Retirement Planning 101
Retirement planning is the practice of saving money so that a person can become financially independent enough to make employment optional for himself or herself. Planning should start as soon as a person enters the workforce, and should continue throughout their working years. Most employers offer retirement savings vehicles, such as a defined benefit or defined contribution plan. There are also retirement vehicles that aren’t provided through employers. A mix of an employer provided vehicle and outside vehicles are generally necessary to help individuals reach their retirement goals. A brief summary of the variety of tools future retirees should be aware of will be covered in the following paragraphs.
Defined Benefits vs Defined Contribution
There are two basic forms of employer sponsored retirement plans, defined-benefit plans and defined-contribution plans.
A defined-benefit plan is when an employees benefit is calculated through a formula. This formula usually involves two major factors; the salary history of the employee, and the duration on employment with the company. The company has complete control over how the funds are invested, and therefore shoulder all of the risk. Since the benefit amount is fixed for every employee based on their individual calculations, companies can find themselves in two very different positions. A company may make money if they earned higher than expected returns from their investments, or if they earn less than expected returns then the company will have to dig into its company's earnings to pay out its predetermined retirement benefits.
With a defined-contribution plan an employee sets aside an amount or percentage of money on a yearly basis. Despite a consistent amount of money being contributed on a yearly basis, there is no fixed benefit amount. The benefit is dependent on the performance of the investments, so many companies prefer this choice since it removes all risk and liabilities from their shoulders.
A defined-benefit plan is when an employees benefit is calculated through a formula. This formula usually involves two major factors; the salary history of the employee, and the duration on employment with the company. The company has complete control over how the funds are invested, and therefore shoulder all of the risk. Since the benefit amount is fixed for every employee based on their individual calculations, companies can find themselves in two very different positions. A company may make money if they earned higher than expected returns from their investments, or if they earn less than expected returns then the company will have to dig into its company's earnings to pay out its predetermined retirement benefits.
With a defined-contribution plan an employee sets aside an amount or percentage of money on a yearly basis. Despite a consistent amount of money being contributed on a yearly basis, there is no fixed benefit amount. The benefit is dependent on the performance of the investments, so many companies prefer this choice since it removes all risk and liabilities from their shoulders.
Pension Plan
A traditional pension plan is a best described as a defined-benefit plan. The longer you have worked for the company you retire with and the higher your annual salary was, the sum of the guaranteed benefit becomes larger. In the 1980s more than 90% of employers had a defined- benefit plan such as a pension plan established, while the remaining plans available were defined-contribution plans. Over the years the tables have drastically turned. Now around 10% of companies still have a defined-benefit plan, while the rest have defined-contribution plans.
Defined Contribution Plans
As explained earlier, these plans put all the investment risk on the shoulders of the employees. So why contribute to these plans when you can hold investments with the same amount of risk outside of your employer? Well with defined-contribution plans that are qualified there are tax incentives to contribute towards them. If you were to invest in a stock such as Apple Inc. (AAPL) on your own, there are many tax consequences. The money you would have paid to purchase the stock, would have already been taxed as income most likely in the range of 15-25% or even higher. Assuming the stock grows while you own it, the amount it has grown by since its purchase is subject to capital gains tax (generally 15%) upon the stocks sale. If the stock pays out a dividend on a yearly basis, that dividend is also subject to income tax (15-25% or higher).
Now lets say that your employers plan holds Apple Inc. stock, so you would like to start contributing towards that plan. The amount you contribute towards the plan isn't taxed, in fact it is actually tax-deffered. This means the amount you contribute is deducted from your taxable income every year which reduces your tax burden. Many employers even offer to match your contribution up to a certain extent. A general example of this would be a company matching your contribution towards you plan up to 3% of your annual salary. This is a great benefit to have as an employee, because you essentially receive free money and double what you are contributing to your plan. As the stocks inside the plan grows and possible pays dividends, it all is tax free. When you reach retirement you are then responsible for paying taxes on the money you withdraw from the account, and it is taxed at your income tax rate.
With defined contribution plans you can invest in the same sorts of vehicles you could on your own such as stocks, bonds, and mutual funds. The biggest advantage is that the employees sponsored plans act as tax-shelters for your money until you reach retirement. If you were to ever withdraw money form these employees sponsored plans before the age of 59 1/2, the federal government requires you to pay taxes on that money as if it were ordinary income, plus a 10% early withdrawal penalty fee assessed by the federal government. So when investing in these plans, make sure that you are committed on not touching that money until you reach full retirement.
Now lets say that your employers plan holds Apple Inc. stock, so you would like to start contributing towards that plan. The amount you contribute towards the plan isn't taxed, in fact it is actually tax-deffered. This means the amount you contribute is deducted from your taxable income every year which reduces your tax burden. Many employers even offer to match your contribution up to a certain extent. A general example of this would be a company matching your contribution towards you plan up to 3% of your annual salary. This is a great benefit to have as an employee, because you essentially receive free money and double what you are contributing to your plan. As the stocks inside the plan grows and possible pays dividends, it all is tax free. When you reach retirement you are then responsible for paying taxes on the money you withdraw from the account, and it is taxed at your income tax rate.
With defined contribution plans you can invest in the same sorts of vehicles you could on your own such as stocks, bonds, and mutual funds. The biggest advantage is that the employees sponsored plans act as tax-shelters for your money until you reach retirement. If you were to ever withdraw money form these employees sponsored plans before the age of 59 1/2, the federal government requires you to pay taxes on that money as if it were ordinary income, plus a 10% early withdrawal penalty fee assessed by the federal government. So when investing in these plans, make sure that you are committed on not touching that money until you reach full retirement.
401 (k)
A 401(k) is a defined-contribution plan. You contribute up to $17,500 per year, and any amount that you contributed is a deducted from your gross income that year. Some employers don't match contributions, however most do. Matches range anywhere from 0-6% of salary. For example if an employee makes $30,000 a year, and elects to contribute to their 401(k) the employees will be willing to match up to $900 ($30,000 x 3% = $900). The employees will only contribute that $900 assuming $900 is contributed by the employee too. It is highly recommended that employees take advantage of their companies benefit of matching, as it will add up to a very meaningful amount over a course of an employees career.
It is important to be aware of your employer's 401(k) vesting schedule. Vesting is the right to the employer contributed money. There are two types of vesting schedules; graded vesting and cliff vesting. Graded vesting (Table 1.1) slowly allows the employee more rights to the employer contribution over a six year period. So if an employee leaves a company after 3 years and has a 401(k) worth $5,000 which includes $1,000 that was matched over the years by the employer. The employee would only have the rights to 40% of that ($400), and would leave the company with a 401(k) valued at $4,400. The other type of vesting called cliff vesting is a little more simple. If you leave a company before 3 years of service, you don't get to keep any of the employees match. If you leave the company any time after 3 years of service, then you have 100% ownership of the employees contributions.
You may have also heard of 403(b)s and 457(b)s. These operate the same way 401(k)s do. A 403(b) is what a non-profit organization offers it employees. A 457(b) is what many government agencies offer their employees. If you remember anything about these three financial vehicles it; make sure to take advantage of your employers matching contribution, and when you do save money into these vehicles be ready not to touch the money until you are at least 59 1/2 years of age.
SIMPLE IRA
A SIMPLE IRA (Savings Incentive Match Plan for Employees) is a plan that is generally see up by very small employers. It is easy affordable to set up and simple to operate, and that is why it attracts small business. Employees can contribute up to $12,000 a year (tax-deffered). The employer then matches up to 1, 2, or 3%.
SEP IRA
A SEP is a Simplified Employee Pension. This was initially created for people who are self-employed, however small businesses also have access to use these. An employee can contribute a maximum of 25% of their income into this plan or no more than $51,000 a year. It is optional for employers to match with a SEP IRA.
The meaning of "Roth"
You many have heard the term "Roth" before, as in "Roth IRA" or "Roth 401(k)". In the case of a Roth 401(k) it just means it is taxed the opposite of a 401(k) as explained above. With a Roth 401(k) and employee would contribute their after tax dollars towards their Roth 401(k), this also means that the contribution can't be deducted from their gross income. A Roth 401(k) isn't taxed as it grows just like a normal 401(k). However, when money is withdrawn from a Roth 401(k) in retirement it isn't taxed at all. This means the money inside the vehicle has grown tax free, and the growth that has accumulated over the years is tax free as well. This is very advantageous to people who believe taxes are going to rise, or that they will be grow into higher tax brackets as they get older.
Individually Owned Vehicles
There are two individually owned retirement vehicles that are important for people to be aware of, those being a Roth IRA and a Traditional IRA.
A Roth IRA operated just as a Roth 401(k) does (explained above). The Roth IRA was initially set up to help encourage people to save for retirement that weren't considered wealth, and that is why it is a tax friendly investment. The government realized that it is a very advantageous vehicle for people to take advantage of and that is why they have rules to qualify for it. A single person can only contribute up to $5,500 a year and must be employed. As of 2014 the person must also earn less that $129,000 a year in gross income to contribute. Once an owner of a Roth IRA turns 59 1/2 years of age they have access to all the money that has been contributed and the growth on those contributions tax-free! It is highly recommended that all people that qualify for a Roth IRA, own and contribute to one to compliment their employees provided retirement plan.
A Traditional IRA is available for anyone has employment, but is most attractive to those who don't qualify for a Roth IRA. A Traditional IRA is taxed the same way a normal 401(k) is treated, however since it isn't an employer provided retirement plan there is no matching contribution from an employer. To contribute to this vehicle, you can make an amount of money, but as a single person you can only contribute up to $5,500 annually.
A Roth IRA operated just as a Roth 401(k) does (explained above). The Roth IRA was initially set up to help encourage people to save for retirement that weren't considered wealth, and that is why it is a tax friendly investment. The government realized that it is a very advantageous vehicle for people to take advantage of and that is why they have rules to qualify for it. A single person can only contribute up to $5,500 a year and must be employed. As of 2014 the person must also earn less that $129,000 a year in gross income to contribute. Once an owner of a Roth IRA turns 59 1/2 years of age they have access to all the money that has been contributed and the growth on those contributions tax-free! It is highly recommended that all people that qualify for a Roth IRA, own and contribute to one to compliment their employees provided retirement plan.
A Traditional IRA is available for anyone has employment, but is most attractive to those who don't qualify for a Roth IRA. A Traditional IRA is taxed the same way a normal 401(k) is treated, however since it isn't an employer provided retirement plan there is no matching contribution from an employer. To contribute to this vehicle, you can make an amount of money, but as a single person you can only contribute up to $5,500 annually.
Social Security
Everyone that works has social security tax pulled from their paychecks. However not everyone understands how Social Security works. It was set up by the government as a government sponsored pension plan. Every employee in the United States would pay into this plan over the course of their working years, and then when they reach full retirement age in the eyes of the government (age 67) they would receive monthly checks until they die. The benefits paid out are calculated in a formula that includes a persons highest 30 years of income and a few other variables. Social Security has been referred to "The Biggest Ponzi Scheme of all time". Sounds harsh, but as more baby boomers start to file to receive their Social Security checks over the next few years, there will soon be a swing of more money being withdrawn from the fund than being contributed which obviously isn't something that is sustainable. At the rate the current system is working, by 2033 benefits being paid out will be reduced to 77% of what they currently are. So when it comes to planning for retirement, it is safer to assume that you won't be receiving much in the form of Social Security checks during retirement unless there is reform.