Retirement Investing: Navigating Your Savings Journey

Investing for retirement can be a daunting task, but it is important to know what options are available to create a financially secure future. There are several retirement plans to choose from, each with its own advantages and disadvantages.

One option is to put money into a retirement account offered by an employer, such as a 401(k) or 403(b) plan. These plans offer tax advantages, such as tax-free growth until withdrawal during retirement. Another option is to put money into a tax-advantaged retirement account, such as an IRA. IRAs offer similar tax breaks to 401(k)s but with different eligibility rules. For those who want to save even more for retirement, there is the option of putting money into a regular investment account without tax advantages.

Other retirement plans include defined contribution plans, traditional pensions, guaranteed income annuities, and cash-value life insurance plans. It is important to consider factors such as contribution limits, tax advantages, investment choices, and ease of setup when deciding on a retirement plan. Seeking advice from a qualified professional is always recommended before making any investment decisions.

Defined contribution plans

One of the key features of defined contribution plans is that they place restrictions on when and how employees can withdraw from their accounts without penalties. These plans allow employees to invest pre-tax dollars in the capital markets, where the funds can grow tax-deferred until retirement. This means that income tax will only be paid on withdrawals, and only when the account holder reaches retirement age (a minimum of 59 1/2 years old).

There are several advantages to defined contribution plans. Firstly, contributions may be tax-deferred until withdrawals are made. For example, in a Roth 401(k), the account holder makes contributions after taxes, but withdrawals are tax-free if certain qualifications are met. Secondly, defined contribution plans offer employees a degree of flexibility and control over their investments. Employees decide how much they want to contribute to their individual accounts, and they also choose how to invest their money. Most plans offer several investment choices, each with its own fee structure and risk profile.

However, defined contribution plans also have some limitations. Unlike defined benefit plans, there are no guarantees with a defined contribution plan, and participation is voluntary and self-directed. This means that there is no way to know how much a plan will ultimately give the employee upon retiring, as contribution levels can change, and investment returns may fluctuate over the years. Additionally, defined contribution plans require employees to invest and manage their own money, which may be challenging for those who are not financially savvy or experienced in investing.

Traditional pensions

A pension plan grows over the years with contributions from both the employer and employee. The employer generally pools all contributions to be professionally invested and managed. After retiring, the employee will receive a set payment from this fund for life. The payment amount is usually determined by factors such as length of service and final salary.

For example, a common formula for calculating pension payments is 1.5% of final average compensation multiplied by years of service. So, a worker with an average pay of $50,000 over a 25-year career would receive an annual pension payout of $18,750, or $1,562.50 per month.

One of the biggest benefits of a pension plan is that it typically pays out until the employee's death, meaning the retiree will not outlive their income. Additionally, pension plans do not require any management from the employee, as the employer takes care of the investments.

However, there are some downsides to traditional pensions. Since the formula for calculating payments is generally tied to years of service and compensation, changing jobs or the company terminating the plan before retirement age can result in receiving a lower benefit than expected. Additionally, pensions are often inaccessible until the employee is close to retirement age, and there is a risk of company bankruptcy resulting in reduced pension benefits.

Despite these potential drawbacks, traditional pensions are still considered valuable because they provide a guaranteed income for life and address the risk of running out of money before death.

Guaranteed income annuities

For example, at age 50, you can start making premium payments until you retire. Each payment will increase your income for life. You can buy these annuities on an after-tax basis, where you'll only owe tax on the plan's earnings, or within a tax-advantaged retirement account such as an IRA, where you get an upfront tax deduction but the annuity will be taxable when you withdraw.

The benefit of a GIA is that it provides a guaranteed income for life, addressing the risk of running out of money. It's a good option for those who want peace of mind or are worried about their pension pot running out. You can also buy an annuity that increases each year to protect yourself from inflation.

However, it's important to note that the decision to buy an annuity is irreversible, and depending on how long you live, you might get less than you paid. Additionally, annuities are complex legal contracts, and it can be challenging to understand your rights and rewards. Furthermore, as annuities offer bond-like returns, you lose the potential for higher returns in the stock market.

The Federal Thrift Savings Plan

The Thrift Savings Plan (TSP) is a defined contribution retirement savings and investment plan for federal employees and uniformed service members. It offers similar tax benefits to those of a 401(k) plan in the private sector.

With a TSP, participants can save part of their income for retirement, receive matching agency contributions, and reduce their current taxes. There are several ways to invest in a TSP, including automatic payroll contributions, tax-deferred contributions, and after-tax investments. The TSP offers a choice of six funds and a mutual fund option:

• The Government Securities Investment (G) Fund
• The Fixed-Income Index Investment (F) Fund
• The Common-Stock Index Investment (C) Fund
• The Small-Capitalization Stock Index Investment (S) Fund
• The International-Stock Index Investment (I) Fund
• Specific Lifecycle (L) funds

The contribution limit for a TSP in 2024 is $23,000, with a catch-up contribution of $7,500 for those over 50, bringing the total limit to $30,500. The federal government provides a sliding percentage scale of matching contributions, starting with a 1% contribution even if the employee contributes nothing. If an employee contributes 5% of their salary, the government will match it with a 5% contribution, doubling the amount invested.

TSP fees are relatively low, usually around 0.05%. Withdrawals from a TSP can be made monthly, quarterly, or annually, and there is no penalty for early withdrawal at age 55 or older. If you qualify under Federal Employees Retirement System (FERS) special provisions, this age is lowered to 50.

Cash-value life insurance plans

Cash-value life insurance is more expensive than term life insurance because of the cash value element. A portion of each premium payment is allocated to the cost of insurance, and the remainder is deposited into a cash value account. The cash value of life insurance earns interest, and taxes on the accumulated earnings are deferred. While premiums are paid and interest accrues, the cash value builds over time. As the life insurance cash value increases, the insurance company's risk decreases as the accumulated cash value offsets part of the insurer's liability.

There are several ways to access the cash value component, which serves as a living benefit for policyholders. Partial withdrawals are usually permissible, although they may reduce the death benefit. Some policies allow unlimited withdrawals, while others restrict the number of withdrawals per term or calendar year. If you withdraw more than the amount you've paid into the cash value, that portion will be taxed as ordinary income.

Most cash value life insurance arrangements allow for policy loans from the cash value. The issuer will charge interest on the outstanding principal, and the outstanding loan amount will reduce the death benefit if the policyholder dies before full repayment. Cash value can also be used to pay policy premiums. If there is a sufficient amount, a policyholder can stop paying premiums out of pocket and have the cash value account cover the payment.

One of the benefits of permanent life policies is the ability to accrue "cash value." The cash value within a policy is the balance remaining after a portion of a premium payment is applied to insurance costs. This feature provides several uses for life insurance in retirement. The cash value account grows over time and can be withdrawn as a source of income in retirement. Provided the amount withdrawn doesn't exceed the amount paid in premiums, it's typically not subject to taxes.

Frequently asked questions