Why Have a Personal Retirement Plan?
It’s never too early to start thinking about retirement. Whether you’re new to the workforce or have a few decades of work experience, you can create a personal retirement plan that will help ensure that your retirement dreams become a reality. Your retirement could last for 30 years or longer. The best way to prepare for it is by learning about the different retirement savings options and deciding which will work best for you.
Supporting Yourself in Retirement
Most people who have worked fulltime throughout their lifetime have paid into the Social Security system and are eligible to receive retirement benefits. While these benefits can help with basic living expenses, they do not cover all expenses for most people. A pension might make up the difference, but fewer Americans are covered by pensions than in the past. The solution for many retirees is one or more retirement accounts that have grown over time into a substantial enough amount to support them throughout the years when they are no longer working.
Types of Retirement Plans
The two main types of retirement savings accounts are employer-sponsored retirement plans, such as 401(k) plans, and Individual Retirement Arrangements (IRAs). Both types of retirement plans offer important tax advantages over regular savings accounts because contributions and gains from investments are not taxed until they are withdrawn. It can also be easier to build a retirement fund in these accounts by adding money through automatic payroll deductions, while penalties for early withdrawals discourage draining the account before retirement.
401(k) Employer Retirement Plans
A 401(k) is a retirement savings plan offered by an employer as a benefit to employees. It is designed to replace the retirement funds normally provided by a pension, but it must be built up by an employee through paycheck deferrals. The money saved in a 401(k) account is taken tax-free directly from an employee’s wages. The account is maintained by a plan administrator or financial institution. Money in the account is usually allocated to mutual funds that include stocks, bonds and money market investments. Many plans allow an employee to decide on their investment mix and also provide some form of free or fee-based investment advice on how to pick the best investments as they near retirement.
Employer Contributions to a 401(k)
The majority of employers that offer a 401(k) to their employees also provide matching contributions, usually after an employee has contributed for a certain amount of time and become vested in the plan. The plan will match a certain percentage of a vested employee’s contribution, typically 3 percent of the employee’s salary.
For example, if an employee who makes $50,000 and has signed up to contribute 5 percent to their 401(k), they would contribute $2,500 and their plan would contribute $1,500. The plan only matches up to 3 percent of the employee contribution and not the entire 5 percent. Some plans match unvested employee contributions, but don’t allow the employee to access the matched funds until vested.
The IRS places some restrictions on how a 401(k) plan is administered. To encourage savers to keep their money in place until retirement, there is a 10 percent penalty for withdrawing money before age 59 ½. Because the money contributed to a 401(k) is not taxed in the year it’s earned, taxes are due on any money withdrawn. In addition, the IRS places a limit on the amount an employee can have deferred to a 401(k) each year. The limit was set to $19,000 for 2019; it is periodically increased as part of IRS cost-of-living adjustments.
Other Employer Plans: 403(b) and 457(b)
In addition to 401(k) plans, there are a few other types of employer-sponsored retirement savings plans with IRS tax-deferred status. A 403(b) is a savings plan for employees of public schools, tax-exempt organizations and certain other types of organizations. A 457(b) retirement savings plan may be offered by local and state governments and other tax-exempt organizations to their employees.
Individual Retirement Arrangement (IRA)
Besides employer-sponsored retirement savings plans, an IRA can be part of your retirement savings. Anyone can make contributions to an IRA retirement savings plan. Like a 401(k), a traditional IRA is funded with pretax contributions. Starting in 2019, the annual IRA contribution limit is $6,000, or $7,000 for those over age 50. Another type of IRA called a Roth is funded with money that has already been taxed. When you take qualified distributions from a Roth, no taxes are due, while distributions from a traditional IRA are taxed. The contribution limit for a Roth is determined by your taxable income and your contribution to other plans.
If you feel like you’re behind in your retirement savings and are over age 50, you can make what the IRS calls catch-up contributions to a retirement plan. Between the years 2015 and 2019, an annual catch-up contribution of up to $6,000 is allowed for 401(k), 403(b) and 457(b) accounts.
Catch-up contributions must be made through elective deferrals within the plan year, which may be different from the calendar year. Up to $1,000 can be contribution on a catch-up basis to IRAs before the due date of your tax return. An example of a catch-up contribution is someone aged 52 who has a plan year lasting from Oct. 1 to Sept. 30. If they make the maximum catch-up contribution by July, they cannot begin make more catch-up contributions until after Oct. 1.
Required Minimum Distributions
Some savings plans are subject to tax rules that require account holders to begin withdrawing a minimum amount at age 70 ½ or at retirement, whichever occurs later. Minimum distributions continue until the account is emptied or the account holder passes away. The required minimum distribution rule is in effect for 401(k), 403(b) and traditional IRA plans. You are also required to begin taking distributions from the account at that age. Failing to take an annual distribution can result in a significant tax penalty.
There is no age limit on Roth IRA contributions and no requirements for minimum distributions. You are not allowed to avoid paying taxes on a minimum distribution by rolling it over into a Roth IRA.
Retirement Plan Contribution Age Limits
401(k) plans are required by law to allow you to make contributions until you leave your job or retire, even if you are older than age 70. Deferred contributions are allowed even for those who are taking required minimum distributions. You can contribute to a traditional IRA until age 70 ½, but there is no age limit for a Roth IRA.
Creating a Retirement Budget
If you’re just a few years away from retirement, creating a budget for your retirement years will help determine how much more you need to save. Begin by tracking your income and expenses for a few months, then take a look at your expenses and decide which you will still have in retirement and which can be eliminated.
According to the IRS, most people need at least 80 percent of their pre-retirement income after they retire. One important way to help prepare for retirement is to plan on paying off outstanding debts while you’re working so you don’t face debt payments after retirement. When you have a clear picture of your retirement expenses, you can determine if your income from Social Security, retirement savings and other sources will be enough. If it looks like you’ll be coming up short, try to increase contributions to your retirement savings plan or plan on working longer before retiring.
Catie Watson spent three decades in the corporate world before becoming a freelance writer. She has an English degree from UC Berkeley and specializes in topics related to personal finance, careers and business.