Retirement Investment Strategies: Navigating Your Golden Years

There are many different types of retirement investment plans, each with its own benefits and considerations. Here are some of the most common options:

- Defined contribution plans: These are now the most common type of workplace retirement plan. Examples include 401(k)s, 403(b)s, and 457(b) plans. With these plans, employees contribute a certain amount or percentage of their paycheck to an individual account within the company plan, often with a company match where the employer contributes a portion as well. These plans usually offer tax advantages, such as tax-deductible contributions or tax-free withdrawals in retirement.

- Individual Retirement Accounts (IRAs): IRAs are one of the most common retirement plans and can be set up by individuals at financial institutions. There are several types of IRAs, including traditional IRAs, Roth IRAs, spousal IRAs, rollover IRAs, SEP IRAs, and SIMPLE IRAs. Each type has different features and eligibility requirements, but generally, IRAs offer more investment flexibility than workplace plans and may provide tax advantages.

- Retirement plans for small business owners and the self-employed: This category includes options such as solo 401(k)s, SIMPLE IRAs, SEP IRAs, and payroll deduction IRAs. These plans often have higher contribution limits and more investment choices than employer-sponsored plans.

- Employer-sponsored defined benefit plans: Also known as pension plans, these plans are becoming less common but provide employees with a fixed, pre-set benefit upon retirement.

Defined contribution plans

In the US, defined contribution plans are specified under 26 U.S.C. § 414(i) as:

> "...plans providing for an individual account for each participant and for benefits based solely on the amount contributed to the participant's account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant's account."

These plans are typically tax-deferred, and employees can choose to contribute a fixed amount or a percentage of their paychecks. The sponsor company may also match a portion of the employee's contributions. Defined contribution plans place restrictions on withdrawals, controlling when and how employees can withdraw funds without penalties.

The most common defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans. As of December 31, 2021, defined contribution plans accounted for $11 trillion of the $34.2 trillion in total retirement plan assets held in the US.

• Voluntary and self-directed participation: Employees choose whether to participate and are responsible for selecting investments.
• No guaranteed benefits: Unlike defined benefit plans, defined contribution plans do not guarantee a specific retirement income. The benefits depend on contribution levels and investment performance.
• Tax advantages: Contributions may be tax-deferred, and investments grow tax-free until retirement.
• Employer matching: Many plans allow employers to match employee contributions, encouraging participation.
• Investment choices: Employees can choose from various investment options, such as mutual funds, to align with their retirement goals and risk tolerance.
• Withdrawal restrictions: Early withdrawals may result in penalties and taxes.
• Portability: Defined contribution plans are generally portable, allowing employees to move their accounts between employers.
• Global prevalence: Defined contribution plans have become widespread globally and are now dominant in the private sector in many countries.

Individual retirement accounts (IRAs)

There are several types of IRAs available, each with different rules regarding eligibility, taxation, and withdrawals. These include traditional IRAs, Roth IRAs, Simplified Employee Pension (SEP) IRAs, and Savings Incentive Match Plan for Employees (SIMPLE) IRAs. Traditional IRAs are tax-advantaged plans that allow individuals to contribute pre-tax dollars, meaning contributions are not considered taxable income. Earnings on these contributions grow tax-free until they are withdrawn at retirement, at which point they become taxable. Roth IRAs, on the other hand, are funded with after-tax money, so there are no further taxes due when the money is withdrawn.

The main advantages of IRAs include the ability to choose the financial institution and make all the investment decisions, as well as the flexibility to decide how and when to get a tax break. IRAs also typically provide a wider range of investment choices than workplace retirement plans. Additionally, individuals can contribute to both a Roth and a traditional IRA in the same year, as long as the total contributions remain below the combined IRA contribution limit.

However, IRAs have lower annual contribution limits than most workplace retirement accounts. For 2024, the maximum amount that can be contributed to an IRA is $7,000, with an additional $1,000 allowed as a catch-up contribution for individuals aged 50 or older. In comparison, the maximum contribution limit for 401(k) plans in 2024 is $23,000. Withdrawing money from an IRA before the age of 59½ typically incurs a hefty tax penalty of 10% of the amount withdrawn, in addition to regular taxes owed. However, there are some exceptions to this penalty for specific situations such as educational expenses and first-time home purchases.

Annuities

There are three basic types of annuities:

• Fixed annuities: The insurance company promises a minimum interest rate and fixed periodic payments.
• Variable annuities: The insurance company allows you to direct your annuity payments to different investment options, usually mutual funds. Payouts will vary depending on the performance of the investments.
• Indexed annuities: 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 S&P 500.

However, annuities are often criticised for being illiquid and complex. Withdrawals during the surrender period, which can last several years, will usually incur a penalty.

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. 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. There's no tax deduction in the contribution year, but withdrawals—qualified distributions—are tax-free.

• Employees can choose to defer a portion of their salary and put it into a 401(k) plan instead of receiving that amount in their paycheck. This deferred money is generally not taxed until it is distributed.
• 401(k) plans offer greater flexibility in contributions compared to IRA plans, and employees may contribute more.
• They are a good plan if cash flow is an issue, and they offer optional participant loans and hardship withdrawals, adding flexibility for employees.
• Administrative costs may be higher than more basic arrangements.
• It is necessary to test that benefits do not discriminate in favour of highly compensated employees, which can be complicated.
• Additional withdrawal and loan flexibility adds an administrative burden for the employer.
• Employees are always 100% vested in their salary deferrals, while employer contributions may be vested on a graduated vesting schedule.
• Annual filing of Form 5500 is required.
• In-service withdrawals are allowed but are subject to a possible 10% additional tax if the employee is under 59 1/2.

Overall, 401(k) plans are a popular way for employees to save for retirement, offering tax advantages and the potential for employer-matching contributions.

403(b) plans

A 403(b) plan is a retirement plan offered by public schools, higher education institutions, and certain tax-exempt organisations, such as charities and churches. It is similar to a 401(k) plan, but the key difference is that 403(b) plans are offered by public and non-profit organisations, while 401(k) plans are generally available to employees of for-profit companies.

A 403(b) plan allows employees to save for retirement by contributing a portion of their salary to individual accounts. The money is typically placed in annuity contracts, custodial accounts invested in mutual funds, or retirement income accounts invested in annuities or mutual funds. Employees can contribute pre-tax dollars directly from their paycheck, and their investments grow tax-deferred until withdrawal. The tax is only paid when the money is withdrawn in retirement.

The maximum amount employees can contribute to a 403(b) plan annually is $23,000 in 2024. Employees aged 50 and over can contribute an additional $7,500 as a catch-up contribution.

There are two types of 403(b) plans: traditional and Roth. A traditional 403(b) plan allows employees to have pre-tax money deducted from each paycheck and paid into a personal retirement account, reducing their gross income and income tax for that year. A Roth 403(b) plan, on the other hand, requires that after-tax money be paid into the retirement account. While there is no immediate tax advantage, the employee will not owe any additional taxes on that money or its profits when it is withdrawn.

Some of the advantages of 403(b) plans include tax benefits, flexibility in contributions, and optional loans and hardship distributions. However, 403(b) plans may have higher administrative costs and more limited investment options compared to other retirement plans.

Frequently asked questions