Maximizing Your Sponsored Retirement Plan: A Guide To Strategic Investing

Investing in a sponsored retirement plan is a great way to secure your financial future. Retirement plans generally fall into two categories: defined benefit plans and defined contribution plans. Defined benefit plans, also known as pension plans, promise a specified monthly benefit upon retirement and are funded by employers. Defined contribution plans, such as 401(k) and 403(b) plans, do not guarantee a specific payment but allow employees and employers to contribute to individual accounts. These plans offer flexibility and higher returns but place investment risks on employees.

Defined benefit plans

A defined-benefit plan is an employer-sponsored retirement plan where employee benefits are calculated using a formula that takes into account several factors, such as length of employment, salary history, and age. Employees are usually required to work for a specific amount of time before becoming eligible to participate in the plan.

The company is responsible for managing the plan's investments and risks, and will often hire an outside investment manager to oversee the plan. Employees typically cannot withdraw funds as they would with a 401(k) plan. Instead, they receive their benefit as a fixed monthly payment or annuity, or in some cases, as a lump sum at an age defined by the plan's rules.

Defined-benefit plans, also known as pension plans, are becoming less common, with only 17% of private sector workers having the option in 2018, down from 83% in 1980. This is due to the rise of lower-cost defined contribution plans, such as 401(k)s, where employees have more control over their investments.

Despite this, defined-benefit plans offer several advantages, including dependable income, insulation from market performance, potential for spousal support, and improved employee retention. However, there are also disadvantages, such as a lack of investment choices, the time it takes to vest, and the expense for employers to maintain the plan.

There are two main types of defined-benefit plans: pensions and cash balance plans. Pensions are the more traditional option, offering a guaranteed monthly benefit starting at retirement, based on factors such as salary and length of employment. Cash balance plans, on the other hand, grant employees a set account balance at retirement or when they leave the company, which can be received as an annuity or a lump sum. This makes cash balance plans a hybrid between traditional pensions and 401(k)s.

Defined contribution plans

The most common defined contribution plans are 401(k) plans, which are available to employees of publicly-owned companies, and 403(b) plans, which are typically open to employees of nonprofit corporations, such as schools. 457 plans are another type of defined contribution plan available to employees of certain types of nonprofit businesses and state and municipal employees.

In a defined contribution plan, the employee shoulders the investment risk, and there is no guarantee of how much the employee will receive upon retirement, as contribution levels can change, and investment returns may fluctuate. However, the tax-advantaged status of these plans generally allows balances to grow larger over time compared to accounts that are taxed annually.

Employees can start withdrawing funds from their defined contribution plans without penalty after reaching the age of 59 1/2. Withdrawing before this age may result in a 10% early withdrawal penalty, and the withdrawn amount will be subject to income tax.

Individual Retirement Accounts (IRAs)

There are several types of IRAs:

• Traditional IRAs: Contributions are typically tax-deductible. Taxes are paid on IRA earnings upon withdrawal during retirement.
• Roth IRAs: Contributions are made with after-tax funds and are not tax-deductible, but earnings and withdrawals are tax-free.
• SEP IRAs: These allow employers, typically small businesses or self-employed individuals, to make retirement plan contributions into a traditional IRA established in the employee's name.
• SIMPLE IRAs: These are available to small businesses that do not have any other retirement savings plan. SIMPLE IRAs, which stand for Savings Incentive Match Plan for Employees, allow employer and employee contributions, similar to a 401(k) plan, but with simpler, less costly administration and lower contribution limits.

Individuals can contribute up to the maximum amount allowed by the Internal Revenue Service (IRS). For 2024, the maximum annual individual contribution is $7,000, or $8,000 for those aged 50 or over. Money in an IRA usually cannot be withdrawn before age 59½ without incurring a 10% tax penalty.

Annuities

An annuity is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. You can buy an annuity by making either a single payment or a series of payments. Your payout may come as one lump-sum payment or as a series of payments over time.

People typically buy annuities to help manage their income in retirement. Annuities provide three things:

• Periodic payments for a specific amount of time. This may be for the rest of your life, or the life of your spouse or another person.
• Death benefits. If you die before you start receiving payments, the person you name as your beneficiary receives a specific payment.
• Tax-deferred growth. You pay no taxes on the income and investment gains from your annuity until you withdraw the money.

There are three basic types of annuities:

• Fixed annuity: The insurance company promises you a minimum rate of interest and a fixed amount of periodic payments.
• Variable annuity: The insurance company allows you to direct your annuity payments to different investment options, usually mutual funds. Your payout will vary depending on how much you put in, the rate of return on your investments, and expenses.
• Indexed annuity: This annuity combines features of securities and insurance products. The insurance company credits you with a return that is based on a stock market index, such as the Standard & Poor’s 500 Index.

In retirement, annuities can offer pension-like cash flow, like a paycheck during working years. Certain types of annuities can offer a boost to retirement savings, while others can offer a dependable income stream for people approaching or already in retirement.

401(k) plans

A 401(k) plan is a company-sponsored retirement account in which employees can contribute a percentage of their income. Employers often offer to match at least some of these contributions.

There are two basic types of 401(k)s—traditional and Roth—which differ primarily in how they're taxed. With a traditional 401(k), employee contributions are pretax, meaning they reduce taxable income, but withdrawals in retirement are taxed. On the other hand, employee contributions to Roth 401(k)s are made with after-tax income, and there's no tax deduction in the contribution year, but withdrawals—qualified distributions—are tax-free.

The 401(k) plan is the most ubiquitous defined contribution (DC) plan among employers of all sizes. Since their introduction in the early 1980s, DC plans, which include 401(k)s, have all but taken over the retirement marketplace.

A 401(k) plan can be an easy way to save for retirement, because you can schedule the money to come out of your paycheck and be invested automatically. The money can be invested in a number of high-return investments such as stocks, and you won’t have to pay tax on the gains until you withdraw the funds (or ever in a Roth 401(k)). In addition, many employers offer you a match on contributions, giving you free money – and an automatic gain – just for saving.

One key disadvantage of 401(k) plans is that you may have to pay a penalty for accessing the money if you need it for an emergency. While many plans do allow you to take loans from your funds for qualified reasons, it’s not a guarantee that your employer’s plan will do that. Your investments are limited to the funds provided in your employer’s 401(k) program, so you may not be able to invest in what you want to.

To start a 401(k), contact your employer and ask if a 401(k) is available, and whether there is a company match. If a 401(k) is available, the company will instruct you on how to sign up with new paperwork. Then, choose your investments. There should be a range of options, from conservative to aggressive. A popular option is the target date account, which automatically adjusts the asset mix to align with a preset retirement date. It typically becomes more conservative as you near retirement.

If you are self-employed or run a small business with your spouse, you may be eligible for a solo 401(k) plan, also known as an independent 401(k). These plans allow independent contractors to fund their own retirement and can be created through most online brokers.

Frequently asked questions