When we think and talk about investing, we often have in mind our ideal retirement scenario — retirement is typically the primary focus of a financial plan.
The most common place individuals turn to for retirement savings is their employer, and that is because the United States offers employers tax benefits and savings solutions for their employees. Common names of employer plans are 401(k), 403(b), 457 and Thrift Savings Plan (TSP).
Other types of retirement accounts can be opened without an employer such as an IRA or Roth IRA.
Social Security is a government system that is aimed at providing income after a specified retirement age.
Let’s take a closer look at each type of account.
A well-known employer-sponsored plan is a 401(k) Plan. It’s called 401 because the savings rules are in the U.S. tax code under section 401.
401(k) Plans are defined contribution plans, which means they are retirement plans that allow you (as an employee) to contribute a portion of your wages pre-tax to an account in your name held in trust by your employer.
By putting your earnings in a 401(k) plan, the income tax will be deferred until it is taken out of the account when you retire. If the income is taken out before retirement, age 59 ½, it is taxed at the current tax rate of the individual and a 10% penalty is applied to the withdrawal.
Employers can choose to offer additional benefits to those employees who contribute to the plan, but they are optional. Some of those benefits may be:
- Match your contribution up to a certain percentage and add it to your retirement account when you contribute to the plan from your paycheck.
- Contribute a portion of company profits to your accounts.
- Offer a loan option, which is secured by your account's value.
A few savings rules apply to 401(k) Plans:
- 2018 contribution limits are $18,500 by the employee.
- In 2018 the employer can contribute so that the total account contribution for the year reaches a max of $55,000 (your contribution + employer contribution) or 100% of compensation, whichever is less.
- Catch-up savings of an additional $6,000 can be contributed each year if the employee is over age 50. The catch-up savings option began in 2001. It allows the employees closest to retirement to save as much as possible before they stop working. The $6,000 is in addition to the $18,500.
- Plans can offer a small select list of mutual funds or exchange-traded funds, guaranteed annuity investments, or they can provide a large universe of funds from which to choose. Mutual funds and exchange-traded funds are investments that are sold on a stock exchange. They invest in a basket of diversified securities by pooling the money provided by those who have purchased shares of the fund. An annuity is an insurance contract that offers a death benefit and a scheduled payout in retirement. When it is inside a retirement plan the purpose is typically to have a guaranteed rate of return on the investment promised by the insurance company. Annuities can be held inside in a retirement account and non-retirement accounts. The investment options available in the plan is up to your employer.
Another common employer-sponsored retirement plan is known as a 403(b), and it is offered to employees of public schools and other tax-exempt organizations like churches. Like 401(k) Plans, employers may contribute to an employee’s account up to a percent of pay match, and both the employee and employer contributions grow tax-deferred.
Withdrawals are allowed after age 59 ½ without penalty but are taxed at ordinary income rates. The same rules and limits for pre-tax contributions apply as the 401(k), listed above.
The 403(b) Plans were designed to have less administrative costs to benefit non-profit organizations. The use of an insurance product called an annuity made these plans unique when they first began. Annuities are an investment vehicle that allows you to contribute money each month to get a target income stream in retirement. It is not a requirement to own your investments within an annuity — your money can now be saved into a brokerage account and hold a variety of mutual funds. Annuities are known for having high fees, and it is crucial for investors to be aware of the costs associated with their investments options.
Retirement Plans 457 are tax-deferred plans offered by state or local governments, or non-profit organizations to employees who want to contribute pre-tax to a retirement account. The same contribution limits apply to a 457 as applies to a 401(k). Also, an employee can contribute to both to a 457 Plan and a 401(k) or 403(b); allowing you to save a max of $37,000 or 100% of an employee’s salary, whichever is lower.
Some unique features apply to 457 Plans. One is that if you need to make a withdrawal before 59 ½ years old, you won’t have to pay a 10% penalty. The other is an additional “catch-up” feature. If you are within three years of retirement age, as defined by the employer’s plan, an employee can contribute twice the standard annual limit ($18,500), which means $37,000 in 2018. 2
Thrift Savings Plans (TSP) are retirement plans offered to federal civil service employees, like postal employees or civil servants/non-elected employees working in any of the three branches of government. This plan is like a 401(k) that is managed by the employer who happens to be the Federal U.S. Government. Because of other employee benefits, some employees who can contribute to a TSP are not eligible for matching contributions. Others are eligible for matching described as a dollar for dollar match on the first 3% of the employee’s contribution and then $0.50 of each dollar when contributing 3-5% of their pay. No match is given after the first 5%.3
Some employees must be employed for two years before they are entitled to their entire contribution, this is called a vesting schedule. Non-government employers can also enforce a vesting schedule, but it is becoming less common than it used to be.
A unique part of a TSP is that they are known for not having a wide array of investment options. There are only 10 mutual funds from which an employee can choose, and they are not mutual funds regulated by the SEC, like most others, and are not traded on a public stock exchange. The ten options are diversified and still provide for solid retirement savings and investment return capabilities. There is a special government office that manages the TSP funds.
Employer sponsored plans are your best bet to start your retirement savings. Begin saving here first and save at least up to the match from your employer. For example, if your employer matches each dollar of your contributions up to 3% of your salary, you've just doubled your savings! You cannot pass that opportunity up because it takes a few minutes to fill out the paperwork. Just do it!
Social security is another type of savings vehicle offered to many types of employees and is provided by the U.S. government.
Employees of for-profit and non-profit employers will pay a social security tax each pay period. Most government employees do not pay social security taxes because another retirement pension program covers them. The government collects the social security tax, pays a benefit to existing retirees, and invests what is left into U.S. bonds. Each person who paid social security taxes throughout their lifetime is eligible to receive retirement or disability benefits based on their salaries and the number of years they have paid the social security tax. An employee can estimate their social security benefits here. There are lots of questions about whether social security can remain a benefit to U.S. retirees in the future. The retirement benefit can continue to exist, but it is likely some tax changes will have to occur.
Here is a summary of what we have discussed above:
We have discussed retirement savings plans offered by employers and the government, now let’s consider investment accounts one can manage and open on their own. There are three types of accounts an investor can open to save for retirement including Traditional IRAs, Roth IRAs, and an individual or joint taxable account.
Traditional IRAs are accounts you open using after-tax dollars, but taxes are deferred until you withdraw funds in retirement, after 59 ½ years old. If a withdrawal is made before 59 ½, you will pay tax plus a 10% penalty. If you do not have an employer plan like a 401(k) or 403(b) you can deduct from your taxes any savings you make into a traditional IRA account, up to certain income limits. See the IRS website for those limits, here. The maximum you can currently save into an IRA is $5,500 per year, $6,500 if you are over age 50, even if you already have a retirement plan at work.
If you decide to leave your job, you can move your employer plan savings into a Rollover IRA. You cannot contribute to it anymore, but the account would continue to grow tax-deferred, and you may find you have more investment options, and possibly lower fees, by moving it from your employer plan. You must do your homework to know if this is best for you.
Many individuals who do not have access to a retirement plan at work will choose to contribute to a traditional IRA because you can deduct the contribution (there are income limits for this, check irs.gov). If you are more concerned about taxes in retirement you should choose a Roth IRA contribution instead of a traditional IRA.
A Roth IRA is a tax-free way of savings. Roth IRA investments grow tax-free, and your withdrawals are also tax-free after age 59 ½, if you make a withdrawal before 59 ½ you will pay a 10% penalty. Your investment into this type of account is made with after-tax dollars and has the same contribution limits as the Traditional IRA. See the IRS website for income limits, here. You may contribute to both a Roth IRA and an employer retirement plan.
Many employers are beginning to offer a Roth 401(k) option which allows you to contribute to a Roth with after-tax dollars but use the contribution limits and other rules of the 401(k) Plan offered by your employer. You can contribute to both a Roth 401(k) and a traditional 401(k), but the combined contributions cannot exceed the $18,500 limit.
After the employer sponsored plan this is the next place to turn when saving for retirement. The Roth IRA is a great place to stash $5,500 each year and you can convert traditional or rollover IRAs into a Roth if you so choose. A Roth conversion is the process of taking a traditional or rollover IRA, paying the taxes now on the distribution (no penalty if within 60 days), and going forward having the benefits of tax-free growth and tax-free distributions in retirement. It is beneficial to go ahead and pay the taxes now if you believe your retirement income will be greater than it is today. Even if you are above the income limits to contribute to a Roth IRA this year you can still convert an IRA to a Roth IRA.
An individual or joint taxable account is another type of account you can designate for retirement. It should be used for non-retirement goals and for retirement savings after you have contributed to an employer plan and a Roth IRA.
The benefit of a taxable account is that you save with already taxed dollars, you can save an unlimited amount, and your tax is only based on the growth and income that you make in the year you make it. Dividends are taxed in the years you receive them, and capital gains made because of selling a security owned for more than 1 year are taxed in the year you sell the security. Both are taxed at capital gains rates, which are less than ordinary income rates. If you buy and sell a security within twelve months your gain will be taxed as ordinary income because it is seen as a short-term capital gain. Talk to your accountant about how you can offset short-term and long-term gains with losses in your portfolio. Taxable accounts allow you to withdrawal the funds at any age.
Many savers decide to contribute to their company plan up to their employer match then save into another retirement account like an IRA or Roth IRA because they have more investment choices outside their company plan and they can save on taxes in retirement by using a mix of account types. Here is a summary of non-employer sponsored or individual retirement account options:
*Savings amounts are subject to IRS income limits, see your tax advisor
Because saving for retirement is so important, new trends in retirement savings are developing.
For example, it is becoming more common for employers to enroll new employees in the company retirement plan automatically. When this happens, a percentage of pay is automatically taken from the employee’s paycheck and contributed to the retirement plan, which can be stopped anytime, and those contributions are automatically invested in a default choice defined by the plan. Sometimes, employers even auto-escalate employee contributions. Auto-escalate means contributions will automatically increase each year, and they also can be changed anytime by the employee.
These features are becoming available because employers know how vital it is for their employees to feel secure with their retirement savings. We have been seeing a positive trend that Millennials (born 1979-2000) are starting their savings sooner than generations before them. Many begin saving by age 24. The average Gen X worker (1964-1978) didn’t start saving until age 30. A 2017 retirement studies survey says that many Millennials are planning to live to age 100 or older, so it is smart they are starting young! The key to a successful retirement savings plan is to start ASAP and to continue saving as much as your budget allows.