Retirement Plans 101

The Main Types of Retirement Plans

Retirement Plans 101
March 9, 2016

The way Americans plan for their retirement has undergone nothing short of a revolution over the past few decades. If you go back a generation, many workers were covered by generous defined benefit (or DB) pension plans that were funded by their employers. These plans guaranteed employees a certain amount of income when they retired that would last for the rest of their lives.

Today, corporate DB pension plans are becoming relics of a time long ago, in a distant galaxy far, far away. If they offer a retirement plan at all, most employers have now switched to defined contribution (or DC) plans like the ubiquitous 401(k), which is funded largely by employees. This has shifted the main responsibility of planning and saving for retirement from employers square onto the shoulders of employees themselves.

Unfortunately, a wide range of different studies indicates that many Americans are not handling this responsibility well. For example, the Employee Benefits Research Institute’s 2015 Retirement Confidence Survey found that just 32% (up from 18% in 2014) of Americans are “very confident” in their retirement financial security. More than half (61%) are actually saving money in a DC plan, while only 3% report having saved at least $100,000 for retirement.

Some of those who are not saving money for retirement think that Social Security will support them when they retire. However, Social Security was never meant to be the sole source of retirement income, but rather an additional source of income to supplement personal retirement savings and DB pension plans.

Types of Qualified Retirement Plans

One of the keys to reversing these disturbing retirement savings trends is increasing education among workers about the importance of saving early and often for retirement, and the different types of plans available to accomplish this goal. Therefore, we have created this broad overview of the main types of qualified retirement plans offered by the federal government that can not only help you save for retirement, but might also provide valuable tax breaks.

  • Individual Retirement Account (IRA) — The IRA is the “granddaddy” of qualified retirement plans. It was introduced in 1975 as the first government-sponsored, tax-advantaged account to help Americans save for retirement. There are now two different types of IRAs to choose from: traditional IRAs and Roth IRAs.

    With a traditional IRA, you can benefit from long-term tax-deferred growth while also receiving a current tax deduction equal to the amount of your annual contribution. Roth IRA contributions are made on an after-tax basis, so there is no current tax benefit. The trade-off is that earnings are tax-free when you withdraw them in retirement. Traditional IRAs are funded pre-tax, so you have to pay taxes on distributions at your ordinary income tax rate when you start making withdrawals in retirement.

    Another important difference is that you can withdraw your Roth IRA contributions without penalty at any age. However, in most instances you will pay a 10% early distribution penalty and taxes at your ordinary income tax rate on traditional IRA withdrawals made before age 59½. The IRA contribution limit (for traditional and Roth IRAs combined) in 2016 is $5,500, or $6,500 if you are fifty years of age or over.

    Important note: If you make too much money, you cannot contribute to a Roth IRA, as eligibility phases out above certain income limits.

  • 401(k) plan — The term “401(k)” has become synonymous with retirement saving in America. Named after a subsection of the Internal Revenue Code, 401(k)s first started to become widespread in the 1980s. Now, more than 73 million American workers actively participate in a 401(k) plan, and these plans hold $3.8 trillion in assets.

    401(k) plans are established by businesses for the benefit of their employees, so you must work for a company that sponsors a plan to participate in one. Once your 401(k) account is established, you will contribute a percentage of your salary each pay period, usually via an automatic payroll deduction so you do not have to remember to make the contribution yourself. Your employer might also offer a matching contribution.

    Traditional 401(k) contributions (or salary deferrals) are made on a pre-tax basis, which means they are taken out of your pay before it is taxed. Therefore, your 401(k) earnings grow without the burden of taxation, and your current tax bill is reduced at the same time. Like with traditional IRAs, you will pay taxes when you start taking distributions from your account during retirement.

    After seeing the popularity of Roth IRAs, Congress recently created the Roth 401(k) plan. Just like with Roth IRAs, contributions to Roth 401(k)s are made on an after-tax basis so they do not reduce your current taxes. However, Roth 401(k) funds can be withdrawn income tax-free as long as the withdrawals occur after you have reached age 59½ and you have held the account for five years or longer.

    The 401(k) contribution limit for 2016 is $18,000, or $24,000 if you are fifty years of age or over. This limit applies to combined employee and matching employer contributions.

  • 403(b) and 457 plans — These are basically 401(k) plans for employees of non-profit organizations, churches, government entities and public schools. They operate in much the same way as 401(k)s, with employees establishing and maintaining their own accounts at a financial institution designated by their employer.

    Like traditional 401(k) contributions, 403(b) contributions are made on a pre-tax basis, so the money is deducted from your paycheck before taxes are taken out. The money is used to purchase an annuity contract from an insurance company or a custodial account to hold investments (like mutual funds). Church employees can purchase a retirement income account that can invest in annuities or mutual funds.

    Non-profit organizations and state and local governments also have the option of offering a 457 plan. These operate just like 403(b) plans with one key difference: There is no 10% penalty for withdrawals before age 59½ (although taxes at ordinary income tax rates must be paid on these withdrawals). Also, matching employer contributions are not allowed with 457 plans.

  • SIMPLE IRAs and SEP-IRAs — These are geared mainly toward small businesses and self-employed individuals. With a Savings Incentive Match Plan for Employees (SIMPLE) IRA, both you and your employer can contribute money to a traditional IRA established for your behalf. This type of plan is available to small businesses with 100 or fewer employees and self-employed individuals. The SIMPLE IRA contribution limit for 2016 is $12,500, or $15,500 if you are fifty years of age or over.

    If you are self-employed, you can sock away a large amount of money for retirement using a SEP-IRA — up to $53,000 or 25% of your gross earnings, whichever is less, for 2016. Contributions to SEP-IRAs grow tax-deferred and are also tax-deductible, which can reduce your current tax bill.

It’s Up to You

Unless you work for one of the dwindling number of businesses that still offers a DB pension plan, you shoulder most of the responsibility for saving for your own retirement. So, if you haven’t established a retirement plan like one of these yet — or if you have but aren’t contributing to it consistently — now is the time to get going.

Let the free MoneyTips Retirement Planner help you calculate when you can retire without jeopardizing your lifestyle.

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