Retirement Plans

    Saving money for retirement is important for ensuring long and comfortable work-free years. It’s all too common for people to assume they are too young to begin saving or underestimate the amount they need to save. In reality, you can never save too much or too soon.

    Although Social Security is the largest source of retirement income for Americans 65 and older, two broad categories of retirement programs have become important sources of supplementary income for prospective retirees: employer-sponsored retirement plans and individual retirement plans.

    For many years, Americans who worked for large companies could rely on employer-sponsored pension programs, known as defined benefit plans. In a defined benefit plan, the amount of future benefits that an employee receives is based on a formula that takes into account the individual’s salary history and years of service.

    Although defined benefit plans still exist, they were replaced increasingly over the past 30 years by defined contribution plans, which offer no guaranteed return. Between 1977 and 2007, the number of participants in defined-contribution plans rose by 358 percent, from 14.6 million workers to 66.9 million.

    At the same time, the number of people in defined-benefit plans dropped 31 percent, from 28.1 million workers to 19.4 million.

    Making a Plan

    EXPERT QUICK TIP

    Financial experts often recommend you pay yourself every month just as you would pay any bill.

    While investing for the future seems obvious, people don’t always make it a priority. It was estimated at the end of 2011 that a 65-year-old retiree would need to have saved $1.1 million in order to draw $50,000 a year in inflation-adjusted dollars. Unfortunately, data indicates a large number of workers nearing retirement age have not saved anywhere near enough to retire comfortably.

    Differences in Retirement Plans

    In defined contribution plans, employees — and in some cases their employers — contribute to individual accounts over the course of a worker’s term of service. The employee’s benefits at retirement, or at termination of employment, are based on the contributions made and any earnings or losses that result.

    Like defined benefit plans, defined contribution plans are still considered employer-sponsored, even though the employee makes the bulk of the contributions. The employer is usually responsible for determining membership parameters, investment choices and, in some cases, providing contribution payments in the form of cash and/or stock.

    There are several types of defined benefit plans. The most common one is the 401(k), which is named for the section of the Internal Revenue Service code that defines it. Other plans are the 403(b) plan and a 457 plan.

    401(k) QUICK TIP

    While a 401(k) will help you save, you may not be able to tap into your employer’s contributions immediately. Some companies will require a certain number of years of service called vesting before gaining access to its payments. There are also costly penalties for pulling out funds before retirement age.

    401(k) Plans

    In a 401(k) plan, employees make regular contributions through deductions from their paychecks. They receive a tax deferment on the amounts contributed. In addition to the tax advantage of the 401(k), the heart of the plan is the “free” money that an employee can collect from employer contributions.

    Not all companies offer 401(k)s, and not all that do contribute to them. But many companies do add a matching sum, or a percentage of whatever an employee chooses to contribute to the plan — usually between 1 percent and 8 percent of salary. The rationale is that it not only saves the company money compared to a defined-benefit pension plan, but it also helps encourage employees to save for retirement.

    There’s also the Roth 401(k) plan, which works much like a regular 401(k), except that employees contribute after-tax income to their accounts but are allowed to withdraw their earnings tax-free during retirement.

    Although employers set the broad structure of their 401(k)s, employees get to make some investment decisions. Depending upon the plan, employees can invest their money in mutual funds, money market accounts, bond funds and/or company stock.

    403(b) Plans

    Another employer-sponsored DC plan is the 403(b). Older than the 401(k), it was originally created for teachers and nurses at public hospitals who were not covered by pension plans.

    Also called Tax Sheltered Arrangements, they are generally available to workers for any non-profit institution. As with 401(k)s, employee contributions are not subject to taxes in the year of contribution and employers may or may not contribute.

    457 Plans

    Other employer-sponsored DC plans include the 457 Plan, which is open to employees working for a state or local government. Both the plan sponsor and participants can make pre-tax contributions.

    HOW MUCH CAN I DEPOSIT IN AN IRA?

    Typically, you can deposit up to $5,000 a year into an IRA — and up to $6,000 a year if you are at least 50 years old and trying to make up for lost time.

    Individual Retirement Accounts (IRAs)

    An IRA is a savings account that allows big tax breaks. There are several types of IRAs, with the Traditional IRA and Roth IRA being the most common. Each account has its own rules and restrictions based on your income or employment status as well as limits to how much you can contribute to the account each year. There are penalties, however, if you need to access this money before retirement age.

    IRAs were created by Congress as part of the Employee Retirement Income Security Act of 1974. By 2009 IRAs held $4.2 trillion, or more than one-quarter of the $16 trillion in total U.S. retirement assets. About 40 percent of U.S. households own one or more types of IRAs.

    Traditional IRAs

    The Traditional IRA is a good choice if you would like a tax deduction, your income is too high to be eligible for a Roth IRA or you think you will be in a lower tax bracket during retirement. You can deduct your contributions from your taxable income (depending on your adjusted gross income) and then pay taxes on the distributions when you receive them in retirement.

    Withdrawals from an IRA before that age incur a 10 percent penalty, although there are a number of exceptions, including the owner’s death.

    Roth IRAs

    The Roth IRA was introduced in 1998. It differs from the Traditional IRA in that it permits only after-tax contributions, and earnings on investments are tax-free if taken after age 59 1/2.

    Distributions of principal before that time are not subject to tax, but investment earnings are. There also is an additional 10 percent penalty in such cases unless the money has been in the account for at least five years or qualifies for other exemptions.

    The Roth IRA is the ideal choice if you would like to take tax-free withdrawals in retirement, avoid the required minimum distributions at age 70, or believe you will be in the same or a higher tax bracket in retirement. While you don’t get the immediate deduction, if the money remains in the account for at least five years, all distributions are tax free.

    With a Roth IRA, there are no required distributions during the account holder’s lifetime, so the account can be passed on to heirs or beneficiaries. As with a Traditional IRA, there are income and contribution limits set by law.

    Simple IRAs and SEP IRAs

    Other types of IRAs are accounts set up by employers for their employees. The SIMPLE IRA, or Savings Income Match Plan for Employees, is designed for sole proprietorships or companies with fewer than 100 employees. Both employer and employee can contribute to these accounts.

    The SEP IRA, or Simplified Employee Pension Plan, is another plan designed for small companies and sole proprietorships. In a SEP IRA, employers make the contributions on behalf of their employees.

    Pension

    Are Pension Funds Tax-exempt?

    Pension funds are typically exempt from capital gains tax and the earnings are either tax-deferred or tax exempt.

    A pension is a type of retirement fund set up by a company to pay you a guaranteed amount when you retire from service. The money is collected by the employer and the worker during the employment years and invested in securities and other assets. The amount is calculated using your salary, years of service and a fixed percentage rate.

    Military Retirement Benefits

    Retirement benefits for military personnel include pensions that pay 50 percent of their salaries for the rest of their lives, with 2.5 percent added for each year of active duty beyond 20 (up to 75 percent). Retirees also get lifetime health insurance for themselves and their families under the military’s HMO plan, Tricare.

    Social Security

    Social Security is a social insurance program established in 1935 that uses public funds to provide financial security for the public. Employers and employees are required to pay Social Security taxes through Federal Insurance Contributions Act tax (FICA). Those taxes are then used to provide benefits for people who are currently of retirement age (or otherwise eligible).

    Fast Fact

    Today, 15.3 percent of income is withheld (split between employee and employer) with a cap at a gross income of around $70,000.

    The amount you receive in benefits is based on the amount you paid in to the system, which is based on your income. Unfortunately, experts anticipate Social Security will eventually pay out more in benefits than it receives in payroll taxes during the year, thereby putting the retirement benefits of millions of people in jeopardy. U.S. policy makers and politicians continue to argue to make changes to the system to ensure funds for future retirees through increased taxes, reduced benefits or through program privatization.

    Savings

    Personal savings accounts allow you to earn interest off the money you have deposited into the account. Interest rates on savings accounts vary; the best option is to find one that doesn’t require any fees to maintain.

    It’s never too late to begin saving for retirement; you can begin with small deposits and make it a goal to increase that amount monthly. If possible, have your savings account set up to receive regular deposits from your paycheck, that way you aren’t tempted to spend it. The earlier you start saving, the more time your money has to grow.

    Fast Fact

    More than half of people age 65 or older receive at least 50 percent of their income from Social Security. More than 15 percent have no other source of income.

    It’s vital to take the steps, at any age, to prepare for the future. If possible, invest in several different retirement programs, so if one doesn’t meet your long-term financial needs, you can still retire comfortably.

    Bill Fay

    Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

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