11.3: Retirement Planning - Ways to Save

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Learning Objectives

Compare and contrast employer, government, and individual retirement plans.
Explain the differences between a defined contribution plan and a defined benefit plan.
Summarize the structure and purpose of Social Security.
State the difference between a Traditional IRA and a Roth IRA.
Identify retirement plans for the self-employed.

While knowing the numbers clarifies the picture of your needs, you must reconcile that picture with the realities that you face now. How will you be able to afford to save what you need for retirement?

There are several savings plans structured to help you save. Some offer tax advantages, while others don't. But first, and most importantly, you need to commit to saving.

Saving means not spending a portion of your disposable income. It means delaying gratification or putting off what you could have today until tomorrow. That is often difficult, as you have many demands on your disposable income. You must weigh the benefit of fulfilling those demands with the cost of not saving for retirement, even though the benefit in the present is much easier to credit than the benefit in the future. However, once you resolve to save, employer, government, and individual retirement plans are there to help you.

Employer Retirement Accounts

Employers may sponsor retirement plans for their employees as part of the total employee compensation. There are two kinds of employer-sponsored plans: defined contribution plans and defined benefit plans.

Defined Contribution Plans (e.g. 401(k) plans)

Commonly, larger employers sponsor defined contribution retirement plans. Under defined contribution plans, each employee has a retirement account, and both the employee and the employer may contribute to the account. The employer may contribute up to a percentage limit or offer to match the employee's contributions, up to a limit. With a matching contribution, if employees choose not to contribute, they lose the opportunity to have both the employer's contribution and their own. The employee makes untaxed contributions to the account through payroll deduction, up to a maximum limit specified in the current tax code.

Defined contribution plans have become increasingly popular since the introduction of Section 401(k) into the tax code. The 401(k) plans—or 403(b) plans for employees of nonprofits and 457 plans for employees of government organizations—offer employees a pretax (or tax-deferred) way to save for retirement, to which employers can make a tax-deductible contribution.

The advantages of a 401(k) plan for employees include its flexibility, portability, and tax benefits. A defined contribution account belongs to the employee and can accompany them when they leave an employer. For the employer, there is a lower cost and the opportunity to shift the risk of investing funds onto the employee. There is a ceiling on the employer's costs: either a limited matching contribution or a limit set by the tax code.

The employer offers a selection of investments, but the employee chooses how the funds in their account are diversified and invested. Thus, the employee assumes the responsibility and risk for investment returns. The employer's contributions are a benefit to the employee. Employers can also make a contribution with company stock, which can create an undiversified account. A portfolio consisting only of your company's stock exposes you to market risk should the company not do well, in which case, you may find yourself losing both your job and your retirement account's value.

Defined Benefit Plans (aka Pension plans)

A defined benefit plan is a retirement plan, sometimes referred to as a pension plan, that is funded by the employer and promises the employee a specific benefit upon retirement. The employer can be a corporation, labor union, government, or other organization that establishes a retirement plan for its employees.

The payout for a defined benefit plan typically consists of an annual or monthly payment for the remainder of the employee's life. In some defined benefit plans, there is also a spousal or survivor's benefit. The amount of the benefit is determined by your wages and length of service with the company.

With a defined benefit plan, your income in retirement is constant or "fixed," and it is the employer's responsibility to fund your retirement. This is both an advantage and a disadvantage for the employee. Having your employer fund the plan is an advantage, but having a fixed income in retirement is a drawback during periods of inflation when the purchasing power of each dollar declines. In some plans, that drawback is offset by automatic cost-of-living increases.

Social Security

The federal government offers a small insurance program for all citizens except federal government employees and railroad workers, known as Social Security. Social Security is funded by a mandatory payroll tax shared by employees and employers. That tax, commonly referred to as the Federal Insurance Contributions Act (FICA), also funds Medicare (see Chapter 10). The program is managed by the Social Security Administration (SSA).

Data provided by the SSA as of December 2023 show that almost 67,077,000 beneficiaries receive an average monthly benefit of $1,767.^[1] The federal government's total annual payment of benefits in 2023 totaled $1.24 trillion.^[2] Most of the beneficiaries are retirees (74.8%) or their spouses and children (3.8%).^[3]

Social Security is not an automatic benefit but an entitlement. To qualify for benefits, you must work and contribute FICA taxes for forty quarters (ten years). Retirement benefits may be claimed as early as age 62, but full benefits are not available until age 67 for workers born in 1960 or later.^[4] If you continue to earn wage income after you begin collecting Social Security but before you reach full retirement age, your benefit may be reduced. Once you reach full retirement age, your benefit will not be reduced by additional wage income.

The amount of your benefit is calculated based on the amount of FICA tax you paid during your working life and your age when you begin collecting the benefit. Up to 85 percent of individual Social Security benefits may be taxable, depending on the amount of other sources of income. Each year, the SSA provides each potential, qualified beneficiary with a projection of the expected monthly benefit amount (in current dollars) for that individual based on their wage history.

Individual Retirement Accounts

Any individual can save for retirement without a special "account." Still, since the government aims to encourage retirement savings, it has established tax-advantaged accounts to facilitate this goal. Because these accounts provide tax benefits as well as some convenience, it is best to use them first in planning for retirement.

Individual retirement accounts (IRAs) are personal investment accounts that allow individuals to save for retirement. As such, they may be invested in a wide range of financial products, including stocks, bonds, certificates of deposit (CDs), and mutual funds. Types of IRAs differ in terms of the tax treatment of contributions, withdrawals, and contribution limits.

The Traditional IRA is an account funded by your tax-deductible and/or nondeductible contributions. The tax-deductible contributions you pay now lower your current tax basis. Deductible contributions are taxed later as funds are withdrawn, but nondeductible contributions are not. In other words, you either pay tax on the money as you put it in, or you pay tax on it as you take it out.

A great advantage of a Traditional IRA is that principal appreciation (interest, dividend income, or capital gain) is not taxed until the funds are withdrawn. As of 2023, withdrawals may be made without penalty after reaching the age of 59.5. Funds may be withdrawn before age 59.5, but penalties and taxes will be applied.^[5] Contributions may be made until age 73, at which time required minimum distributions (withdrawals) of funds must begin.^[6]

Because they create tax advantages, contributions to a Traditional IRA are limited, currently up to $7,000 (or $8,000 for individuals over 50), effective for tax year 2024.^[7]That limit on deductible contributions becomes smaller (the tax benefit is phased out) as income rises. The Internal Revenue Service (IRS) provides a worksheet to calculate how much of your contribution is taxable with your personal income tax return (Form 1040).

For the Roth IRA, contributions are not tax-deductible; however, withdrawals are tax-free. You can continue to contribute at any age, and you are not required to take any minimum required distributions. A Roth IRA's most significant advantage is that capital appreciation is not taxed.

As with the Traditional IRA, contributions to a Roth IRA may be limited depending on your income. If you have both a Traditional and a Roth IRA, you may contribute to both, but your combined contribution is limited.

Table 11.3.1 is an adaptation of a guide provided by the IRS to the key differences between a Traditional and a Roth IRA.^[8]

Table 11.3.1 : Differences between the Traditional and the Roth IRAs
	Traditional IRA	Roth IRA
Tax-deductible contributions allowed?	Yes	No
Tax-deductible contributions limited?	Yes, by income	N/A
Nondeductible contributions allowed?	Yes	Yes
Nondeductible contributions limited?	Yes	Yes
Withdrawals are taxed?	Yes, of deductible contributions	No
Minimum required distribution?	Yes	No
Age of mandatory distribution?	73^[10]	None
Minimum age for distribution?	Yes, 59½	Yes, 59½

A rollover is a distribution of cash from one retirement fund to another. Funds may be rolled into a Traditional IRA from an employer-sponsored plan (such as a 401(k), 403(b), or 457 (b)) or another IRA. You may not deduct a rollover contribution (since you have already deducted it when it was contributed initially). Still, you are not taxed on the distribution from one fund that you immediately contribute to another. A transfer moves a retirement account, a Traditional IRA, from one trustee or asset manager to another. Rollovers and transfers are not taxed if accomplished within sixty days of distribution.

Self-Employed Individual Plans

People who are self-employed wear many hats: they are both employer and employee, as well as individuals in their own right. To accommodate them, several plans are available that allow for deductible contributions.

A Simplified Employee Pension (SEP) is a plan that allows an employer with few or no other employees, aside from themselves, to make deductible retirement contributions to an employee's Traditional IRA. Such an account is called a SEP-IRA and is set up for each eligible employee. Contributions are limited: in any given year, they can't exceed 25 percent of salary or $69,000 (in 2024), whichever is less.^[9] If you are self-employed and contributing to your own SEP-IRA, the same limits apply, but you must also include any other contributions that you have made to a qualified retirement plan.

A Savings Incentive Match Plan for Employees (SIMPLE) is a plan where employees make salary reduction (before-tax) contributions, and the employer matches them. If contributions are made to a Traditional IRA, the plan is referred to as a SIMPLE IRA. Any employer with fewer than one hundred employees who were paid at least $5,000 in the preceding year may use a SIMPLE plan. There are also SIMPLE 401(k) Plans.

A Keogh Plan is another retirement vehicle for small or self-employed individuals. It can be a defined benefit or a defined contribution qualified plan with deductible contribution limits.

Summary

Employers, the government, or individuals may sponsor retirement plans.
Defined benefit plans differ from defined contribution plans in that the benefit is a specified amount for which the employer is liable. In a defined contribution plan, the benefit is not specified, and the employee is responsible for the accumulation in the plan.
Social Security is financed by payroll taxes and is designed to supplement employer retirement plans or individual retirement plans.
Traditional and Roth IRAs differ in their taxable nature, as well as in the age limits for contributions and withdrawals.
Retirement plans for the self-employed are designed for individuals who are both employees and employers.

Exercises

Do you participate in an employer-sponsored retirement savings plan? If so, what kind of plan is it, and what do you see as the benefits and drawbacks of participating? If you contribute to your plan, how did you decide how much to contribute? Could you contribute more?
As part of your planning, how can you estimate what you can expect from Social Security as a contribution to your retirement income? Find this answer by visiting the Social Security Administration's Plan for Retirement site (www.ssa.gov/retirement/plan-for-retirement). Using the menus at this site, find out your retirement age. How many credits toward Social Security do you have now? How many do you expect to accumulate over your working life? Use one of the benefit calculators to find your estimated Social Security benefit. How much could you receive monthly? Could you live on your Social Security benefits alone? How much more would you need to save for? What would happen if you continued to work or went back to work after taking your retirement benefit? What would happen if you took your benefit before your full retirement age?
Will your career path lead you to employment through government at the local, state, or federal level (for example, in education, law enforcement, or public health)? How are retirement plans for government employees different from the plans described in this section? Find answers to this question by visiting the Office of Personnel Management's Retirement Center (www.opm.gov/retirement-center/).
What individual retirement account(s) do you have? Which type of IRA, if any, would be best for you, and why? Why might it be a good idea to have an IRA as a means of funding your retirement, along with other means? According to Investopedia's Individual Retirement Account (IRA) article (www.investopedia.com/terms/i/ira.asp), what are the chief advantages of IRAs? How many types of IRAs are there? Can you withdraw money from an IRA account? When must you take a distribution (cash out your IRA)?

^[1] Social Security Administration. “Monthly Statistical Snapshot, December 2023”, SSA.gov, December 2023. www.ssa.gov/policy/docs/quickfacts/stat_snapshot/2023-12.html.

^[2] Social Security Administration, “Fast Facts & Figures about Social Security, 2023”, Social Security Administration Research, Statistics, and Policy Analysis, 2023, www.ssa.gov/policy/docs/chartbooks/fast_facts/2023/fast_facts23.html.

^[3] Social Security Administration. “Monthly Statistical Snapshot, December 2023”, SSA.gov, December 2023. www.ssa.gov/policy/docs/quickfacts/stat_snapshot/2023-12.html.

^[4] Social Security Administration, “See Your Full Retirement Age (FRA)”, Social Security, August 16, 2023, www.ssa.gov/retirement/full-retirement-age.

^[5]Internal Revenue Service, “What If I Withdraw Money from My IRA?”, Irs.gov, 2019, www.irs.gov/newsroom/what-if-i-withdraw-money-from-my-ira.

^[6] Internal Revenue Service, “Publication 590-A (2024), Contributions to Individual Retirement Arrangements (IRAs)”, www.irs.gov, 2023, www.irs.gov/publications/p590a.

^[7] ibid.

^[8] ibid.

^[9]Internal Revenue Service, “Publication 560 (2021), Retirement Plans for Small Business”, www.irs.gov, 2023, www.irs.gov/publications/p560.

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