By Stephanie Spillmann 8/30/17
Making Sense of Retirement Plans: The Simple Explanation
Do retirement plans make your head spin? Are you afraid you don’t make enough money to put away for later? Let’s simplify some of the options and dispel the myth that you have to be rich to begin saving for your future.
The 401(k) is the most common type of employer-sponsored retirement savings plan. Not all employers offer this plan, but if they do, take full advantage of it. The biggest benefit of the 401(k) is most employers match employee contributions — that’s free money for retirement. This plan is funded with pre-tax dollars.
It’s entirely up to each employer as to how much (or if) they choose to match. Often it’s a percentage of what the employee contributes, up to a certain amount of their salary. Even if an employer doesn’t do a 401(k) match, it’s an easy way to save for retirement. Employees can contribute up to $18,000 per year, and with automatic deposit with each paycheck, the funds are rarely missed.
Roth 401(k) is similar to the traditional 401(k) with the exception of taxes. Contributions made to a Roth plan are taxed at that time and have no assessed taxes upon retirement. Conversely, a traditional 401(k) takes pre-tax dollars and the individual is taxed once the money is withdrawn after age 59 1/2.
A Profit-Sharing Plan is another option for employer-sponsored retirement planning. Some companies opt for this plan instead of a 401(k), and some offer it in addition to. Profit sharing is when a company decides to share its profits with the employees.
In this plan, the contribution amount (and whether to contribute yearly) is completely the employer’s decision. The primary difference between the profit-sharing and a 401(k) is that employees do not contribute to a profit-sharing plan. Most employer contributions happen at year end, but some opt for quarterly contributions.
Non-Employment Retirement Plans
Individual Retirement Accounts (IRAs) are not sponsored through employers, and can be opened by anyone age 21 (sometimes 18) and over. The most important qualifier for IRAs is that contributions must be from earned income. W-2 forms are the best way to prove income, but thorough records of earnings may work as well.
Parents may open up an IRA for their kids, at certain participating investment firms, as long as the income contributed has been earned by the child. This is where good records for lawn mowing and babysitting come into play.
A person may open up an IRA with less than $100 and contribute any amount they wish. An E*Trade IRA has no yearly or commission fees, and it’s perfect for a beginner who doesn’t have much to start with. My suggestion is to start out with an E*Trade (or Charles Schwab) account and then switch to a Vanguard Target Retirement or STAR fund once you hit $1000.
The limits for yearly contributions to an IRA for 2017 (per the IRS) are $5500 or $6500 if age 50 and up. You can contribute to an IRA in addition to having an employer-based account, and non-working spouses may also open an IRA. This is called a spousal IRA account, and it’s opened by the working spouse (in the stay-at-home spouse’s name) and funded by the working spouse’s earnings.
Roth IRAs are a fantastic choice for retirement planning. They follow all of the basic rules that a traditional IRA has, but the contributions are after-tax earnings. Because it’s taxed upfront, there are no taxes on Roth withdrawals at retirement age. The major perk with a Roth IRA is its liquidity. Individuals have complete access to their contributed funds, without tax or penalty, any time (and any age) they need them. Check out Roth IRA: The Rockstar of Retirement for more awesome Roth perks.
Great Self-Employment and Small Business Plans
Solo 401(k) plans are perfect for a one-person show. If you own a business/are self-employed and have no other employees, this is a great choice. The Solo 401(k) gives the solo-preneur a chance to save for retirement with the same guidelines as a traditional 401(k), but with some added benefits.
Since the employer is also the employee, they are “both” allowed to invest. As an employer, up to 25% of the business earnings can be contributed. Employee contributions are capped at $18,000 (same with 401(k)), but the combined total allowable yearly contribution is a whopping $54,000 a year.
SIMPLE 401(k) accounts are for small businesses with 100 employees or less and they follow the same basic rules of the regular 401(k) as well, with a few changes. Employees are vested in (owners of) their accounts right away with no waiting period. Employee contributions are capped at $12,500 per year.
SIMPLE IRAs are another retirement investment plan for small businesses. They’re beneficial to employers for tax deduction purposes, and employees are allowed a higher contribution compared to regular IRAs. Employers are required to contribute, usually matching employee deposits up to 3% of their salary. The yearly allowable contributions for employees is much higher than the standard IRA, at $12,500.
The Simplified Employee Pension IRA (SEP) is the gem of retirement accounts for freelancers and self-employed individuals. Besides the tax write-offs for contributions, the yearly contribution limits blow traditional IRAs out of the water.
The business owner must have one or more employees and be 21 years of age or older. The yearly limit for employer (or business owner) contributions is $54,000 or 25% of salary, whichever is less. The employer/self-employed may also fund a traditional IRA account besides the SEP and fund the additional allowance of $5500.
With so many choices for retirement planning and saving, it’s hard to know what to choose. The best choice is always to pick something and get started right away. Money saved and invested is money well spent.