Do you know someone that is retired and receiving a nice, predictable pension check every month? Maybe you're lucky enough to be covered by a pension plan—perhaps your benefit is still growing, maybe it’s frozen, or perhaps you are already receiving payments. While the word pension still means something in our vocabulary, more and more the pensions of old are going the way of the dinosaurs.
Today's new breed of employer-sponsored retirement plans places the responsibility of preparing for a successful retirement squarely on the shoulders of the employee. There are many different types of employer-sponsored plans in the retirement alphabet soup (401(k), 403(b), 457, SEP IRA, etc).
Although you do not have a choice in the type of plan your employer offers, you do have some important decisions to make when choosing how to contribute and invest within the plan.
You need to think carefully about your retirement plan options to make sure you are heading toward retirement in the straightest path possible.
1. How much should I contribute?
Many employer plans offer to match your contribution up to a certain amount. We would always encourage you to contribute at least enough to get the full match. The matching part is essentially “free money”, and no one should ever turn that down!
If you have more available funds, you could consider raising the amount you contribute. You should keep in mind that the maximum contribution for most employer plans is $19,500 per year with an additional catch-up amount of $6500 for individuals 50+ years of age.
Before you decide to max out your retirement plan contributions, you should first be sure that you have funded your Emergency Savings. Once that is in place, we would encourage you to work through the financial planning steps for the ideal savings plan that we discussed in this video on the 5 Step Investing Framework. Or if you would like to talk through the benefits of maxing out your retirement plan vs. other types of investments, give us a call!
2. Should I make Roth contributions or Traditional?
Retirement planning is complicated enough, but the introduction of a “Roth” contribution option in 1997 added one more decision in the planning process. At first the Roth option allowed investors to contribute after-tax dollars to their IRA and receive tax-free growth going forward. Over time that feature has found its way into many of the employer-sponsored plans available to workers today.
At first glance, it may seem like an obvious choice that every employee would want their money to grow tax-free in which case they should choose the Roth option.
However, the reality is that you will have to pay taxes on these funds at some point. Either on the front end when you make the contribution, or on the back end when you take the funds out. We need to determine which of those is more beneficial for each individual situation. Ideally, you will pay taxes whenever your marginal tax bracket is the lowest.
For example, if your salary/commissions/bonuses/etc. put you in a high tax bracket during your working years but you expect a frugal retirement, it might make more sense to use a pre-tax retirement account and pay the taxes on your distributions in retirement when your tax bracket is lower. If on the other hand you plan on saving aggressively during your working years so that you can enjoy a more expensive retirement, a Roth IRA could be the best choice since it would allow you to pay taxes up front.
When selecting the Roth or Traditional option it’s important to consider all forms of income - salary, pension, rental income, and even social security may all factor into the decision.
3. Which investments should I choose in my plan?
Once you have chosen the correct tax status for your contributions, you are still left with the decision of how to invest these funds to grow your money over time. Due to their simplicity and convenience, investments known as target date funds have become very popular as a way for workers to grow their retirement assets within their employer plans.
According to a Vanguard study, in 2019 98% of 401k participants were offered some type of target date fund and 78% of all participants used a target date fund. If you are one of the many workers taking advantage of a target date fund, it’s important to understand what you are really invested in as not all target date funds are created equally.
At its most basic level, a target date retirement fund selects a date at which the investor would “retire” (it could be 2020, 2030, 2045, etc). The fund manager then allocates the fund’s dollars towards the various asset classes with an eye towards that retirement date. Hypothetically, that means the fund would get more conservative over time because the retirement date is getting closer.
However, the simplest option is not always the best option for your specific needs. Surprisingly, there can be a difference in the amount of risk one fund is taking vs that of another fund with the same target date. For instance, our risk analysis assigns the Fidelity Freedom 2050 fund a risk score of a 79, while the Vanguard Target Retirement 2050 has a score of a 73. If your retirement fund is invested with a higher risk score, you could see a larger decrease in value during a market sell off.
Outside of the Target Date Funds, many plans offer high-quality investment options that could be used to drive growth in your account at a risk tolerance that’s best for you.
If you are not sure which funds to select we can help with that.
As the dinosaur pension plans die out and the new breeds of retirement savings plans begin to multiply it's important that you understand all of the options available to you. For most of us, the employer sponsored retirement plan is our largest retirement asset. It’s vital that this asset works together with all of your accounts when formulating your retirement savings and investment strategy. Many investors find it helpful to discuss their situation with a financial professional who has their goals in mind.
It’s your employer’s responsibility to provide the plan, but it’s your responsibility to make the decisions about how much to contribute, what type of contributions to make, and how to invest those dollars. If you have questions regarding your specific situation, let’s set up a time to talk.
Do you have other questions about retirement?
Text our team for answers at 309-925-2043!