oddly specific), traditional IRA holders are required to begin taking minimum distributions. Once an investor begins taking these distributions, they may no longer contribute to the IRA.
- Roth IRA: Contributions to this type of IRA are NOT tax-deductible, but qualified distributions will be tax-free. Like a traditional IRA, there are contribution and income limits. However, there is no required minimum distribution for a Roth IRA and you can contribute at any age.
- Rollover IRA: A rollover IRA account allows you to move funds from an employer-sponsored plan into an IRA with the purpose of maintaining the tax-deferred status of the investment, or to switch to a more favorable IRA.
There is no cap on the amount that can be rolled over, and the funds can be moved back to an employer-sponsored plan as needed.
Defined-Benefit Plans (pensions)
Employers use factors such as length of employment and salary history to structure this kind of retirement plan, and they manage the portfolio of the investment.
Benefits are paid out for life, and often rise incrementally to account for increased costs of living. If the investment is mismanaged or runs out, the company is financially obligated to make up for the funds with cash contributions.
Employers typically contribute a regular amount of each employee’s pay to fund a defined-benefit plan, but sometimes employees may contribute as well. Payouts are delivered as monthly amounts or as a lump sum, and employees with higher incomes and a greater number of years of service will receive larger payouts.
This type of plan is similar to a pension plan because it provides workers with a lifetime annuity that is insured and guaranteed. The difference is that cash-balance plans establish an account for each individual employee.
Younger employees benefit more from cash-balance plans vs. pension plans because the benefits grow over time. Dollars contributed early in their career have more time to compound, whereas traditional pension plan payouts are determined based on the salary earned in the last few years of the employee’s work history.
Guaranteed Income Annuities
Insurance companies sell annuities to guarantee income to retirees. To establish the annuity, you would provide a sum of money which the insurance company will invest. At a pre-specified time, payouts would begin.
This kind of retirement plan is best for conservative investors or for those who have maxed out other retirement contributions but still would like to make more tax-deferred investments.
Penalties apply if the annuity is canceled or if funds are withdrawn before age 59½. Investment fees can also catch buyers by surprise, so it’s important to have a clear understanding of the long-term costs of this form of investment vs. 401(k)s and IRAs.
We strongly encourage you to meet with a trusted financial advisor to help determine the best retirement plans for your unique circumstances and retirement plans. Whatever your situation, learning how to save for retirement can help you achieve any financial goals for your golden years. Happy investing!
- James Royal (May 2019) Saving vs. investing: Here are the key differences for managing your money
- Julia Kagan (Nov 2019) Cash Balance Pension Plan
- Advisor Voices (June 2016) What Consumers Need to Know About Annuities