To retire, you must comprehend the various kinds of retirement programs and their advantages. These savings options range from insurance-based after-retirement plans to defined-benefit pension plans.
A defined contribution plan promises you a specific account balance in retirement. This money is based on your contributions plus investment gains or losses.
401(k)
Employees can deposit a percentage of their salary to a tax-deferred account through an employer-sponsored retirement savings plan called a 401(k) plan. This plan offers a menu of investment alternatives, among which employees may select how to deploy their contributions. The 401(k) plan provides several benefits for employers and workers.
A significant advantage of a 401(k) is its tax deferral feature, which helps to reduce an employee’s taxable income. Since funds are withdrawn from the account in the future, they will be subject to lower taxes than would be the case with earnings removed from a taxable brokerage account.
Some 401(k) plans offer employer-matching contributions to employees’ accounts, which are tax-deferred. These match contributions are based on the employer’s profits and must satisfy specific special rules to qualify for tax-favoured status. In addition, a 401(k) plan must meet the Actual Contribution Percentage (ACP) test to ensure that it does not disproportionately favour highly compensated employees over non-highly compensated employees. Other types of retirement plans include a Simplified Employee Pension Plan (SEP) with salary reduction contributions and the SIMPLE 401(k) plan for small businesses.
457
State, local, and certain nonprofit companies offer a tax-advantaged retirement savings program called the 457 plan. It enables workers to defer a portion of their wages into an account, which lowers their taxable income for that year and delays taxes until they take their savings in retirement. This feature is similar to the more well-known 401(k) plan. Some 457 plans also allow employees to make after-tax contributions, although this is uncommon.
A 457 plan typically offers investment options, such as mutual funds provided by the plan administrator or a third-party provider. Employees can choose to build a customized portfolio from these options or rely on the guidance of a financial planner. Some 457 plans also offer specialized options for participants who want to save more money before they retire.
These unique contributions can start three years before a participant’s average retirement age, specified in their specific plan. These plans may also include a Roth option, which enables employees to contribute after-tax money and avoid paying taxes when they withdraw the money in retirement, depending on their employer’s regulations.
403(b)
Like 401(k) plans, 403(b) plans allow you to invest pre- or after-tax dollars. The investments grow tax-deferred until you withdraw them in retirement; at this point, they’re typically taxed as ordinary income. The only exception is if you make a qualified withdrawal due to military reserve duty, permanent disability, or medical expenses exceeding a certain percentage of your adjusted gross income.
Most 403(b) plans offer low-cost bond and stock index funds that experts recommend for retirement savings. Some even offer target-date funds, automatically adjusting their investment mix as you approach retirement.
Another benefit of a 403(b) plan is that it offers additional catch-up contributions for those over 50 on top of the standard catch-up contribution you can make to an IRA. However, many insurance companies administer these accounts and tend to have fewer investment options than a 401(k) or an IRA.
Some employer-sponsored plans also come with vesting periods, which means that if you leave your job before a certain period, often up to six years, you may forfeit some or all of the employer’s contribution to your account. However, you can still move the funds from one company-sponsored plan to another or roll them over into a regular IRA or other eligible retirement plan once you retire.
Thrift Savings Plan
For federal employees and members of the uniformed forces, there is a defined contribution retirement savings plan called the Thrift Savings Plan (TSP). It offers a variety of investment alternatives to participants and functions similarly to a 401(k) plan. The assets in the account are taxed once withdrawn, and no minimum withdrawal age is required. Participants may withdraw the funds from their TSP account in a lump sum or purchase a life annuity that provides guaranteed payments for life.
TSP participants can allocate their funds among five funds with varying investment approaches, returns, and purposes. They can also invest in a lifestyle fund, which automatically diversifies their account with a mix of investments.
The TSP is part of the Federal Employees Retirement System (FERS) and Blended Retirement System (BRS). Eligible for FERS or BRS, participants can receive a matching contribution from their agency or service. This matching contribution is immediately vested and can be taken with them when they change jobs or retire. It is a significant advantage over a traditional pension plan, which typically provides a fixed income in retirement.
Nonqualified
Although nonqualified retirement plans are not subject to the Employee Retirement Income Security Act (ERISA) and do not enjoy the same tax benefits as qualified plans, they offer more flexibility. They are often used as incentives to recruit and retain high-ranking executives. Nonqualified plans are also more likely to be sued because of the lack of ERISA protections.
One of the main benefits of a nonqualified retirement plan is that it allows employees to save more for their retirement because they don’t have to meet the contribution limits set by the IRS. However, they must still pay taxes when they withdraw their funds in retirement.
Nonqualified deferred compensation or executive bonus plans are typically offered to company officers and highly compensated employees. These plans allow HCEs to avoid a lower maximum contribution limit that may be imposed on their 401(k) contributions. In addition, these plans can offer more investment options. HCEs can also defer the income taxes on their deferred compensation until they retire. This way, they can enjoy a better lifestyle during their retirement years.
