If you have young kids or you’re still building your career, retirement may not be top of mind at this point in your life. But someday, if you’re lucky and save on a regular basis, it will be.
To have the best retirement, it’s wise to create a plan early in life — or right now if you haven’t yet done so. By diverting a portion of your paycheck into a tax-advantaged retirement savings plan, for example, your wealth can grow exponentially to help you achieve financial security for those so-called golden years.
Retirement benefits are so important that they should be a top consideration when you’re shopping for a new job. Yet only about half of current employees understand the benefits offered them, according to the Employee Benefit Research Institute.
“Plan design is individualized, so one company’s benefit formula may not be as generous as others,” explains David Littell, professor of taxation and a retirement planning expert at The American College of Financial Services. “It’s really important that you read the summary plan description that is provided to all participants so that you can understand the design of the plan.”
Bankrate picked Littell’s brain about the best retirement plans available to workers to discover their pros and cons.
Key plan benefits to consider
Virtually all retirement plans offer a tax advantage, whether it’s available up front during the savings phase or when you’re taking withdrawals. For example, 401(k) contributions are made with pre-tax dollars, which reduces your taxable income. Roth IRAs, in contrast, are funded with after-tax dollars but withdrawals are tax-free.
Some retirement savings plans also include matching contributions from your employer, such as 401(k) plans, while others don’t. When trying to decide whether to invest in a 401(k) at work or an individual retirement account (IRA), go with the 401(k) if you get a company match – or do both if you can afford it.
If you were automatically enrolled in your company’s 401(k) plan, check to make sure you’re taking full advantage of the company match if one is available. And consider increasing your annual contribution, since many plans start you off at a paltry deferral level that is not enough to ensure retirement security. Roughly half of 401(k) plans that offer automatic enrollment, according to Vanguard, use a default savings deferral rate of just 3 percent. Yet T. Rowe Price says you should “aim to save at least 15 percent of your income each year.”
If you’re self-employed, you also have several retirement savings options to choose from. In addition to the plans described below for rank-and-file workers as well as entrepreneurs, you can also invest in a Roth IRA or traditional IRA, subject to certain income limits, which have smaller annual contribution limits than most other plans.
Here are the best retirement plans to consider in 2019:
Pensions, more formally known as defined benefit (DB) plans, are the easiest to manage because so little is required of you.
Pensions are fully funded by employers and provide a fixed monthly benefit to workers at retirement. But DB plans are on the endangered species list because fewer companies are offering them. Just 16 percent of Fortune 500 companies enticed workers with pension plans in 2017, down from 59 percent in 1998. Why? DB plans require the employer to make good on an expensive promise to fund a hefty sum for your retirement. Pensions, which are payable for life, usually replace a percentage of your pay based on your tenure and salary. A common formula is 1.5 percent of final average compensation multiplied by years of service, according to Littell. A worker with an average pay of $50,000 over a 25-year career, for example, would receive an annual pension payout of $18,750, or $1,562.50 a month.
Pros: This benefit addresses longevity risk – or the risk of running out of money before you die. “If you understand that your company is providing a replacement of 30 percent to 40 percent of your pay for the rest of your life, plus you’re getting 40 percent from Social Security, this provides a strong baseline of financial security,” says Littell. “Additional savings can help but are not as central to your retirement security.”
Cons: Since the formula is generally tied to years of service and compensation, the benefit grows more rapidly at the end of your career. “If you were to change jobs or if the company were to terminate the plan before you hit retirement age, you can get a lot less than the benefit you originally expected,” says Littell.
What it means to you: Since company pensions are increasingly rare and valuable, if you are fortunate enough to have one, leaving the company is major decision. Should you stay or should you go? It depends on the financial strength of your employer, how long you’ve been with the company and how close you are to retirement. You can also factor in your job satisfaction and whether there are better employment opportunities elsewhere.
This is a type of defined benefit, or pension plan, too.
But instead of replacing a certain percentage of your income for life, you are promised a certain hypothetical account balance based on contribution credits and investment credits (e.g. annual interest). One common setup for cash-balance plans is a company contribution credit of 6 percent of pay plus a 5 percent annual investment credit, says Littell. The investment credits are a promise and are not based on actual contribution credits. For example, let’s say a 5 percent return, or investment credit, is promised. If the plan assets earn more, the employer can decrease contributions. In fact, many companies that want to shed their traditional pension plan convert to a cash-balance plan because it allows them better control over the costs of the plan.
Pros: It still provides a promised benefit, and you don’t have to contribute anything to it. “There’s a fair amount of certainty in how much you’re going to get,” says Littell. Also, if you do decide to switch jobs, your account balance is portable so you’ll get whatever the account is worth on your way out the door of your old job.
Cons: If the company changes from a generous pension plan to a cash-balance plan, older workers can potentially lose out, though some companies will grandfather long-term employees into the original plan. Also, the investment credits are relatively modest, typically 4 percent or 5 percent. “It becomes a conservative part of your portfolio,” says Littell.
What it means to you: The date you retire will impact your benefit. “Retiring early can truncate your benefit,” says Littell. Working longer is more advantageous. Also, you’ll get to choose from a lump sum or an annuity form of benefit. When given the option between a $200,000 lump sum or a monthly annuity check for $1,000 for life, says Littell, “Too many people,” he says, choose the lump sum when they’d be better off getting the annuity for life.”
If you’re married and don’t want to leave your spouse in the lurch in the event you predecease him or her, consider a joint-life annuity rather than a single-life annuity.
Some companies offer a profit-sharing plan to their workers as an incentive for them to be productive so that they can both help boost and share in the company’s profits.
This is another hands-off benefit, in the sense that you can’t contribute to it; only the employer can. But here’s the catch: your employer has discretion as to whether to contribute from year to year. However, the government does insist that contributions be “recurring and substantial.”
Pros: “It doesn’t cost you anything,” says Littell. “In some profit-sharing plans you can choose the investments you want and in others, the trustees handle the investment decisions.”
Cons: Profit-sharing plans are not a fail-safe way to ensure your financial security. “It’s difficult to predict how much benefit you’re going to get in retirement,” says Littell. “You don’t know how much the company will contribute from year to year, and you don’t know what the investment experience will be.”
What it means to you: When you’re planning for retirement, it’s a good idea to look at the history of company contributions to get a sense of what to expect. You don’t have to make a lot of decisions unless the plan allows you to determine how to invest the money. One important caveat: “At the time of distribution, as with any account, you want to make sure it’s rolled into an IRA so you defer income tax,” says Littell.
Since their introduction in the early 1980s, defined contribution (DC) plans, which include 401(k)s, have all but taken over the retirement marketplace.
Roughly 80 percent of Fortune 500 companies offer DC plans rather than traditional pensions. While 401(k) plans are the most ubiquitous DC plan among employers of all sizes, the similarly structured 403(b) plan is offered to employees of public schools and certain tax-exempt organizations, while the 457(b) plan is most commonly available to state and local governments. The employee’s contribution limit for each plan is $19,000 in 2019 ($25,000 for those 50 and over).
Pros: They allow you to save on a pre-tax basis. That means the amount you contribute goes into your retirement savings account and isn’t counted as part of your taxable income, reducing your tax liability with the IRS. Many DC plans provide matching contributions as well. “They sometimes provide nonelective contributions, meaning you don’t have to contribute anything to get employer contributions,” says Littell. However, you might have to work for the employer for a certain period of time before those employer contributions are vested.
Cons: You assume all the risk, since you bear the responsibility of deciding how much to contribute and what types of assets to invest in. And there’s no guarantee that the savings you accrue will adequately prepare you financially for retirement. “When you give people a lot of choice, they might get it wrong,” says Littell.
What it means to you: Contribute enough to at least get the company match, which amounts to free money. “And generally, you need to save more than that in order to accumulate enough for retirement,” Littell adds. Many DC plans offer a Roth version, in which you use after-tax dollars to contribute, but you can take the money out tax-free at retirement. “The Roth election makes sense if you expect your tax rate to be higher at retirement than it is at the time you’re making the contribution,” says Littell. So, young people who aren’t earning a lot early in their careers would benefit by going the Roth route.
The Federal Employees Retirement System, or FERS, offers a secure three-legged retirement-planning stool for civilian employees who meet certain service requirements:
- A basic defined benefit plan
- Social Security
- The Thrift Savings Plan, or TSP
Only two of these are portable if you leave government work – Social Security and TSP, the latter of which is also available to members of the uniformed services. The TSP is a lot like a 401(k) plan on steroids. Participants choose from five low-cost investment options, including a bond fund, an S&P 500 index fund, a small-cap fund and an international stock fund — plus a fund that invests in specially issued Treasury securities. On top of that, federal workers can choose from among several lifecycle funds with different target retirement dates that invest in those core funds, making investment decisions relatively easy.
Pros: Federal employees are eligible for the defined benefit plan. Plus they can get a 5 percent employer contribution to the TSP, which includes a 1 percent nonelective contribution, a dollar-for-dollar match for the next 3 percent and a 50 percent match for the next 2 percent contributed. “The formula is a bit complicated, but if you put in 5 percent, they put in 5 percent,” says Littell. “Another positive is that the investment fees are shockingly low – four hundredths of a percentage point.” That translates to 40 cents per $1,000 invested – much lower than you’ll find elsewhere.
Cons: As with all DC plans, there’s always uncertainty about what your account balance might be when you retire.
What it means to you: You still need to decide how much to contribute, how to invest, and whether to make the Roth election. However, it always makes sense to contribute at least 5 percent of your salary to get the maximum employer contribution.
This is like a traditional IRA for small business owners and their employees.
Only the employer can contribute to this plan, and contributions go into a SEP IRA for each employee rather than a trust fund. Self-employed individuals can also set up a SEP IRA. Contribution limits in 2019 are 25 percent of compensation or $56,000, whichever is less. Figuring out contribution limits for self-employed individuals is a bit more complicated.
“It’s very similar to a profit-sharing plan,” says Littell, because contributions can be made at the discretion of the employer.
Pros: For employees, this is a freebie retirement account. For self-employed individuals, the higher contribution limits make them much more attractive than a regular IRA.
Cons: There’s no certainty about how much employees will accumulate in this plan. Also, the money is more easily accessible. This can be viewed as more good than bad, but Littell views it as bad.
What it means to you: Accountholders still are tasked with making investment decisions. Resist the temptation to break open the account early. If you tap the money before age 59 ½, you’ll have to pay a 10 percent penalty on top of income tax. “Make sure you save the money for retirement,” Littell says.
7. SIMPLE IRA
With 401(k) plans, employers have to pass several nondiscrimination tests each year to make sure that highly compensated workers aren’t contributing too much to the plan relative to the rank and file.
The SIMPLE IRA bypasses those requirements because the same benefits are provided to all employees. The employer has a choice of whether to contribute a 3 percent match or make a 2 percent nonelective contribution even if the employee saves nothing in his or her own SIMPLE IRA.
Pros: Littell says most SIMPLE IRAs are designed to provide a match, so they provide an opportunity for workers to make pre-tax salary deferrals and receive a matching contribution. To the employee, this plan doesn’t look much different than a 401(k) plan.
Cons: The employee contribution is limited to $13,000 for 2019, compared to $19,000 for other DC plans. But most people don’t contribute that much anyway, says Littell.
What it means for you: As with other DC plans, employees have the same decisions to make: how much to contribute and how to invest the money.
Alternatively known as a Solo-k, Uni-k and One-participant k, the Solo 401(k) plan is designed for a business owner and his or her spouse.
Because the business owner is both the employer and employee, elective deferrals of up to $19,000 can be made, plus a nonelective contribution of up to 25 percent of compensation up to $56,000 for incorporated businesses, not including catch-up contributions. The limit for unincorporated businesses is 20 percent, says Littell.
Pros: “If you don’t have other employees, a solo is better than a SIMPLE IRA because you can contribute more to it,” says Littell. “The SEP is a little easier to set up and to terminate. So if you don’t want to contribute more than 20 percent of your earnings, I would set up a SEP.” However, if you want to set up your plan as a Roth, you can’t do it in a SEP, but you can with a Solo-k.
Cons: It’s a bit more complicated to set up, and once assets exceed $250,000, you’ll have to file an annual report on Form 5500-SE.
What it means to you: If you have plans to expand and hire employees, this plan won’t work. Once you hire other workers, the IRS mandates that they must be included in the plan if they meet eligibility requirements, and the plan will be subject to nondiscrimination testing.
Unless you’re a top executive in the C-suite, you can pretty much forget about being offered an NQDC plan.
But we can wistfully check them out. Littell says there are two main types: One looks like a 401(k) plan with salary deferrals and a company match, the other is solely funded by the employer. The catch is that most often the latter one is not really funded. The employer puts in writing a “mere promise to pay” and may make bookkeeping entries and set aside funds, but those funds are subject to claims by creditors.
Pros: The benefit is you can save money on a tax-deferred basis, but the employer can’t take a tax deduction for its contribution until you start paying income tax on withdrawals.
Cons: They don’t offer as much security. “There’s some risk that you won’t get your payments (from an NQDC plan) if the company has financial problems,” says Littell.
What it means to you: For executives with access to an NQDC plan in addition to a 401(k) plan, Littell’s advice is to max out the 401(k) contributions first. Then if the company is financially secure, contribute to the NQDC plan if it’s set up like a 401(k) with a match.
GIAs are generally not offered by employers, but individuals can buy these annuities to create their own pensions.
You can trade a big lump sum at retirement and buy an immediate annuity to get a monthly payment for life, but most people aren’t comfortable with this arrangement. More popular are deferred income annuities that are paid into over time. For example, at age 50, you can begin making premium payments until age 65, if that’s when you plan to retire. “Each time you make a payment, it bumps up your payment for life,” says Littell.
You can buy these on an after-tax basis, in which case you’ll only owe tax on your earnings. Or you can buy it within an IRA and can get an upfront tax deduction, but the entire annuity would be taxable when you take withdrawals.
Pros: Littell himself invested in a deferred income annuity to create an income stream for life. “It’s very satisfying, it felt really good building a bigger pension over time,” he says.
Cons: If you’re not sure when you’re going to retire or even if you’re going to retire, then it may not make sense. “You’re also locking into a strategy that you can’t get rid of,” he says.
What it means to you: You’ll be getting bond-like returns and you lose the possibility of getting higher returns in the stock market in exchange for the guaranteed income. Since payments are for life you also get more payments (and a better overall return) if you live longer. “People forget that these decisions always involve a trade-off,” Littell says.
Some companies offer insurance vehicles as a benefit.
There are various types: whole life, variable life, universal life and variable universal life. They provide a death benefit while at the same time building cash value, which could support your retirement needs. If you withdraw the cash value, the premiums you paid – your cost basis – come out first and are not subject to tax. “There are some similarities to the Roth tax treatment, but more complicated,” says Littell. “You don’t get a deduction on the way in, but if properly designed you can get tax-free withdrawals on the way out.”
Pros: It addresses multiple risks by providing either a death benefit or a source of income. Plus, you get tax deferral on the growth of your investment.
Cons: “If you don’t do it right, if the policy lapses, you end up with a big tax bill,” he adds. Like other insurance solutions, once you buy it, you are more or less locked into the strategy for the long term. Another risk is that the products don’t always perform as well as the illustrations might show that they will.
What it means to you: These products are for wealthier people who have already maxed out all other retirement savings vehicles. If you’ve reached the contribution limits for your 401(k) and your IRA, then you might consider investing in this type of life insurance.