Having retirement savings or a retirement plan is in everyone’s best interest. However, knowing what type of retirement plan best suits you can be challenging, especially with so many terminologies out there. Keeping track of them all can not only be difficult, but it can be confusing. From a 401 k to roth accounts taking a moment to understand your investment options before you reach retirement age can be beneficial.
We understand this, which is why we put together a list of 10 retirement plan terms simplified to can help you with the basics of retirement plans.
IRA (Individual Retirement Account)
Individual retirement accounts are savings accounts that, as the name suggests, individuals can open at any institution that has been approved by an Internal Revenue Service (banks, brokerage companies, etc.)
You can only contribute to an IRA with earned income. The amount of money you contribute allows you certain tax advantages. For example, if you put in $3,000, your taxable income reduces by exactly that amount for the year.
However, the only limitation is you cannot withdraw from your IRA before the age of 59½ without getting a 10% tax penalty on the withdrawn amount.
The maximum amount that can be contributed yearly as of recently is $6,000 for individuals younger than 50 and for individuals 50 and above, it is $7,000.
A Roth IRA is not much different from a traditional IRA. The major difference between the two is, that, unlike your traditional IRA, Roth IRA contributions are not tax-deductible. What this means is you can contribute to your Roth IRA post-tax, thereby allowing you to spend freely without fear of tax as a retiree.
The money you contribute to your Roth IRA is your income after it has been taxed ensuring free withdrawal without tax.
Simplified Employee Pension IRA (SEP IRA)
A SEP IRA follows the same tax application as a traditional IRA. It is important to note that employees cannot make payments into their accounts, only their employers can. Typically, business owners can make contributions on behalf of their employees. The IRS taxes their withdrawals as income.
For those who may be self-employed as a freelancer, contractor or small business owner, this retirement plan may be just what you are looking for. This is because SEP-IRAs offer high annual contribution limits, low setup costs, and minimal paperwork. You also have the flexibility of varying or even skipping your contributions based on the needs of your business.
According to the IRS, SEP plans (that are not SARSEPs) only allow employer contributions. For a self-employed individual, contributions are limited to 25% of your net earnings from self-employment (not including contributions for yourself), up to $61,000 for 2022 ($58,000 for 2021; $57,000 for 2020)
SIMPLE (Savings Incentive Match Plan for Employees) IRA
This plan is also suited for small business owners or self-employed individuals. The difference between this and a SEP IRA is, that with a SIMPLE IRA, employees are also able to make contributions as well as their employers. Employers are required to set aside money for their employees with or without the contribution of their employees.
SIMPLE IRAs are available to any small business – generally with 100 or less employees. This plan, according to the IRS, is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan.
A 401 ks are employer sponsored retirement plans. This particular type of retirement plan is only offered by companies or large businesses. It gives an individual the ability to sign up for a 401(K) plan simply by agreeing to a particular percentage of their income to be paid into an investment account. The money is then invested in most cases, into mutual funds.
A 401(K) plan is broken into either traditional or Roth 401(K). As stated earlier with a traditional IRA, contributions being made into a traditional 401(K) are pre-taxed. What this means is, when you withdraw as a retiree, the amount is taxed-reduced.
A Roth 401(K) plan is post-tax. This allows a retiree to withdraw freely without paying any tax. To put it simply, the income being put into your 401(K) account is post-tax.
A tax-deferred retirement plan is tax income put off to a later date. Tax-deferred means you don’t pay taxes until you withdraw your funds, instead of paying them upfront when you make contributions. Usually, with tax-deferred accounts, contributions are deductible now. Meaning you’ll only pay applicable taxes on the money you withdraw while in retirement.
The rationale behind this type of retirement plan is, that individuals generally tend to have less taxable income when they retire. This puts them in a lower tax bracket.
For example, if an individual’s taxable income is $40,000 and they were to contribute $3,000 to a traditional IRA or traditional 401(K), when they retire, if their taxable income is $30,000 and they withdraw $4,000, their overall taxable income would be $34,000- much less than the initial $40,000.
Another advantage is increased savings.
For example, an individual is paying a 22% tax rate. If they contribute $3,000 to a tax-deferred account, their tax refund would be $660 (0.22 x $3,000). With this money, they would be able to invest more than the initial $3,000.
Annuities are a contract between you and an insurance company that pays you back regularly. How does this work? Simple, if you pay money periodically to the company with the agreement that in return you will receive regular disbursement. This could be immediate or accrued over time to be paid in the future. When it comes to retirement plans, the purpose of annuities is usually to serve the latter function.
There are three types of Annuities:
- Fixed: Pays you a fixed amount of money.
- Variable: Here, you have the option of choosing what you invest in(mutual funds). It is riskier, but with higher returns.
- Indexed: You are guaranteed a certain percentage of money irrespective of the outcome of your investment, while the remaining percentage is dependent on the performance of your investment.
Defined Benefit Plan
Defined benefit plans are an agreement between an employer and an employee. An employee’s benefit plan is calculated with various factors considered, such as; duration of employability, salary, etc. The employee cannot withdraw this fund. The fund becomes available to the employee only at an agreed age or at a specified time.
This agreement is managed by the employer. The advantage, however, is that the employee is usually aware of the criteria and formula used to determine their benefit.
Defined Contribution Plan
Employees make a fixed amount or percentage of their income (pre-tax) to an account that funds and cater to their retirement. In some ways, this is similar to a 401(K) plan.
Employers may choose to match employee contributions up to a certain percentage. For example, an employee takes part in an employer-sponsored retirement plan. They choose to invest 9% of their income. A company may choose to match employee contributions up to 6%. Making the total percentage of investment earnings 15%.
The term vesting means non-forfeitable ownership. In this instance, employees have complete ownership of employer assets or retirement money (such as a 401K). This is a strategy employed by employers to encourage company loyalty. Employees usually become 100% vested when they have remained in the company for a certain period.
Get Your Retirement Plans Where You Want Them To Go
Planning for retirement early and getting your retirement plans put together long before you retire is one of the wisest financial decisions you can make. If you’re like so many and aren’t sure where to start in the retirement planning process become a Planning Made Simple Member.
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