Now more than ever, saving for retirement is one of the biggest keys to long-term financial success. After all, just 15 percent of US employees had access to both defined-benefit plans (also known as pensions) in 2020, according to the Bureau of Labor Statistics. An additional 3 percent had access to defined-benefit plans only. That adds up to just 18 percent of all workers with access to defined-benefit (pension) plans.
What does this mean? With the vast majority of employees not having a pension and the future of Social Security in jeopardy, employees must do their own saving. Having adequate retirement savings is crucial if you want to ensure you will have enough money in retirement.
While that can sound intimidating, with proper planning it is more than possible to save money on your own. The purpose of this guide is help you understand the ins and outs of retirement saving so you can set yourself up for the future.
Why is Retirement Savings So Important?
Whether you are 25 or 45, it's important to set money aside in order to secure your retirement. The sooner you start, the better, but it's never too late. Hopefully, government programs can provide at least some money in retirement, but we can't rely on them to provide a comfortable standard of living at this point.
Employer-Sponsored Retirement Plans
Employer-sponsored retirement plans, are retirement plans provided by an employer. Typically, information on these plans will come from your HR department or benefits office, if you have one.
The first three types of plans mentioned below are considered defined -contribution plans because you contribute a percentage of your paycheck to them. While not quite as nice as defined-benefit plans (covered later), they offer a few advantages.
For example, you can contribute to them via payroll deduction, where your employer simply takes a percentage of every paycheck and adds it to the plan. Along with it often comes matching contributions where your employer will match your contributions up to a certain percentage of your paycheck.
The 401(k) is one of the most common types of defined-contribution plans. Like the other defined contribution plans mentioned here, it is named for its corresponding subsection of the Internal Revenue Code.
Many employers offer these plans. They come in two different forms; the traditional 401(k), where only withdrawals are taxed, and the Roth 401(k), where only contributions are taxed. Which plans are available may vary by employer.
These plans allow employees to invest in an array of different assets, including stocks, bonds, and mutual funds. Because the plan is sponsored by the employer, they have the final say over what investments are available. You can contribute via payroll deduction, and employer matching may be offered.
The 403(b) is another defined-contribution plan that is very similar to the 401(k). The main difference is that these plans are offered to employees who work at places like government agencies and non-profit organizations. You may also see a 401(a) plan offered if you work at one of these organizations.
Effectively, there is little difference between the 401(k) and the 403(b) from the perspective of the employee. The distinction mostly has to do with the tax code and how these plans are categorized by the IRS.
Like the 403(b), the 457(b) plan is offered to employees of organizations which are not for-profit companies. For example, state and local governments and some non-profit organizations offer these plans.
From the perspective of the employee, 457(b) plans work much the same as 401(k) and 403(b) plans. They are a defined-contribution plan and matching contributions may be offered.
However, there is one major difference: these plans do not have an early withdrawal penalty. The other plans have a 10% penalty if you withdraw from them before age 59 & 1/2, and that is in addition to the tax you pay for non-Roth plans. Because there is no early withdrawal penalty, these plans are extremely desirable for those who want to retire early.
Defined-benefit plans are commonly referred to as pension plans. Although these plans are far less common than they used to be, they do still exist. Today, they are more common in the public sector than in the private sector.
Unlike defined-contribution plans, defined-benefit plans don't always require employees to chip in to receive money in retirement. They simply receive a certain amount on a regular basis, typically as a percentage of their salary in the final years of work. The number of years the employee worked for the organization is also a factor.
Employee Stock Ownership Plans
An employee stock ownership plan (ESOP) gives employees the option to have ownership in the company. These plans are offered at companies where the controlling interest has a vision for the future of the face of the company.
These plans come with tax advantages and may be offered at a discounted rate. They require employees to purchase the shares, but the company will buy the shares back when the employee retires. If the shares appreciate significantly, employees can earn a substantial return.
As the name implies, profit-sharing plans are retirement plans that allow employees to share in the profits of a company. Under this type of plan, employees are entitled to a percentage of quarterly or annual earnings. Thus, they can be seen as a way to incentivize employee performance.
These plans, also known as deferred profit-sharing plans, are plans to which only employers contribute. Employers decide how much of the profits to share with its employees.
Individual Retirement Plans
Individual retirement plans allow you to contribute money independent of your employer. These plans are beneficial to self-employed people, but they also have advantages for those who don't work for themselves.
For instance, with an employer-sponsored plan, you have to use whatever arrangement your employer offers, such as NetBenefits. With an individual retirement plan, you can open an account wherever you want. That also means you aren't limited to whichever investments your employer decides to offer in its plans. Instead, you can invest your money however you choose.
The traditional individual retirement account (IRA) is a retirement account that any individual can open. Individuals can hold many types of assets in these accounts, including stocks, bonds, mutual funds, ETFs, REITs, mutual funds, and more.
Neither contributions nor growth is taxed on the traditional IRA. The only thing that is taxed are withdrawals. Because the IRS is not able to claim any taxes on these funds until withdrawal, traditional IRAs are subject to required minimum distributions (RMDs). The SECURE Act changed the first RMD year to age 72.
Like other types of retirement accounts, traditional IRAs are subject to a 10 percent early withdrawal penalty if you withdraw before age 59 & 1/2. There is also a $6,000 contribution limit for 2021, or a $7,000 "catch-up" contribution limit for those age 50 and over.
The Roth IRA is similar to the traditional IRA with a few key differences. The difference you will immediately notice is that with a Roth IRA, contributions are taxed, but distributions are tax-free. This is the opposite of how a traditional IRA is taxed. Growth is not taxed on either type of account.
Because the traditional IRA has pre-tax contributions, it lowers your adjusted gross income (AGI). This may knock you down to a lower tax bracket. With a Roth IRA, though, you don't have this possibility because contributions are taxable.
Roth IRAs also have income limits. Single people must make less than $139,000 in 2020, and married couples must make less than $206,000. As you might expect, these limits change, so you will have to keep an eye on them if your income increases over the years. If it increases enough, you might be phased out of eligibility. However, if that happens, you can contribute to a traditional IRA instead, which has no such income limits.
Roth IRAs also don't have RMDs. You pay tax on the contributions; the IRS gets its money up-front, so it doesn't much care if and when you take your money out.
A simplified employee pension (SEP) plan is a favorite among self-employed people who don't have a 401(k) or 457(b). However, it may be established by those employing others, too. Employers make tax-deductible contributions on behalf of employees. Self-employed people are technically both the employer and the employee, making this an easy way for them to save for retirement.
It is also possible to contribute quite a bit more to these accounts than to traditional or Roth IRAs, making them a great way to sock away significant retirement savings. Employers determine how much to contribute to these plans, not the employees. But again, this point is moot for self-employed people.
For those who are not self-employed but have a SEP IRA issued by their employer, they can be a bit limiting. 2021 contribution limits are 25% of the employee's salary or $58,000, whichever is less. Thus, those with high incomes can contribute a substantial amount to these accounts. Like a traditional IRA, contributions are tax-deductible.
The Solo 401(k), or one-participant 401(k), is another retirement plan for self-employed people. That "one-participant" part is quite literal: you cannot have a solo 401(k) if you have employees. There are no income limits or age restrictions, but you cannot open a solo 401(k) unless you are self-employed.
The contribution limit for these plans is $58,000 in 2021, plus an additional $6,500 catch-up contribution. Contributions are pre-tax for a traditional account and taxable for Roth accounts. Like other types of retirement accounts, there is a penalty if you withdraw before age 59 & 1/2.
Health Savings Account
While not technically a retirement account, the health savings account (HSA) can be used like a retirement account. Plus, they offer significant tax advantages. The money you contribute to an HSA is pre-tax and can be used to cover qualified medical expenses. The money also rolls over to the next year if you don't use it.
Here's the key part: the money in an HSA can be invested just like money an an IRA. Plus, the earnings are not taxable. Individuals can contribute up to $3,500 to them in 2021, or $7,000 for families.
You can withdraw money from these accounts at any time, but there is a 20% penalty if you use the money for anything other than qualified medical expenses. However, after age 65, you can use the money for anything you want with no penalty. The money will still be taxed as income, though.
Note that you must have a high-deductible health plan (HDHP) to be eligible for an HSA. This means an HSA is not right for everyone.
There are many different types of assets in which you might invest. Exactly which options you have will vary depending on the retirement plan, but we'll cover some of the basics here.
Mutual funds are a way for individual investors to pool their money in an investment fund that is managed by a fund manager. Investors simply buy shares of the mutual fund, and the fund manager does the work of buying and selling securities.
This type of fund is offered in many 401(k) plans, but there are some mutual funds that are popular outside of employer-sponsored retirement plans. However, because mutual funds have a separate fund manager, the fees can sometimes be high.
Exchange-traded funds (ETFs) are similar in many ways to mutual funds. The biggest difference is that most ETFs are passively-managed, meaning they do not have a fund manager. This means the fees are often lower.
In addition, ETFs can be traded at any time while the market is open. Mutual funds, on the other hand, can only be traded once, after market close. However, some brokers do not allow you to buy ETFs shares automatically. Therefore, it is sometimes easier to automate your strategy if you buy mutual fund shares.
Stocks and Bonds
You can invest in stocks and bonds the same way you would in a mutual fund or ETF. In fact, most mutual funds, ETFs, and index funds are made up of stocks and bonds. However, you can also invest in individual stocks and bonds.
The common advice in the personal finance community is to avoid these if you are investing long-term. For the average investor that does make sense, but there are still scenarios where you might have them in your portfolio.
For example, we mentioned stock profit-sharing plans above. We also like buying individual stocks as a small portion of our portfolio for greater growth potential.
Bonds can also be useful. For instance, you might consider buying series I savings bonds or treasury bonds as an inflation hedge. Even though these investments are not part of a diversified fund, they are backed by the US government and thus are quite safe.
How to Set Up Your Retirement Plan
The way you set up your retirement plan will vary depending on the type of plan. The two most basic ways to set up your plan are either through your employer (see employer-sponsored retirement plans above), or on your own (see individual retirement plans above).
Your HR department or benefits office should have information on setting up an employer-sponsored retirement plan. If you are setting up an individual retirement plan, you have a lot more choices. That can also make it seem more complicated or overwhelming, but we have a few articles to help get you started: