Retirement Plans: Navigating The Investment Danger Zone

Retirement plans are an important part of financial planning, but are they dangerous? Well, it depends on how you want to invest and what's available to you.

There are two main types of employer-sponsored retirement plans: defined benefit plans and defined contribution plans. Defined benefit plans, or pension plans, are becoming less common, with only 14% of Fortune 500 companies offering them to new hires in 2019. Defined contribution plans, such as 401(k)s and 403(b)s, are now the most common type, allowing employees to contribute to an individual account within the company plan.

While retirement plans can be beneficial, there are some potential dangers to be aware of. One common assumption is that stock and bond market returns will be robust, but this may not always be the case. Inflation can also impact retirement savings, as retirees may need to withdraw more than anticipated to maintain their standard of living. Additionally, health issues or unemployment could impact your ability to work past the age of 65, affecting your retirement plans.

It's important to carefully consider your retirement goals, time horizons, spending needs, and risk tolerance when creating a retirement plan. Seeking advice from a financial planner can help you make informed decisions and avoid potential dangers.

Defined contribution plans

One of the main advantages of defined contribution plans is that they give employees control over their retirement savings. Employees can decide how much they want to contribute to their individual accounts, and their contributions are automatically deducted from their paychecks. Additionally, defined contribution plans offer a tax-advantaged way to save for retirement. Contributions are often made with pre-tax dollars, and employees can benefit from tax deferral until they withdraw the money during retirement. This means that income tax will only be paid on withdrawals, and at a potentially lower tax bracket than when the employee was working full-time.

However, defined contribution plans also come with certain limitations. There are no guarantees with this type of plan, and participation is voluntary and self-directed. The value of the account will fluctuate over time due to changes in the value of the investments, and there is no way to know how much the plan will ultimately give the employee upon retiring. Employees are responsible for investing and managing their own money, which can be challenging for those who are not financially savvy or experienced in investing.

To address some of these limitations, the U.S. government has introduced legislation such as the Securing a Strong Retirement Act of 2022, which includes provisions for mandatory automatic enrollment, increased catch-up contributions, and matching contributions for student loan payments.

Individual retirement accounts (IRAs)

There are several types of IRAs: traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. IRAs are meant to be used to invest and maximise the growth of funds for retirement savings. There is usually an early withdrawal penalty of 10% if you take money out before age 59½, which is in addition to the taxes you'd pay on the withdrawn amount. However, there are some exceptions to the penalty rule, including withdrawals for educational expenses and first-time home purchases.

A traditional IRA is a tax-advantaged personal savings plan where contributions may be tax-deductible. Anyone with a retirement plan at work can also open a traditional IRA and invest additional savings. In 2024, the maximum amount an individual can contribute to a traditional IRA is $7,000, or $8,000 if you're aged 50 or over.

A Roth IRA is also a tax-advantaged personal savings plan, but contributions are not deductible, and qualified distributions may be tax-free. The Roth IRA is funded with post-tax money, so no further taxes are due when the money is withdrawn. There are income limitations on contributions to a Roth IRA. In 2024, the contribution limit is $7,000, or $8,000 if you're aged 50 or over.

A SEP IRA is a Simplified Employee Pension plan set up by an employer. It's intended for small businesses and self-employed individuals. Contributions are made by the employer directly to an IRA set up for each employee. A SIMPLE IRA is similar but requires employer matching contributions to the plan whenever an employee makes a contribution.

Retirement plans for small-business owners

Retirement plans can be confusing, and dangerous if you don't know what you're doing. Luckily, there are plenty of options for small-business owners to choose from. Here are some of the most popular retirement plans for small-business owners and a guide on how to choose the right one for you.

SEP IRA

The Simplified Employee Pension (SEP) IRA is a popular choice for small-business owners as it is the simplest option. A SEP IRA is a retirement plan that allows employers to contribute to their employees' retirement savings. The employer decides how much to contribute each year, and the contributions are tax-deductible. The maximum contribution for 2024 is $69,000. SEP IRAs are best for small businesses with a small number of employees as they can be costly for larger companies.

SIMPLE IRA

The Savings Incentive Match Plan for Employees (SIMPLE) IRA is a great starter plan to encourage employees to contribute to their retirement savings. With a SIMPLE IRA, employees can contribute a set amount of their pre-tax salary to the plan, and the employer matches a certain percentage of their contributions. For 2024, employees can contribute up to $16,000, and catch-up contributions for those aged 50 or older lift this ceiling to $18,000. This type of plan is best for small businesses that want to encourage their employees to save for retirement and are willing to contribute a small amount each year.

Solo 401(k)

The Solo 401(k), also known as a Self-Employed 401(k) or Individual 401(k), is designed for business owners with no employees other than their spouse. It allows the business owner to contribute as both the employer and employee, maximising their retirement savings. For 2024, the contribution limit is $23,000, or $30,500 if aged 50 or older. The Solo 401(k) is a good option for small businesses with no employees as it allows for higher contributions than a traditional IRA.

Payroll Deduction IRA

A Payroll Deduction IRA is a low-cost, low-maintenance option for small-business owners. With this plan, employees open their own IRAs and authorise payroll deductions to fund them. The employer's only responsibility is to deduct the authorised amounts from employees' paychecks and direct them to the designated IRA accounts. Employees can contribute up to the normal IRA limits, which for 2024 are $7,000, or $8,000 for those aged 50 or older. This option is best for small businesses that want to offer their employees a retirement plan but don't want to contribute financially.

Factors to Consider

When choosing a retirement plan, small-business owners should consider the number of employees they have, the level of contributions they want to make, and the amount of administration they are willing to take on. It is also important to think about the investment choices available within each plan and whether these align with the business's and employees' goals and risk tolerance. Additionally, early withdrawal options and associated penalties may be an important consideration for some.

Risk tolerance and investment goals

Risk tolerance is the degree of risk an investor is willing to take on, given the volatility in the value of an investment. It often determines the type and amount of investments an individual chooses. For example, investors with a higher risk tolerance are often synonymous with investments in stocks, equity funds, and exchange-traded funds (ETFs). On the other hand, those with a lower risk tolerance tend to purchase bonds, bond funds, and income funds.

Age, income, and investment goals are factors that contribute to an investor's risk tolerance. As retirement approaches, investors tend to have less time to recover from market losses, and their comfort with risk may be lower than during their working life. Therefore, it is essential to assess risk tolerance and adjust the mix of assets in your portfolio accordingly.

Retirement plans, such as 401(k)s, IRAs, and annuities, offer different levels of risk and potential returns. 401(k) plans, for instance, offer high-return investments such as stocks, while IRAs provide a wide range of investment options, including stocks, bonds, CDs, and real estate. Annuities, on the other hand, provide bond-like returns and guaranteed income but may not offer the potential for higher returns.

When planning for retirement, it is crucial to consider your risk tolerance and investment goals. This will help determine the types of retirement plans and investments that align with your financial situation and retirement objectives.

Estate planning

Create an inventory

Make a list of all your assets, including physical assets such as real estate, vehicles, collectibles, and other personal possessions, as well as intangible assets such as bank accounts, insurance policies, stocks, bonds, mutual funds, and retirement plans. Also, make a list of all your debts, including any loans or lines of credit that you haven't paid off yet.

Account for your family's needs

Think about how to protect your assets and your family after you're gone. Write a will if you don't already have one, and ensure you have enough life insurance, especially if you have dependent children. Name a guardian for your children in your will, as well as a backup guardian, to help avoid family court fights that could drain your estate's assets.

Establish your directives

A complete estate plan includes important legal directives such as a trust, a medical care directive or living will, a durable financial power of attorney, and a limited power of attorney. With a revocable living trust, you put your assets into a trust and select a trustee to manage them for your benefit and that of your beneficiaries. If you become incapacitated, your trustee can take over, and upon your death, the assets transfer to your beneficiaries, bypassing probate. A medical care directive spells out your wishes for medical care if you become unable to make those decisions, and you can give someone medical power of attorney to make those decisions if you can't. A durable financial power of attorney allows someone to manage your financial affairs if you're medically unable to do so, and a limited power of attorney allows you to grant someone the power to act on your behalf in specific situations.

Review your beneficiaries

Check and update the beneficiary designations on your retirement and insurance accounts. Make sure the right people are listed as beneficiaries and that you haven't left any sections blank. Also, name contingent beneficiaries as backup in case your primary beneficiary dies before you do.

• Note your state's estate tax laws
• Weigh the value of professional help

Whether or not to hire an attorney or estate tax professional to help with your estate plan depends on your situation. If your estate is small and your wishes are simple, an online or packaged will-writing program may be sufficient. However, if you have a large or complex estate, or if you live in a state with its own estate or inheritance taxes, it may be worthwhile to consult an estate planning attorney and/or a tax advisor.

Keep your estate plan up to date

Revisit your estate plan when your circumstances change, such as after a marriage, divorce, birth of a child, or job loss. Also, periodically review your plan even if your circumstances haven't changed, as laws may have been updated.

Frequently asked questions