Retirement Plans – Understanding the Basics

October means pumpkins, turning leaves, and the beginning of the holiday season. While it is easy to launch yourself into shopping mode and spend your money on gifts for family and friends, WISER suggests paying yourself first. Luckily, National Save for Retirement Week is right around the corner (October 19-25, 2014). It’s a perfect time to improve your knowledge of retirement plans and how to maximize your savings.

The first step is to understand the different types of retirement plans and which ones may be available to you at your workplace. Many employers offer retirement plans. There are two types available – defined benefit plans and defined contribution plans. What do these mean?

Defined benefit plans are ones in which your employer often contributes money to the plan and selects a plan administrator who makes investment decisions. Since the plan has an administrator, your company entirely controls your investment risk and portfolios management. Once you retire, you receive a specific monthly benefit determined by formula. The formula takes into account the age at which you retire, your rate of pay, and the number of years you worked at the company. One of the best features of this type of plan is that you will have a fixed benefit, ensuring you know exactly how much income you will have in retirement.

Defined contribution plans, on the other hand, are ones in which you as the employee contribute some or all of the funds and decide how to invest the money. Sometimes an employer will match part or all of the employee contribution. If this is the case, you should always invest at least enough to receive your full employer match. It’s basically free money for your retirement!

The most common defined contribution plan is a 401(k). If you have a 401(k), your money is contributed from your paycheck before taxes, meaning you do not pay taxes on the money you add to your retirement plan. The more you contribute, the lower your taxable income. You will only be taxed on the money once you start withdrawing it. If you withdraw the money, however, before you are 59 ½, you will pay a penalty up to a 10% additional tax. There are some contribution limits to these plans, but they are significantly higher than other retirement plans. The current limit (for 2013 and 2014) is $17,500. Check out the IRS website for more information on contribution limits. Unlike the defined benefit plan, however, the amount of money available at your retirement depends entirely upon how much money you contributed and how well your chosen investments performed over the years.

Additionally, 401(k)s are considered “portable.” When you change jobs, you can take all the money in your account and roll it over into an individual retirement account (IRA) or other qualified, employer-sponsored 401(k) plan. WISER has a chart to help you understand what types of plans you can rollover.

If you work for a tax-exempt organization, you may have a 403(b) plan. These plans are similar to 401(k).

Other defined contribution plans include an employee stock ownership plan, money purchase plans, profit-sharing plans, and stock bonuses. Small businesses may offer Keogh plans, payroll deduction for IRAs, a simplified employee pension (SEP), or a savings incentive match plan for employees (SIMPLE). Our factsheet offers some more details on these plans.

Are you self-employed, working part time, ineligible for an employer-sponsored retirement plan, or otherwise want other options? There are other ways to save for retirement.

You can open an IRA account. There are two typical types of IRAs – Traditional IRA and Roth IRA. For both types, your contribution limit is $5,500 ($6,500 if you’re age 50+) in 2014. This limit may change in 2015. The main differences between these two accounts are how they are taxed and when you can withdraw your money. For a Traditional IRA, your money is tax deductible, meaning you will not pay taxes on it in the year you contribute it. Like contributions to a 401(k), you will only pay taxes on the money once you start withdrawing it in retirement. You cannot withdraw money before you are age 59 ½ without paying a penalty. You also must start taking distributions by April 1 following the year you turn age 70 ½. If you are further along in your career and in a high-income bracket for taxes, a Traditional IRA may be a good option for you because it will lower your taxable income.

Contributions to Roth IRAs, in contrast, are taxed as you contribute them, and are tax-free when you withdraw them (if you are 59 ½ older and opened your account at least 5 years prior). If you are younger than 59 ½, you can withdraw money 5 years after opening the account for certain medical expenses, higher education expenses, or to buy your first home. You are not required to take distributions at any age. Many young savers prefer Roth IRAs because they have a lower tax bracket now than they will when they retire.

You may also want to invest in government bonds. These are safe ways to invest money because the government backs them. You can buy small bonds for as little as $25. Different bonds have different interest rates and cash them in at different times. We break down I bonds, EE bonds, and HH bonds in more detail on our factsheet.

Understanding your retirement plans may seem daunting at first, but by starting with the basics, you can continue to build on what you learn. The more you know, the better prepared you will be to make decisions that can greatly impact your savings and future financial security.

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