It’s no secret that retirement savings should claim a chunk of every paycheck, but choosing the right vehicle for investing those funds depends on a variety of factors. Age, employment status and tax situation are all essential considerations when deciding among the types of retirement plans. With the average American worker holding only $63,000 in a retirement account, according to a 2015 study by the Transamerica Center for Retirement Studies, there’s no time to waste getting that money squirreled away so it can start earning interest.
Pensions of the Past
Pensions, or defined benefit plans, were the standard type of retirement savings account several generations ago. These types of plans are rarer nowadays due to their complexity, cost and inflexibility. A pension promises to pay out a specific amount every year, or month, from retirement until death. Employee contributions are mandatory at a set amount, and the setup involves a financial planner or pension specialist and an actuary. One of the main benefits of a pension is that workers who earn a great deal can contribute large amounts into the account.
The 401(k) is today’s standard employer-sponsored retirement account, and most employers that offer retirement benefits to their full-time employees use this type of savings plan. Generally, eligibility is determined by a list of factors set forth by the company that must adhere to federal and state regulations. These may include the number of hours worked per week and the length of employment with the company. Once an employee becomes eligible to contribute to the account, contributions are made pre-tax and on a completely voluntary basis. Many employers offer a matching contribution for the first several percent added by the employee as part of their benefits packages. The combined total of all contributions is $30,000 annually, or 25 percent of the individual’s total salary. The types of investments offered under the umbrella of these plans are varied, and contributors normally choose from among a list of offerings.
An Individual Retirement Account, or IRA, comes in two types, a traditional or a ROTH. Both accounts are designed to receive personal money, rather than contributions through an employer, and can be set up through a bank, financial advisor or other institution. Yearly contribution limits depend on the age of the earner, and eligibility is limited for those who are covered by an employer-sponsored plan. Traditional accounts decrease taxable income, as contributions are made pre-tax, while ROTH accounts are designed for post-tax contributions and tax-free withdrawals.
Plans for the Self-Employed
Those who are self-employed, or work as independent contractors, have several savings vehicles designed for their situation. Decisions about which type to use are influenced by business ownership, overall wages, tax status, administration cost, and the number of individuals they employ. The main types are:
- SEP: A Simplified Employee Pension, or SEP, is popular among small business owners for its flexibility, frugality and simplicity. Employers may set up a match for eligible contributors. Employee investors are limited to a contribution of 25 percent of their total compensation or $53,000, whichever is lesser. For self-employed individuals, the contribution maximum is calculated based on a percent of the annual net profit after the contribution.
- Solo 401(k): Solo accounts allow self-employed people to add more than a SEP would. On top of a dollar cap, contributors are allowed to add up to 20 percent of the income from the business.
- Keogh: These types of plans are more complicated to establish and maintain, although they are often beneficial for high wage earners, as they allow for larger contributions than other types. Think of these accounts as a self-funded pension.
Both employees and self-employed workers have several retirement savings options at their disposal. Adding funds to an account up to the matching percentage is usually beneficial. Beyond that, considering the current and future tax situation helps narrow down the options.
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