The oft-repeated advice to start saving for retirement early doesn’t help much when you’re choosing between the different types of retirement plans. When you start saving, you have to consider whether you need to catch up, how much you think you’ll need after you stop working, and cost and tax implications. Here’s a rundown of several types of retirement accounts.
Defined Benefit Plans
Commonly known as a pension plan, this type of retirement saving is beginning to disappear as employers switch to other products that may cost them less and provide employees with more flexibility. Essentially, this plan provides a fixed payout upon retirement based on the worker’s age, salary, and length of employment. Contributions are tax-deferred, and the employer and an actuarial partner set limits on savings.
A 401(k) is an employer plan that offers investment options for employees to select. Contributions come out of paychecks on a pre-tax basis, and employers often offer a match to supplement savings. Putting money into a 401(k) plan reduces taxable income, and the money in the plan grows without incurring taxes until withdrawal. Upon retirement, people usually drop into a lower tax bracket, and the payouts are taxed according to their income in retirement. Contribution limits are generous. The employer chooses the investment options, so watch out for plans that offer extremely limited selections.
Employees of tax-exempt or state and local governmental entities may find their employers offer 403(b) plans (for tax-exempt organizations) or 457 plans (for state and local government positions) that provide similar tax-deferred benefits
Traditional and Roth IRAs
Individual retirement accounts (IRAs) are retirement plans funded directly by the owner of the account. Contributions up to the allowed annual limit may be tax-deductible, and savings compound and build until withdrawal. People often use them used as repositories for rolled-over 401(k) plans from previous positions. Traditional IRAs have eligibility requirements and large penalties for early withdrawals. Contributions aren’t deductible if there’s an employer plan in place and the income is above the set limit. Roth IRAs are also self-funded, but contributions are after-tax and not deductible. The upside is that withdrawals upon retirement are tax-free (your money is taxed only once). These work well for people who are currently in low tax brackets and who expect to be making more money at a higher tax bracket in the future.
An annuity is a type of retirement plan that isn’t really a plan—it’s a contract that promises a payout for a defined amount of time: a set number of years, the employee’s lifetime, or the employee and their surviving spouse’s lifetime. Annuities are contracts with insurance companies, purchased with either a lump sum payment or payments over time. Payouts can be fixed or they can fluctuate, depending on the type of annuity, and they may begin immediately or at a later date. Annuities usually supplement but don’t replace other types of retirement accounts.
Select from several professional retirement plan advisors before selecting any retirement product.