Retirement Plan Types
1. Defined Contribution Retirement Plans
How 401(k) works
- Plan sponsor: your employer
- Plan administer: employer hires a mutual fund company or a brokerage firm to manage the plan and its investments.
- finite set of investment options are provided by employer typically are mutual funds, company stock, etc.
- Asset Allocation: you decide how much and where to invest.
- Funding option: funding happens thru payroll deduction
- Matching Contribution:
- For every dollar you invest, company pays you $0.5 to $1.0, which is free.
- Matching contributions usually vest over time, typically 25% every year or all at once after 3 yrs. If you leave or let go before that, you get nothing.
- No tax for matching contribution until you withdraw them in retirement.
- Withdrawal - If you withdraw before age 59.5, you pay 10% penalty on top of income tax. IRS waives the penalty for certain hardship withdrawals like sudden disability, higher education expenses, etc. You could take loan as well.
- Switching Jobs - You have 4 options
- Move money to personal IRA rollover accounts - at a mutual fund company or discount brokerage so that the money grows tax deferred. Make sure you choose ‘direct rollover’ where the old employer pays a check to the fund company/brokerage firm. If it is made out to you, the money is taxed.
- Move money to new employer’s plan
- Leave the money right where it is - Your former employer may not allow you to stay in the plan if your account balance is less than $5,000, however. And because you’re no longer an employee, you may miss out on important information about plan changes and investment options.
- Cash out: pay penalty and taxes.
- RMD (Required Minimum Withdrawal) - At age 70.5, you must make minimum withdrawals.
- Investments are tax deferred. Earnings from the investment like interests, dividends, etc. are tax deferred.
- Free matching contribution money
- There is a max cap on how much you can invest. (~$17,000 p.a.)
- Heavy penalty on early withdrawals.
b. Roth 401(k)
- some employers offer in addition to traditional 401(k).
- Unlike 401(k), in Roth, taxes are paid before, not during withdrawal. Earning from the contribution grows tax free.
- No required minimum withdrawal requirement.
- Your combined contribution to 401(k) and Roth 401(k) cannot exceed $17,000
- Offered to employees of government and tax-exempt groups like schools, hospitals, churches, etc.
- Works the same way as 401(k)
- Investment choices are limited than corporate plans.
- Offered to state and local public employees.
- Works the same way as 401(k)
- No penalty on early withdrawals.
e. Thrift Savings Plan
- Offered to employees of federal government.
2. Supplemental Retirement Plans
3. Individual Investors
- IRA - Individual Retirement Account. Basically a savings accounts with big tax breaks.
- IRA itself is not an investment, it is just a basket in which you keep stocks, bonds, mutual funds and other assets.
- You open your own IRAs.
- Contribute, money grows tax-free and pay tax on withdrawal in retirement.
- Anyone earning taxable income can contribute to traditional IRAs.
- Withdrawals before age 59.5 are penalized with 10%
- Big tax breaks. Earning on investments are not taxed.
- High penalty on early withdrawals.
- RMD (Required Minimum Withdrawal) at age 70.5
Same as IRA, but here you pay taxes first and invest. Money grows tax-free. Withdrawals before age 59.5 are penalized with 10% only if earnings are withdrawn. Pros Earning on investments are not taxed. No RMD. You can leave it as long as you want. Withdrawals are not penalized as long as earnings are left untouched. Cons There are income limits for contributing to Roth IRAs (less than $183K).
4. Self-Employed Individuals Plan
- Any business owner or individual with freelance income can open a SEP IRA.
- Must have less than 100 employeed earning more than $5000 each. Employer cannot hvae any other retirement plan besides SIMPLE IRA.
- An insurance product that pays out income after retirement.
- Tax benefits: Investment grows tax deferred. At the time of withdrawal, only the earnings are taxed, not the contribution.
- Annuities are a popular choice for investors who want to receive a steady income stream in retirement.
- Make an investment in the annuity, and it then makes payments to you on a future date or series of dates.
- Early withdrawals are penalized with 10% penalty.
- Pay out frequency - The income you receive from an annuity can be doled out monthly, quarterly, annually or even in a lump sum payment.
- Size of payments - determined by a variety of factors, including the length of your payment period.
- Pay out duration - rest of your life or a set number of years.
- Similar to bank CDs (Certificate of Deposits)
- Guaranteed payout - pays guaranteed rates of interest on investment.
- You are not responsible for choosing the investments.
- Pros - No tension about market volatility
- Cons - Do not keep pace with inflation.
- You choose from a selection of investments and the payout is based on the performance of the funds chosen.
- Pros: compared to fixed annuity, inflation is handled here.
- Investment risk due to volatility
- Though the investment is tax deferred, the annual expenses are higher compared to regular mutual funds.
- Combination of Fixed and Variable Annuity.
- As with Fixed Annuity, you get guaranteed minimum return (usually 2-3%)
- As with Variable Annuity, you have a shot at higher gains since it is tied to the performance of a benchmark index like S&P 500.
- Pros: safety + probable higher gain. Better than fixed, and less riskier than variable.
- Cons: Complex. Full returns of the market index gain is not always shared. High surrender charges.
Deferred or immediate annuity
With a deferred annuity, your money is invested for a period of time until you are ready to begin taking withdrawals, typically in retirement.
Opposite of Life Insurance policy. In Life Insurance, you pay regular premiums to an insurer that makes lump sum of cash upon your death. In Immediate Annuity, you pay a bulk amount and receive fixed payments starting immediately until you die.
Protection against outliving your money late in life. This requires you to wait until you reach age 80 or so, to begin receiving payments until death. After death, your heirs get nothing.
- Period Certain Annuity - guaranteed a specific amount for a set period of time. If you die before the end of the period, your beneficiary gets the payment for the rest of the period.
- Life Certain Annuity - guaranteed income payout until you die. If you die, your heirs don’t get anything.
- Life with Period Certain Annuity - life + period certain annuity. Guaranteed income for life that includes a a period certain phase. If you die during that period, beneficiary will continue to receive the payment for the remainder of the period.
Joint and survivor Annuity - Beneficiary will continue to receive payouts for the rest of his/her life after you die.
- Sock away large amount of cash without paying taxes.
- No annual contribution limit for an annuity.
- High expenses (hidden fees, commissions, surrender charges, high annual fees) cut into profits paid out by annuities. Some companies sell low cost annuities without charging sales commission or surrender charge. These are called ‘direct-sold annuities’ because there is no insurance agent unlike in an insurance company.
- Buy annuities only after maxing out 401(k) plans and IRAs.