A Primer on Retirement Savings Accounts
- Most people who have saved for retirement are invested in several accounts.
- Consolidating savings accounts makes sense because it simplifies management and monitoring.
- It’s important to know the pros and cons of each type of savings account
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There’s $30 trillion invested in US retirement savings accounts, broken into 3 broad categories: Defined Benefit, Defined Contribution and Individual Retirement Accounts (IRAs). In the following, we discuss each of these and the types of accounts that fall into these categories.
Defined Benefit Plans: $10 trillion
- Standard Pension: Best deal for beneficiaries
- Pays an annuity based on pay plus years of service
- Dwindling usage, mostly government and union
- All investment risk is borne by the employer.
- Keogh: Eugene Keogh established the Self-Employed Individuals Tax Retirement Act of 1962
- For self-employed & unincorporated businesses
- Can be either defined contribution or defined benefit (HR(10))
- Both are governed by the Employee Retirement Income Security Act of 1974 (ERISA).
Defined Contribution Plans: $9 Trillion
- Elective salary deferrals up to $19,500 plus $6500 for over 50
- Many have an employer match
- Most have automatic enrollment, necessitating Qualified Default Investment Alternative (QDIA) that is typically a target date fund
- Employee chooses investments, so bears all investment risk, including QDIA which is not chosen by employee
- Governed by ERISA
- 401(k) plan for public school employees and tax-exempt organizations
- May have more limited investment choices
- Might not be governed by ERISA
- 401(k) for government employees
- Generally, not governed by ERISA
- All investment risk is borne by the beneficiary.
Individual Retirement Account (IRA): $11 Trillion
- For individuals
- Contribute up to $6000, plus additional $1000 for over 50
- Can roll over other savings accounts into this IRA
- For small companies
- Contribute up to $13,500
- Usually an employer match, like 2%
- Roth, like Traditional except
- Contributions are not deductible, but distributions are not taxed
- Convert from Traditional by paying taxes as if income for the year of the rollover
- Simplified Employee Pension (SEP)
- For companies, especially sole proprietorships
- Contribute up to 25% of pay, but no more than $57,000
- All can be self-directed: More flexibility than Defined Contribution Plans
A Discussion of Defined Contribution Plans and IRAs
The common default (QDIA) in defined contribution plans is a target date fund. There is more than $2.5 trillion of 401(k) assets in TDFs, but despite this popularity, most agree that they have a serious deficiency – they’re one-size-fits-all. Individual investors in IRAs do not have to settle for one-size-fits-all TDF mutual funds. They can instead manage glidepaths tailored to their needs and circumstances, described as a “Lifetime Asset Management Plan” in the following:
Profit Sharing Plans (not truly savings plans, but discussed here for completeness)
- Discretionary contributions tied to company profits, up to 25% but no more than $57,000
- Like defined contribution, but with no employee contribution
- Employees have investment discretion, so bears the risk.
- Money Purchase
- Employer contributes a fixed percentage of pay, up to 25% but no more than $57,000
- Employee might have investment discretion from limited choices
- Employee Stock Ownership Plan (ESOP)
- Mostly used in non-public closely held companies
- In essence the employer contributes shares of the company’s stock in lieu of money.
- Popular for buying out departing employees
Save and Protect
The most important thing we can do to secure a comfortable retirement is to save enough. And secondly, we need to protect those savings – to not lose them – especially in the Risk Zone that spans the 10 years before and after retirement. The following guide shows how much Fidelity advises us to save through life:
The Department of Labor also provides a very useful Retirement Income Calculator we can use to determine savings adequacy and develop a spending budget in retirement.
In reality, whatever we’ve saved as retirement approaches has to be “enough” because that’s all there is. We adapt a lifestyle that our savings can support for a lifetime, as we discuss in this article.
It’s important that we save for retirement and that we understand our options for the types of retirement savings accounts we use. There is plenty of help along the way. We just have to take it. For example, this article explains mistakes you should avoid.