Saving for retirement
Summary
Deciding on how to invest, and in what types of accounts, can be challenging for people. This article gives a broad overview of the types of investment accounts available. It offers factual information on tax consequences and distribution benefits, but it does not offer investment advice. Consult with your financial investment advisor to determine the types of accounts that are best for your long- and short-term retirement goals.
Individual FDIC-insured accounts
Deciding on how to invest, and in what types of accounts, can be challenging for people. For many older people, making the most of their savings is more important than risking loss in return for a higher reward. For that reason, choosing a low-risk, low-reward account to deposit money into is a safe bet to grow money slowly and steadily.
The Federal Deposit Insurance Corporation automatically backs any deposit at an FDIC-insured bank or financial institution for checking accounts, savings accounts, money markets, and Certificates of Deposit (CDs). By choosing FDIC-insured accounts, investors get the backing of the federal government, and a small interest rate is added to the amount deposited. Although single-digit percentage interest may not seem like a high reward, there is safety in knowing that the older person’s nest egg will never decrease with this kind of account.
Stocks, annuities, and bonds
Each retirement account type comes with its own range of benefits and drawbacks. For the most part, U.S. Treasury accounts are a safe investment because it is unlikely that the U.S. government will default on its debt. Annuities are backed by individual insurance companies, which makes it very important to check out the issuer before investing; that said, they can be an attractive option because of their steady payouts in retirement. The stock market is generally regarded as higher risk because of the volatile nature of stocks and because investing in the stock market does not come with insurance for that investment.
U.S. Treasury accounts
U.S. Savings bonds and Treasury bills (T-Bills) and notes (T-Notes) are generally considered a safer investment option. They are issued by the U.S. government to fund its operations.
T-Bills mature—meaning they are eligible for withdrawal—four weeks to a year after deposit. T-notes are issued in terms of two, three, five, seven, and ten-years until maturity. The investor is paid interest twice a year on these investments.
U.S. Savings Bonds are longer-term investments but usually offer a higher return if they are held onto until they have reached their full interest potential. This usually takes 20 to 30 years.
Fixed annuities
A fixed annuity is a contract between an investor and an insurance provider. The investor deposits a sum of money and signs a contract with the insurance company. This contract spells out the way in which the investment is paid out. Some annuities, called life annuities, pay the investor a set amount of money every year for life. Others pay out for a pre-specified number of years. Fixed annuities can also be designed to pay interest-only for a certain period of time, reserving the capital invested for a later distribution. Because of the flexibility and the guarantee of annual income, many retirees choose fixed annuities.
Fixed annuities are not tied to stock market performance, which makes them less susceptible to market fluctuations. While fixed annuities are not backed by the FDIC, they are guaranteed by the insurance company providing them, so investors should carefully examine the insurance company’s ratings from agencies like Standard & Poor’s before investing.1
Individual stocks
Stocks are shares of a company: by purchasing a stock, the investor owns a small portion of that company. The value of that stock is then tied to the value of the company as determined by the stock market. Stock values can be unpredictable. They are not guaranteed to increase in value, but they also have potential to bring high returns. They run the risk of becoming completely worthless, however, if the company fails.
Index funds
Index funds are a collection—also called a portfolio—of individual stocks. Index funds are put together to keep up with a particular index, such as the Dow Jones Industrial Average or the S & P 500. These indexes monitor individual stocks sales and purchases, and then lump them all together in a general report on their performance as a whole.
If people are paying more for the stocks in the Dow Jones, for example, the average value of the index goes up. When that happens, the index funds that are tied to that index also increase in value. The converse is true: if the index decreases in value as the individual stocks’ value goes down, then the index fund will decrease in value. Because of this, index funds are generally tied to the performance of the stock market as a whole rather than the performance of individual stocks.
Mutual funds
Like index funds, mutual funds invest in a portfolio of stocks. But unlike index funds, mutual funds are actively managed by an investment manager hoping to outperform the stock market. Mutual fund managers make more frequent changes to the stocks in their funds, and usually charge a higher management fee as a result of this.
Employer-sponsored retirement accounts
There are several different types of employer-funded retirement accounts. These are accounts in which an employer helps their employees save for retirement. Some are controlled by the employers, while others leave the decisions up to the employees on how their funds are to be managed. For some of these funds, employers pay money into them for employees to take out after retirement, while others are made up entirely from employee contributions. They each have different tax and return structures. Some of the most common employee-sponsored retirement accounts are pension funds, 401(k)s, solo 401 (k)s, 453 (b)s and 457 (b)s, and Roth 401(k)s.
Pension funds
Pension funds are set up by employers, usually of large corporations or government entities, to distribute to qualified employees after they retire. In a defined-benefit pension, an employee receives a set amount of money from the plan each month after retirement. The amount is based on the employees’s length of employment and average income before they retired.
Some pensions are guaranteed and others are not. A lot depends on the entity that provided them and whether the employer was a private company, or a local, state, or federal government agency. In recent years, some private pension funds have become much less common for private employers due to changes in the financial markets and corporate performance.
401(k)
A 401(k) is a retirement account that is provided as a benefit by some employers. Employees can set aside a certain amount out of each paycheck to deposit into this investment fund. The amount that they deposit into the account is not included in income taxes, which can save investors money over the years at tax time.
Some employers also put money into 401(k) funds for their employees, which is called matching. 401(k) funds have high limits on how much money investors can deposit into them each year, which means that for those saving for retirement, adding as much money as possible in the early years can yield high returns down the road from interest payments and from the tax savings.
401(k) plans are guided by the employer’s preference, so employees have little involvement in what funds are invested in or how the plan is managed. When an employee leaves their job, they can cash out the 401(k) at a penalty, or choose to “roll over” the plan into a new 401(k) or into an IRA.
After the age of 59-½, investors can begin withdrawing money, in lump sums or in regular distributions, without any penalties.2 Regular income taxes do apply to these withdrawals, since they were not taxed when they went into the account. After the age of 73, 401(k) funds generally require investors to begin withdrawing a certain amount of money each year, also called “required minimum distributions.”
Under certain circumstances, investors can withdraw money early without penalty if, for example, they fulfill certain criteria under a “hardship withdrawal.” In order to receive a hardship withdrawal, the person must demonstrate an “immediate and heavy financial need,” and the distribution generally does not cover consumer purchases such as boats or televisions. The amount allowed per account varies due to several factors, including how much the individual has deposited into the account. Taxes must be paid on these withdrawals.3 Some people are also eligible to take out loans against their 401(k) plans under certain circumstances, including for paying medical bills or making home repairs.
Solo 401(k)
A solo 401(k) functions in many of the same ways as a regular one, but it is designed for business owners without any employees. The contribution limits per year are larger than regular 401(k) plans, to allow entrepreneurs and self-employed people to save more for retirement.
403(b) and 457(b)
A 403(b) is another variation on the 401(k), this time for nonprofit employees and some public school employees. For some nonprofit employees who have served more than 15 years at the nonprofit, they may be able to invest more per year than in a regular 401(k); otherwise, the only difference between the two is that they have different tax codes. A 457(b) is a similar employer-funded retirement plan offered to state and local government employees.
Roth 401(k)
A Roth 401(k) is similar to a standard 401(k) in the fact that it is an employer-sponsored retirement fund. Roth 401(k) accounts have the same limits on how much money individuals can invest each year as well as when and how much they can withdraw from the account. The difference between a Roth 401(k) and a standard 401(k) appears when it comes to taxes. In a traditional 401(k), the funds are taxed when they come out of the account in a distribution; in a Roth 401(k), money going into the account is taxed as regular income, but no taxes are taken out when the funds are distributed.
Individual retirement accounts (IRAs)
For those individuals whose employers do not contribute to or sponsor a retirement plan, there are still plenty of options for investment. Lumped together, these are called Individual Retirement Accounts, or IRAs for short. In addition to not having direction from an employer, there are a few key factors that make IRAs different from 401(k) plans.
- IRAs are available to anyone who has earned income from salary, wages, or other work.
- There are a wider variety of investment type choices in an IRA than in a 401(k) because the fund is not directed by an employer.
- An IRA also usually has a smaller annual contribution limit than a 401(k).
Having a 401(k) does not preclude investors from also having an IRA. Investors can choose to diversify and put funds into both types of accounts.
Traditional IRA
A traditional individual retirement account allows investors to choose from a variety of investment options, including stocks, bonds, mutual funds, and other options. As in a 401(k), contributions to a traditional IRA are not taxed until they are distributed, which means that investors can put money into a traditional IRA without paying income tax on that amount. When the investor withdraws money, it is taxed as regular income. Like a 401(k) plan, traditional IRAs also require account holders over the age of 73 to take a required minimum distribution from the account.
Roth IRA
A Roth IRA differs from a traditional IRA in a few key ways:
- Money that is deposited into a Roth IRA is taxed before it is put into the account, and there is no tax taken out when it is distributed.
- Funds can be withdrawn from Roth IRAs without taxes or penalties after 5 years, so long as the account holder is over the age of 59-½.
- A Roth IRA, unlike a traditional IRA or 401(k), does not have minimum required distributions. That means that the money can wait in the account until it is needed, or until it is passed down to a beneficiary.
SEP IRA
SEP stands for Simplified Employee Pension. A SEP IRA is designed for single business owners with no or very few employees. It differs from a traditional IRA in that the contribution limits are higher, allowing investors to contribute a higher amount each year towards retirement into the account.
Simple IRA
Simple IRAs are designed for small businesses with 100 or fewer employees. Simple stands for “Savings incentive match plan for employees.” If an employee contributes to the Simple IRA, employers are required to match those employee contributions up to 3% of the employee’s salary. If the employee chooses not to contribute, the employer is still required to contribute 2% of the employee’s salary.
Spousal IRA
A spousal IRA is a way to get around the IRA requirement for account holders to have earned income. One spouse who earns income can open a spousal IRA account for their spouse who does not earn income and contribute money to that account. Otherwise, this account follows the same rules as traditional IRA plans. In order to qualify, the spouses must file a joint tax return.
Health Savings Account (HSA)
Although many people don’t consider it, a Health Savings Account works very much as an investment account for an individual’s health and medical bills. Health Savings Accounts are part of certain health insurance plans. Policy holders can contribute a certain amount of money from each paycheck to the HSA; this contribution is not taxed, so the contributor does not have to pay income taxes on that amount.
These funds can be removed tax-free to pay for qualified medical expenses. They can also, in many cases, be rolled over just as a 401(k) would be, to a new HSA at a new job. HSAs allow policy holders to keep those funds and build on them year after year, in order to save up for major medical expenses in later years.
Related information
Overview of financial planning
Financial advisors
Getting help from a financial expert
Paying for long-term care
Senior tax credits and deductions
End notes
1 Standard & Poor’s. Search by entity.
2 IRS.gov. 401(k) Resource Guide: General Distribution Rules.
3 IRS.gov. Retirement Topics: Hardship Distributions.
