Funding Your Retirement: The Elements of Retirement Income

By: Eva Sadej

There are five standard vehicles from which you can draw an income after retirement: an IRA, a 401(k), a pension, an annuity (or other life insurance product), and Social Security. The rule of thumb is that you will need a retirement income of 75-85% of pre-retirement income every year that you live as a retiree. [1] Be it a blessing or a curse, ever-increasing life spans make it difficult for these sources of retirement income to support you and your family at that 75-85% level unless you are diligent in your retirement planning.

In this article, we will walk through the definitions and implications of each of the five standard elements of retirement income.

 

Individual Retirement Accounts (IRA)

An Individual Retirement Account, or IRA as it’s more commonly known, is a specialized investment account that you can open with any brokerage or a bank. There are three categories of IRAs—the Traditional IRA, the Roth IRA, and the Rollover IRA. Some sites list only two types of IRAs, and some list as many as eleven, confusing source of an IRA’s funds with type. You can deposit lump-sums into an IRA whenever you or arrange automatic withdrawals from your checking account based on a monthly or annual plan. Depending on the type of IRA, you have different options for how to put money into the account and for what happens when you take money out.

Traditional and Roth IRAs are contributory accounts that allow you to deposit money over a period of time. Traditional IRAs accept money only up to age 59 1/2, and Roth IRAs accept money whenever you want to deposit it, no matter the age. However, Roth IRAs also have an income cap—if you make above a certain amount of money per year ($105,000 for single filers as of 2010), you can’t contribute any funds to a new or an existing Roth IRA. Roth IRAs also differ in tax structure from Traditional IRA accounts. Traditional IRAs are tax-deferred accounts, meaning that you contribute pretax income now and will only pay taxes on the money upon withdrawal at retirement. Roth IRAs are tax-exempt in that you your contributions come from your after-tax income (the same as if you bought, say, a television set), but the IRS has no further claim to those assets at retirement. Both Traditional and Roth IRA account types have contribution limits of $5,000 for 2010, but are scheduled to increase by $500 each year after 2010.

The Rollover IRA is an account that does not accept contributions other than those in the form of a rollover. It accepts money only from a former employer-sponsored plan, such as a 401(k), or from another IRA. Because the source of funds is another retirement vehicle, there are no contribution limits on how much you can contribute to a Rollover IRA account. After money is deposited into this account, it can then be comingled with other IRA or qualified retirement plan money.

You can read more about the different types of IRA accounts in this article.

401(k)

A 401(k) is the typical retirement savings account that private employers offer to their workers. Non-profits offer the 403(b) instead, which is essentially the same except for a few minor legal differences. With a 401(k), you really only control your contribution to the account and not the investments made with your money.

An employer-sponsored 401(k) is a form of pain-free retirement saving. Your maximum contribution limit per year is $16,500 a year, whether or not you have an employer match program in place.[2] Typically, you choose the percentage of your pay that you want deposited, and your employer takes that money out every pay period. The primary drawback to a 401(k), however, is that you might only have a handful of mutual funds to choose from as investments. The limited investment options may not be a perfect fit with your personal investment objectives. Additionally, your employer may be choosing funds with higher underlying fees, especially if they only offer target-date funds.

You can read more about the different types of 401(k) accounts in this article.

Pension

A pension is distinct from a 401(k) or an IRA in that you don’t have an individual account in your name. Rather, you contribute money to a pool of funds that the plan-owner then invests on your behalf. It is available predominately for those that work in the public sector, in large corporations, or in the armed forces. Pensions are extensively regulated by the 1974 Employee Retirement Income Security Act (ERISA) and the Pension Benefit Guarantee Corporation (PBGC), which guarantees that employees will receive pension benefits even if employers default. Employer contributions to qualifying plans are tax deductible; employee contributions and growth is tax deferred until withdrawal. Pensions that do not qualify under the ERISA guidelines are usually those suited for high-level employees and executives. These are not backed by the PBGC or well suited for basic employee retirement plans.

There are two types of pension plans: a defined-benefit plan and a defined-contribution plan. In a defined-benefit plan you receive a certain payment amount based on years of service to the company. In a defined-contribution plan, you receive money based on the plan’s performance and how much you contributed. There has been a shift toward defined-benefit contribution plans since these are more predictable costs for employers.

Qualifying for a pension plan is very company specific. New workers are not offered pensions, but may be eligible after 5-10 years of service. A pension is essentially free money – no income is withheld from your salary when you receive a pension. Pensions are a complicated vehicle used to help employers retain good employees in a tax-advantages manner. Pensions can be passed on to a spouse at death through survivor benefits by trading the amount you receive throughout your retirement for greater longevity of the plan. Again, see your company’s specific benefits.

Annuity And Other Life Insurance Products

An annuity is a pension-like stream of income paid out at pre-arranged time intervals (monthly, weekly, quarterly, annually, etc.) during retirement for pre-set number of years. Annunities are funded by insurance companies. An annuity is similar to a traditional IRA in that both allow any earnings to grow tax deferred. There are no contribution limits and you can choose from many different annuity funds—single fund solutions and multi-fund solutions.

However, annuities have additional costs and expenses not found in IRAs.  Though their growth is advertised as tax-deferred, the income payments are taxed at ordinary tax rates. Annuities are highly illiquid, meaning you can’t sell your stake in them, and the payments cease on the date of death (this is called the “mortality premium”), cannot be overdrawn from in the case of unexpected medical expenses, limiting choices considerably.

There are three types of annuities: the fixed annuity, the variable annuity, and equity-index annuity. A fixed annuity is a vehicle in which the insurance company makes fixed monthly payments to a retiree and a variable annuity provides variable monthly payments depending on portfolio performance. An equity-index annuity is a vehicle through which your monthly payments are based on the changes in an equity index, such as the S&P 500 Composite Index.

The circumstances under which annuities are a good investment are very specific, and we warn against them unless you have contributed the maximum to your 401(k) and IRA plans already, expect to be in a lower tax bracket at retirement, and are unwilling to take any chances with anything but 100% guaranteed low-yield income vehicles.

Social Security

The final potential source of retirement income is Social Security. The Social Security program is a fairly straightforward retirement vehicle; every worker in the United States gets Social Security tax taken out of their paycheck in every pay period.

That tax goes into a pool of money that the Social Security Administration then disburses to anyone above the age of 62 who wants access. The payment you receive is determined by the average lifetime wages earned, with a maximum of $102,000 per year. One interesting point is that your regular monthly disbursement increases as you delay electing to receive Social Security payments.  The monthly Social Security payments increase as you delay from 62 up until age 70.

The five standard elements of retirement income should be the basis of your retirement planning.

[1] https://moneycentral.msn.com/content/retirementandwills/createaplan/p142702.asp

[2] https://www.bloomberg.com/personal-finance/calculators/401k/

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