A retirement plan is an investment account designed to encourage you to save money for retirement by providing special tax benefits. The plans are open only to account owners (called participants) who meet certain qualifications based on income and other factors. There are dozens of types of retirement plans available to US workers but over the next few weeks, I’ll cover:
- Traditional Individual Retirement Accounts (IRAs)
- Roth IRAs
- SEP IRAs
- SIMPLE IRAs
How Retirement Plans Work
Retirement plan accounts are like regular investment accounts, but with a few twists. Here’s how they work:
- Set up an account: You establish a retirement plan account through your employer, a bank, a financial services firm, or an … my personal favorite … a discount online brokerage like Scottrade, E*Trade, or Charles Schwab’s optionesXpress.
- Contribute money to the account: Depending on the plan, you can contribute by deducting money from your paycheck at each pay period or by depositing money from your savings into your retirement account whenever you choose. The amounts you can contribute depend on several factors, including the plan’s contribution limits and your income.
- Invest the money in your account: Most plans allow you to choose among various investment options, such as stocks, bonds, and mutual funds.
- Sell your investments and withdraw money: Though you can withdraw money from a retirement account at any time, for most plans you’ll incur a 10% penalty for withdrawing money before age 59 1/2, unless you qualify for certain exemptions. Depending on the type of plan you have, you may or may not owe taxes at the time of withdrawal on gains (profits) you’ve earned from your investments in the account. Though early withdrawals may be penalized, you can buy and sell investments within the account at any time.
Why Invest in a personal Retirement Plan?
Regardless of your age or income, investing in retirement plans is a great idea. Retirement plans offer tax advantages, encourage financial discipline, and in many cases make you eligible for employer contributions to your savings.
Tax Advantages of Retirement Plans
Retirement plans feature tax benefits that a regular investment or savings account can offer. These benefits fall into two categories:
- Up-front tax incentives: These include income tax deductions or credits that you receive immediately upon contributing to certain retirement plans. A tax deduction is an amount of money that you can deduct from your gross income in order to reduce your total tax liability. For instance, if you have $100,000 in gross income, and tax deductions worth $10,000, you’ll pay tax on only $90,000 of your income. A tax credit reduces your actual tax bill by a certain amount. For instance, if you owe $10,000 in tax and have a tax credit of $3,000, your tax bill would fall to $7,000.
- Tax-favored treatment of investment gains: Some retirement plans, called tax-free plans or Roth plans, allow you to pay no tax whatsoever on gains. Other plans, called tax-deferred plans, allow you to avoid paying taxes on gains until retirement. Some plans are available in two versions: a tax-deferred version and a tax-free (Roth) version.
Financial Discipline and Retirement Plans
If you’ve never been much of a “saver,” it can be hard to find the motivation to save money now when you know you probably won’t use it for decades. Investing on a regular basis in a retirement plan can help instill the financial discipline required to do just that. You HAVE to give yourself the opportunity to invest if you want your money to grow.
Some retirement plans transfer money right from your paycheck into a retirement plan account before you have the chance to touch it. Other plans require you to contribute a minimum amount of money each year but don’t allow you to withdraw it – except for qualified uses – without a penalty. Though these features may seem strict, they can really help you avoid spending money that could go toward building a secure financial future for you and your family.
Employer contributions are deposits that companies make into retirement plans on behalf of plan participants. These contributions take two forms:
- Employer match contributions: The company contributes on an ongoing basis a certain percentage of the amount that you contribute.
- Profit-sharing contributions: The company makes a lump-sum contribution at certain intervals, such as every year or every six months.
Employer contributions can take the form of cash or company stock. Since employer contributions are essentially “free money,” it almost always makes sense try to take advantage of any matching or profit-sharing options that your company offers.
Who Can Invest in Retirement Plans?
Though people often associate retirement plans exclusively with full-time workers at large companies who invest in 401(k)s, there are plans available to all kinds of workers, including sole proprietors with no employees, small business owners with a few employees, and many more.
How to Set Up a Retirement Plan Account
You can enroll in retirement plans through your employer or directly through an online brokerage, or a financial services firm.
Enrolling through an employer: Many employers sponsor, or offer, at least one type of retirement plan. These plans, known as employer-sponsored plans, include 401(k)s, 403(b)s, 457(b)s, SIMPLE IRAs, and SEP IRAs. In this kind of setup, you company’s human resources or benefits department works with an outside bank, financial services firm, or insurer to administer employee retirement plan accounts. Some companies automatically enroll all eligible employees in their plan, while others require you to opt in. If you need to opt in manually, you’ll be required to complete a few forms to set up an account. From there, you’ll likely work directly with representatives from the outside firm to set deposit amounts, select investments, check account balances, and so on.
Enrolling through banks, financial services firms, or insurers: By establishing a retirement account with a bank, financial services firm, or insurance company, you can set up, invest in, and manage certain types of retirement plans entirely on your own. The most common types of plans that individuals invest in through banks, financial services firms, and insurers are IRAs (Individual Retirement Accounts). To enroll, you complete a few forms online, in person, or by mail, and make an initial deposit (usually at least $500–1,000) to fund the account. You then need to decide, either on your own or with a financial advisor, which investments to make within your plan.