Most people know that one critical element of an effective financial plan is a retirement strategy. However, many are unsure of the retirement plan options that are currently available to them.
Today, in “What is a Retirement Plan?” you will learn why a retirement strategy is vital to your financial future and how to begin building a retirement plan.
Some people see “the golden years” as something far away in the distant future, while others are worried that they will not have enough money when they retire.
Regardless of your circumstances, creating a retirement plan is critical to achieving financial security.
Customizing your plan based on individual factors like age, income, investment goals, and risk tolerance is best.
Consulting a financial advisor will help you create a plan that is best suited for you.
Why is planning for retirement important?
Longer Life Span
While it is great to live longer, this means that you will likely need more money to meet your needs over time.
Generally, as we age, we have higher healthcare costs, long-term care insurance premiums, and living expenses. And, if your spouse dies, you may have less monthly income from social security and their pension than expected. Additionally, most people underestimate the money they will need in retirement.
A retirement plan will help ensure you have enough money to cover your expenses and live comfortably in your “golden years.”
A good retirement plan will provide you with options. For example, it can help you afford better medical care and disability insurance. It can also ensure that your kids and grandkids get the best education. Lastly, it allows you to live wherever you choose, take your family on that dream vacation, and do whatever else your heart desires.
What are the types of retirement plans?
Let’s begin by reviewing the different options available:
Individual Retirement Accounts (IRAs)
An IRA is an individual retirement account that offers tax-advantaged growth and withdrawals.
There are two types of IRAs: Traditional and Roth.
Contributions to a traditional IRA may be tax-deductible, depending on your income and whether an employer retirement plan covers you or your spouse. Earnings on the investments grow tax-deferred. This means you won’t pay taxes on the earnings until you withdraw the money from the account.
Traditional IRA withdrawals are subject to income taxes. You may also be subject to an early withdrawal penalty if you withdraw funds from the account before a certain age.
Because tax laws change, always review the current rules and ages before withdrawing money from a retirement account.
A Roth IRA is a type of individual retirement account (IRA) that offers tax-free growth and tax-free withdrawals in retirement.
You make Roth IRA contributions with after-tax dollars. This means you have already paid taxes on the money you contribute. Investment earnings grow tax-free. As a result, you do not have to pay taxes on the profits when you withdraw the income.
If you meet the eligibility requirements, Roth IRA withdrawals may be tax-free and without a penalty. However, you may be subject to an early withdrawal penalty if you withdraw earnings before age 59½.
A 401(k) plan is a retirement savings plan sponsored by an employer. It allows employees to save and invest for retirement on a tax-deferred basis.
Contributions to a 401(k) plan are made with pretax dollars, which reduce your current taxable income. Earnings on the investments grow tax-deferred. This means you won’t pay taxes on the earnings until you withdraw the money from the account.
Withdrawals from a 401(k) plan are subject to income taxes. You may also be subject to a 10% early withdrawal penalty if you withdraw funds from the account before age 59½.
Many 401(k) plans offer a matching contribution from the employer, which can be an incentive to save for retirement. Employer matching contributions are usually vested immediately, which means you have the right to keep the employer’s contributions even if you leave the company before retirement.
A 403(b) plan is a tax-advantaged retirement savings plan available to employees of public schools and certain nonprofit organizations.
The pre-tax contributions to a 403(b) plan reduce your current taxable income. Earnings on the investments grow tax-deferred, which means you won’t pay taxes on the earnings until you withdraw the money from the account at retirement.
Withdrawals from a 403(b) plan are subject to income taxes. Earnings may also be subject to a 10% early withdrawal penalty if you withdraw funds from the account before age 59½.
A 457 plan is a tax-advantaged retirement savings plan available to state and local government employees, as well as some employees of nonprofit organizations.
Contributions to a 457 plan are made with pretax dollars, which reduces your current taxable income. Earnings on the investments grow tax-deferred, which means you won’t pay taxes on the earnings until you withdraw the money from the account at retirement.
Withdrawals from a 457 plan are subject to income taxes. You may also be subject to a 10% early withdrawal penalty if you withdraw funds from the account before age 59½.
A pension plan is a retirement savings plan sponsored by an employer. A defined benefit plan uses a formula to determine your retirement benefit rather than your account balance.
Pension plans are becoming less common as employers switch to 401(k) plans. However, some government employees and employees of private firms still have access to pension plans.
If you have a pension plan, you may be required to make contributions to the plan. The employer may also make contributions on your behalf.
Pension plans generally pay out benefits in an annuity, providing a stream of lifetime income. Alternatively, you may elect to receive a lump-sum payout at retirement.
Pension benefits are usually taxed as ordinary income. However, if you made after-tax contributions to the pension plan, those contributions can be withdrawn tax-free.
The best retirement plan depends on your circumstances. As previously mentioned, contributing factors include age, income, investment goals, and risk tolerance. Always consult a financial advisor to discuss which type of retirement plan is right for you.
Important Retirement Plan Terms
Many investment options are available for retirement plans. Examples include stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Your investment selections depend on your goals, risk tolerance, and time horizon.
Many employers offer retirement plans that include employer contributions. Employer contributions may be tax-deferred, meaning they are not subject to income taxes until you withdraw them.
These plans are often in the form of matching funds, meaning the employer will match a certain percentage of your contributions up to a specific limit. For example, an employer may match 50% of your contributions up to 6% of your salary.
The contribution limit for a retirement plan is the amount you can contribute to the plan each year. This varies depending on the type of plan and, in some situations, your age. Because rules change, always check with an advisor before contributing money to a retirement plan.
This means that the amount funded into a retirement account is not taxed currently, and the funds grow tax-deferred until withdrawal. The funds are then taxed as income.
Pre-tax money is income you have earned but have not yet paid taxes on.
After-tax money is income that you have paid taxes on.
In a tax-deferred plan, such as a 401(k) or 403(b), you do not pay taxes on the income you contribute until you withdraw the money from the plan.
This refers to income received from a pension or retirement account. Retirement income may come from other sources, too. Examples include rental property, side-hustles, or part-time work.
You will eventually have to pay taxes on the withdrawals from a tax-deferred retirement plan. For this reason, you may pay more tax when you withdraw the money than if you contributed to a Roth IRA.
You should consult a tax advisor to determine if a tax-deferred retirement plan is right for you.
Retirement plans are generally tax-deferred. This means you do not have to pay taxes on the money you contribute to the plan. However, you will eventually have to pay taxes on your withdrawals. Withdrawals from traditional retirement plans are taxed as ordinary income. In comparison, withdrawals from Roth retirement plans are not taxed because the contributions were not deductible when you invested the funds (this is because you made the contributions with after-tax dollars).
Conclusion – What is a Retirement Plan?
There are a wide variety of retirement plan choices. Therefore, you should always consult with a qualified advisor before deciding which plan to move forward with.
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