Different retirement plans – What is right for you?

All of us dream about retirement.  In our parents’ generation retirement meant you would get a pension; all you had to do was work hard for a company and  your retirement will be taken care of. Its not the case anymore. If you want a comfortable retirement you have to work for it. With a lot of planning, saving and a little bit of luck you might realize that dream.  But you are not alone in your effort to save enough to retire. The government helps you as well, by providing you with different retirement plans that have tax benefits and give your retirement savings a real boost. Whether you are self employed, have a small business, work for an employer or one of those fortunate folks to still have a pension plan, there are ways you can save for your comfortable retirement.

Why choose a retirement account?

You might think you don’t need a retirement account, that a bank or the brokerage company will work. They could, but you won’t be able to take advantage of the tax savings, so you will always accumulate less money with the same contribution outside of a retirement account.

For example, person A chooses to put $200 each month in a mutual fund outside of a retirement account that earns 8% interest. Person B contributes the same amount, $200 each month, in a company sponsored retirement plan and chooses the same mutual fund that pays 8%. Lets assume both of them are in the 25% tax bracket. At the end of 30 years person B will have $293,630.09 and person A will have $201,124.01. Big difference. What made the difference? Uncle Sam. In person A’s case, year after year, the IRS took a cut on the 8% earnings, so there was less amount of money accumulated each year, which impacted the power of compounding. But the IRS couldn’t touch the earnings of person B as they were in a special retirement account, so all the earnings joined the principal to do the magic of compounding and the result was almost 50% extra money. Even after taxes during withdrawal you will come out way ahead with the help of a retirement account. You can try it with your numbers and then decide – Taxable vs Tax-advantaged accounts.

What are the tax benefits for using retirement plans?

The tax benefits come in three ways depending on which plan you choose -

1. You pay no income tax on the money you contribute and the money grows in a tax sheltered account. You pay income tax when you take the money out (401k).
2. You pay no income tax on the money you contribute. If you are under certain income limit, the government gives a tax credit for contributing the money (Traditional IRA).
3. You contribute after tax dollars, but the withdrawals are tax free, both principal and the earnings (ROTH IRA).

What type of retirement plans are available?

There are plans available through your employer, plans for self-employed and plans for everyone.

Most of the plans fall under these 2 categories:

Defined-benefit plan: An employer sponsored retirement plan, where you will get a fixed amount every month during your retirement years. The amount will be calculated using a formula that involved your duration of employment with that employer and your salary history. Very very few companies offer this plan now.

Defined-contribution plan : This is the most widely used plan. In this plan, you choose the amount you want to set aside every month (up to the limit set by law) and choose the investment vehicle (stocks, mutual funds, bonds, precious metals like gold, etc.). So the amount of money you have in your portfolio depends on how much you managed to save and how well your investments performed. The defined contribution plan comes in different flavors and kinds. There are plans for the self employed, company employees and stay at home spouses.

Now the actual plans :

Traditional IRA: Individual Retirement account

In a Traditional IRA, you make contributions with money you may be able to deduct on your tax return and any earnings potentially grow tax-deferred until you withdraw them in retirement.

1. Who can open a Traditional IRA? Anyone can open a traditional IRA and contribute upto the maximum allowed by law based on income. You should have earned income to open an IRA.
2. Tax benefit : Contributions are often tax deductible.
3. Contribution limit (2010) : Upto $5000. Age 50+ catch up contribution $1000.
4. Loans allowed : No
5. How to set up a traditional IRA? : You can set up different kinds of IRAs with a variety of organizations. You can set up an IRA at a bank or other financial institution or with a mutual fund or life insurance company. You can also set up an IRA through your stockbroker. Examples : Vanguard IRA, Fidelity IRA, T.RowePrice IRA.
6. Where can I find more information? : To check out how to open an IRA use the vanguard/Fidelity/T.RowePrice links. If you want to know more about the current year’s contribution limit or your eligibility to contribute, check the IRS Individual Retirement Account help page.  2011 IRA contribution limit is $5000.

401k : Employer sponsored retirement plan

The employer may choose to match whatever you contribute up to a limit (most commonly 6%). The employee will make pre-tax elective deferrals through payroll deductions. The elective deferral (employee contributions) are 100% vested immediately (meaning if you leave the company the money is yours). The matching contribution (employer contribution) will vest based on the company’s vesting schedule (if the vesting schedule is 25% every year, that means if you leave in 2 years you will get 100% of your contribution + 50% of your employers contribution. If you leave after 4 yrs you get 100% your contribution and 100% employer contribution as well).

1. Who can open an 401k? : Your employer.
2. Tax benefit: Contributions are tax deductible.
3. Contribution limit (2010) : 2011 401k contribution limit $16,500. The limit is subject to cost-of-living increases after 2010. Age 50+ catch up contribution $5,500 for year 2010.
4. Loans allowed : Yes. But it is not a good idea. You are required to pay it back within 60 days if you leave your employer and also you are not keeping the money in the account to grow which beats the purpose of a 401k account.
5. How to set up a 401k? Go to your Human Resources and sign up for the payroll deduction. If your company does not offer a 401k as part of your benefits, lobby for one and in the mean time open an IRA.
6. Where can I get more information? : Your 401k plan documents will detail all the investment options available to you within your 401k. If you don’t know where your plan document is ask your HR representative. If you have your 401k with a major brokerage firm such as Vanguard or Fidelity, their online resources or customer service could be a greatsource of assistance too. You can learn about basics of investing, setting up a balanced portfolio, how much you need for your retirement and more.

403(b)

Very similar to 401k, but the non-profit version of it. A 403(b) plan, also known as a tax-sheltered annuity (TSA) plan, is a retirement plan for certain employees of public schools, employees of certain tax-exempt organizations, and certain ministers.

1. Who can open an 403b? : Your non profit employer. If you are a self-employed minister, the organization (denomination) with which you are associated can set up an account for your benefit.
2. Tax benefit: Contributions are tax deductible.
3. Contribution limit (2010): 2011 403b contribution limit $16,500. Up to $19,500 if you have 15 yrs or more of service(Lifetime Catch-up). Age 50+ catch up contributions for year 2010 is $5,500.
4. Loans allowed: Yes
5. How to set up a 403(b)? Ask your employer for a list of the participating investment companies (vendor list) available to you. Research the investment options provided by these companies and the fees they charge. Let your employer know of your choice of company and contribution. Sign the paperwork.
6. Where can I get more information? : The investment company’s resources are a good place to start. 403bwise is an excellent resource for all your questions and concerns.

457(b)

401k equivalent for government employees and some non profit entities.

1. Who can open an 457b? Employer.
2. Tax benefit: Contributions are tax deductible.
3. Contribution limit (2010) : 2011 457b contribution limit $16,500. The limit is subject to cost-of-living increases after 2010. Age 50+ catch up contribution $5,500 for year 2010.
4. Loans Allowed : Yes
5. How to set up a 457(b)? Sign up for the salary deferral contribution through payroll deduction.
6. Where can I get more information? : The investment company’s resources are a good place to start. 457bwise is an excellent resource for all your questions and concerns.

ROTH IRA/401k/403b

Most of the above plans have a ROTH version. ROTH IRA, ROTH 401k and ROTH 403b. The only difference between the ROTH version and the traditional version is you can make after tax contributions and you will never pay taxes on the growth portion/original contribution when you withdraw, whereas in the traditional version you take a tax deduction now, but your withdrawal is taxed.

Self-employed/small business retirement plans :

SEP (Simplified Employee Pension) plans: Under a SEP, employers make contributions to traditional Individual Retirement Arrangements (IRAs) set up for employees (including self –employed individuals), subject to certain limits. It is easy to operate and has less maintenance costs. Contribution limit is the smaller of $49,000 or 25% of participant’s compensation.

SIMPLE (Savings Incentive Match PLan for Employees): Under a SIMPLE IRA plan, employees and employers make contributions to traditional Individual Retirement Arrangements (IRAs) set up for employees (including self-employed individuals), subject to certain limits. It is ideally suited as a start-up retirement savings plan for small employers who do not currently sponsor a retirement plan. Contribution limit is up to $11,500, $14,000 if age 50 or over for the employees and either dollar-for-dollar matching contributions, up to 3% of employee’s compensation,or fixed non-elective contributions upto 2% of compensation from the employer’s part.

Qualified plans including 401k plans: The qualified plan rules are more complex than the SEP plan and SIMPLE plan rules. Qualified plan could be a defined contribution or defined benefit plan. These include the keogh (H.R.10) plan, solo 401k and solo ROTH 401k. (Contribution limit is up to $16,500, $22,000 if employee is 50 or over.

There are other plans like money purchase plan or the profit sharing plan. I have not covered them here as I don’t know much about them, but the linked IRS website should give you more information.

If I have both ROTH and the traditional option which one should I choose?

Well, it depends. If you think you are in a high tax bracket and expect to be in a lower bracket when you retire you will want to take the tax deduction now and pay taxes in the lower tax bracket when you retire. On the other hand if you are just starting out or are still in school and paying very little in taxes now, go for the ROTH. You will pay less taxes on the contribution now and the earning will be tax free during withdrawal so you will come out ahead.

Whatever plan you choose the most important thing is to start early, save consistently and review your plan at regular intervals to make sure it still meets your needs. Pay yourself first and look forward to that dream retirement!

Tagged as: 401k, 403b, 457b, retirement, ROTH, sep, simple