When it comes to workplace retirement plans there are two basic options
- Defined Benefit pensions
- Defined Contribution pension and retirement plans
If you have a Defined Benefit pension plan at work, do a little happy dance right now as you can count yourself in a shrinking minority. Defined Benefit (DB) pensions plans are possibly the most valuable retirement planning tool you can have.
Here’s how a DB plan works.
- As an employee, you are guaranteed a certain annual income in retirement.
- That income is based off your salary (either your career average or the average in your final 5 years), the number of years you work for the company and your retirement age.
- Based off market conditions you and your employer will contribute to the plan to ensure there are enough funds to finance your retirement.
I love DB pensions because they only leave the employee with one retirement decision to make when to retire.
Defined Contribution (DC) pensions are retirement plans where the employee does not have a guaranteed income in retirement but there is a guarantee for how much their employer will match the employee’s contributions to the plan. These matching employer contributions are free money and one of the most effective ways to build long term wealth.
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While DC pensions are still a fantastic retirement planning tool, require more decisions to be made by the employee.
The employee usually must actively decide whether to enroll, how much they will contribute, how they will invest their money and when to retire. Then when they do retire, they are left with the choice of how to live off their retirement nest egg without running out.
What if I have no Workplace Retirement Plan?
If your employer does not offer any type of workplace retirement plan, then you are on your own. Without the luxury of an employer matching your retirement savings, you will have to stay disciplined to achieve as high of a savings rate as possible.
Individual Retirement Accounts
If you are self-funding your retirement you may consider opening an Individual Retirement Account (IRA). There are two forms of IRA a “traditional” IRA and a Roth IRA.
A traditional IRA is a pre-tax retirement account. Meaning any contributions into your IRA are tax deductible. The investments inside your IRA can grow tax-free and then any withdrawals are fully taxable.
A Roth IRA is a post-tax retirement account. Your contributions into your IRA are not tax deductible. However, not only can your investments grow tax-free while inside your Roth IRA, but if you meet certain conditions your withdrawals are tax-free as well.
(Be warned. If you are under the age of 59 1/2 and you withdraw from your Roth IRA less than five years after you opened the account, you may be subject to taxes and penalties. Click here for a list of the conditions and penalties of early withdrawal).
Pre-Tax or Post Tax?
A dilemma for many is whether to contribute to a traditional IRA where you get a tax deduction today but pay the tax in retirement or a Roth IRA where you don’t get a tax deduction today but (potentially) pay no tax in retirement.
As a rule of thumb, many people make that decision based off the answer to the following question.
Do I expect to have more income today or in retirement?
If you expect you will have more taxable income today, then in retirement it may make sense to fund a traditional IRA and get your tax deduction today while you have a high marginal tax rate.
If you have a low income or are just starting out in your career, it may make sense to fund a Roth IRA. If your current marginal tax rate is low, you are not missing out as much on a foregone tax deduction today and the ability to withdraw your retirement funds tax-free in the future may be appealing.
That is a tough call and one each person will have to make based on their individual circumstances.
How Much Can I Contribute to my IRA?
In 2019, individuals under 50 can contribute a maximum of $6,000 into your IRA’s and those over 50 can contribute up to $7,000. That can be split between the traditional and Roth IRA.
So, if you are in the dilemma I described above deciding between a traditional and Roth IRA, the good news is you can have both! So long as you don’t contribute more than the $6,000 (or $7,000 if your 50 plus).
Once you have maxed out your contributions into your IRA accounts, you may want to consider additional investing vehicles.
- You can open a taxable “brokerage” account and continue investing in stocks and bonds. However, any dividends and capital gains will be fully taxable, hence the name.
- You may also want to consider investing in Real Estate which can provide positive cash flow and has a bunch of preferential tax treatments.
If you are looking for some inspiration on investing in Real Estate here are two stories worth reading.
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The Bottom Line
While having access to a workplace retirement plan is a huge plus, it is not the only way to ensure you have the retirement you always dreamed of. Saving for retirement on your own lowers your margin for error but if you are disciplined and smart you can fully fund your dream retirement.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.