In the past, it was not unusual to spend your entire career working for the same company. When you retired, the company paid you a pension and sometimes covered your health care costs.
Defined Contribution Retirement Plans
Today, many American workers are in charge of planning ahead for their own retirement years using a “defined contribution” retirement plan, such as a 401(k). And while it’s not quite as simple as sitting back and letting your employer handle the details, it certainly offers you a great deal more control over your future.
As an employee, you can fund your retirement plan account with money that is automatically deducted from your paycheck. You then decide how to invest the money based on your life goals, your tolerance for risk and your time remaining until retirement. One of your plan’s most attractive features is that the government does not tax any contributions, capital gains, dividends or interest until money is withdrawn.1
1 Contributions to Roth accounts are made after taxes. Earnings then grow tax-free and qualified distributions are not subject to federal income taxes.
Taxes on Contributions and Investment Gains
Contributions you make to your account are not subject to federal income taxes until you retire or decide to withdraw your money. This does two things. First, it lowers your current tax burden, as your income will be reduced by the amount you contribute. Second, any investment gains and earnings also enjoy tax deferral until distribution, when your tax rate will possibly be lower.
Those Tax Advantages Help Your Money Grow
Small amounts of money, when left to compound over long periods of time, can potentially grow into much larger amounts of money. The dividends, interest and capital gains within your account — and not immediately taxed by the government — can compound for years, until you’re ready to withdraw the money. This tax-deferred compounding can really add up over time.
This chart is hypothetical and for illustrative purposes only and is not intended to be a projection of future values of any product. The investment return and principal value of an investment will fluctuate and an investor’s interest, when redeemed, may be worth more or less than the original investment. Past performance is no guarantee of future results. The Standard imposes certain asset-based fees and administrative fees. These charges were not included; if they were, the tax-deferred performance would have been lower. Withdrawals prior to age 59½ may be subject to a 10 percent federal income tax penalty. This illustration assumes a $25 weekly contribution, a 25 percent federal income tax rate, a gross annual growth rate of 8 percent, and a 3 percent annual wage increase with a corresponding increase in weekly contributions. Note that lower maximum tax rates on capital gains and dividends could make the investment return for the taxable investment more favorable, thereby reducing the difference in performance between the investments shown. Please consider your personal investment horizon and income tax bracket, both current and anticipated, when making an investment decision as these may further affect the results of the comparison. Withdrawals from the tax-deferred account will be subject to federal and possibly state income tax.
You Decide How Much to Save
Unlike traditional pension plans, your retirement plan gives you, the employee, the ability to determine how much you save. However, it does not guarantee a fixed amount of monthly income at retirement. As a retirement plan participant, the amount of money you contribute to your plan is one of the most significant factors in how much cash flow you will have in your retirement years.
How much money will you need to save for retirement? Financial experts suggest living on about 80 percent of your pre-retirement income when you retire. Use the chart below to see how much income that could mean to you and how much you should save each month to reach that goal.
|A Basic Guide to Saving for Your Income and Age1|
|Gross yearly income before retirement||Total savings required to provide 80% of income with Social Security||Monthly savings needed if you start saving at age 25||Monthly savings needed if you start saving at age 35||Monthly savings needed if you start saving at age 45|
You Decide Where to Invest
Your contributions are invested according to your instructions, chosen from the investment options available in your plan. Usually, your plan will offer a variety of investment options, ranging from lower-risk money market funds to higher risk stock investments. These options give you quite a bit of discretion over how much risk you’re willing to take, and let you choose an investment plan that works best for you. Over time, as your priorities change, you can make adjustments to your investments to keep them in line with your needs.
You Can Take it With You
The money you save in your retirement plan is portable, meaning you keep it if you change jobs or retire. You have many choices. You can leave it right where it is, or you can roll it over into a retirement plan at your new employer. You may also roll it into an IRA, or you can withdraw the money. If you begin making withdrawals before retirement age, though, be aware that you will pay taxes and penalties on the money you withdraw.
1 Calculations assume the participant plans to retire at age 65 with a life expectancy of 86. The assumed annual rate of return on investments is 8 percent and the assumed inflation rate is 3 percent. This example is hypothetical and for illustrative purposes only and is not indicative of the performance of any specific investment. Investment return and principal values will fluctuate so your investment, when redeemed, may be worth more or less that its original cost. Past performance is no guarantee of future results. Total savings requirements are calculated for a 25-year-old participant.
Investing is Automatic
Because retirement plan contributions are automatically taken from your paycheck, you regularly invest the same dollar amount regardless of fluctuations in market prices. In effect, your plan automatically practices dollar cost averaging, a simple and effective approach to investing. When the price of a fund rises, you’ll buy fewer shares, and when the price dips, you’ll buy more.
While dollar-cost averaging does not ensure a profit or protect against loss in declining markets, it takes the emotion out of investing and can help lower your average cost-per-share in the long run. Consider the following example:
|Dollar-Cost Averaging at Work|
|Month||Amount Invested||Average Share Price||Number of Shares Purchased|
|$1,200||$16 (avg. price)||94.25 shares|
|Average cost per share = $12.73 ($1,200 investment ÷ 94.25 shares)|
This example is hypothetical and for illustrative purposes only and is not indicative of the performance of any specific investment. Past performance is no guarantee of future results. Systematic investing does not ensure a profit or protect against a loss in declining markets.