Retirement Planning: Building A Nest Egg
There are a myriad of investment accounts, savings plans and financial products you can use to build your retirement nest egg. Many countries have government-sanctioned retirement accounts that provide for tax-deferral while your savings are growing in the account, thus postponing taxation of your investment earnings until you withdraw your funds for retirement.
Due to the wide array of savings methods available (each with their own pros and cons) – and the fact that each individual will have a different solution based on his or her circumstances and personal preferences – it would be impractical to discuss each in detail.
That said, there are financial goals and strategies common to pretty much everyone, and a core group of investment vehicles available to most as well. A quick overview of the tools at your disposal and the characteristics of each will help you determine what route is best for you. If you feel you need assistance choosing the financial vehicles with which to build your nest egg, consider consulting with a professional financial planner.
Most governments of developed countries provide a legal framework for individuals to build retirement savings with tax-saving advantages. Due to the advantages these investment accounts offer, there are usually limits regarding contribution amounts and age limits at which you will stop enjoying the benefits of those savings plans.
It's generally advisable for you to exhaust the contribution room you have for your government-sponsored accounts before you begin looking at other avenues, as whichever securities you invest in are more likely to deliver enhanced returns through compounding of tax-sheltered earnings or otherwise beneficial accounts.
Here's a breakdown of the government-sponsored investment accounts available to most people:
A 401(k) plan is a voluntary investment account offered to employees by their company. The plan allows up to a certain percentage of your pre-tax employment income to be contributed to your 401(k) account. This means that you do not have to claim the portion of income you route to 401(k) as employment income for the year it is earned. As well, all investment gains you reap from the funds invested in your 401(k) are not taxable as long as they remain in the fund.
401(k) plans, and the percentage of earnings they allow to be contributed, vary from company to company. Check with your employer to learn the details of the 401(k) plan applicable to you. What securities your 401(k) funds can be invested in varies from company to company as well – some employers require that you choose from a list of approved mutual funds or similar securities, while others allow you more latitude to choose your investments.
Check with your employer to see which 401(k) options you have available and consider using the 401(k) as one of your key retirement savings vehicles. The benefits of the tax-deferral it provides can add up to substantial tax savings over long periods of time and go a long way to boosting the size of your nest egg. (To learn more about the details of 401(k) plans, see our 401(k) And Qualified Plans tutorial.)
An IRA, or individual retirement account, is a retirement savings account that allows an individual to make an annual contribution of employment income, up to a specified maximum amount. Similar to a 401(k), your IRA contributions can lower your taxable income, and capital gains are tax-deferred until you begin withdrawing your funds as income.
The rules for IRAs, and whether your contributions are tax deductible, vary according to income levels and other factors, such as the type of IRA and whether you participate in an employer-sponsored retirement plan. Generally speaking, however, IRAs offer the opportunity for tax-rate optimization, since most individuals fall into lower tax brackets during their retirement years. By postponing taxation on funds you contribute to your traditional IRA, not only are you likely to be taxed later in time, you can also enjoy a lower rate of taxation on your funds. With Roth IRAs (you contribute after-tax income), your savings can accumulate on a tax-free basis. (There are many different types of IRA accounts that have been offered over the years. (To learn more about them, check out our Roth IRAs tutorial and Traditional IRAs tutorial.)
If you need help assessing which type of IRA account is best for your needs, consider consulting with a professional financial planner. For Canadian citizens, the RRSP account is essentially the equivalent of an IRA. (For more information about Canadian retirement savings plans, see the Registered Retirement Savings Plans tutorial.)
Company Pension Plans
Many private businesses have shifted from offering defined-benefit pension plans to other forms of employer-sponsored plans, such as defined-contribution plans, but some still do offer defined-benefit plans to employees. Let's take a brief look at the key differences:
A defined-contribution plan can be a money-purchase pension plan or profit-sharing plan, in which only your employer makes contributions, or a 401(k) plan where you contribute amounts from your paycheck and your employer may also make contributions.
For a defined-benefit pension plan, your employer usually makes periodic contributions, and a specified amount of funds is deposited into the plan every month.
Regardless of the form of payment you receive, the value you get from a defined-contribution plan depends on how much money is put in over time and the returns its investments generate. Should your plan's investments perform well, you will accrue the benefits. Likewise, you bear the risk of poor market performance. With a defined-contribution plan, your contributions are certain (i.e., they are defined), but the eventual size of your nest egg is not guaranteed.
This contrasts with the structure of a defined-benefit plan, in which your employer uses a formula to calculate a specific monthly retirement allowance you'll receive when you retire. Like a defined-contribution plan, these plans also require monthly contributions, which can come from your paycheck, your employer or some combination of both.
Typically, defined-benefit plans calculate your benefits based on factors such as the number of years you've been a member of the pension plan, your average (or perhaps peak) salary, your retirement age, etc.
The key difference here is that, with a defined-benefit plan, your employer essentially guarantees that you will receive a certain amount of money each month for the rest of your retired life. Regardless of whether the capital markets do well or poorly, your employer is bound by the terms of the plan to provide your monthly pension amount to you as calculated by the formula. If the stock market crashes, your benefits remain the same. On the flip side, good returns enjoyed by the pension fund do not accrue to you – if the stock market does very well, you do not reap the benefits, and your pension remains the same.
Either type of plan can provide you with a reasonable retirement, but be aware of the differences between the two. If your employer offers both, the eligibility requirements will determine which of the plans you are allowed to participate in.
There are a host of other retirement vehicles available as well. For example, retirees are able to purchase annuities through insurance companies, which essentially provide them with a defined pension for the rest of their lives, or for a fixed period. There are many different annuity types and various options for each, so if you are considering this route, carefully assess your options. (To learn about how annuities work, check out An Overview of Annuities.)
There are many other investment products that may or may not be useful for you, depending on your individual circumstances. Term life insurance can be an effective way to guarantee that your spouse or loved ones will have a sufficient nest egg if you suffer an accident or early death and cannot continue earning income to contribute to your retirement fund. (To learn more about this option, see Buying Life Insurance: Term Versus Permanent and Life Insurance Distribution And Benefits.)
Generally, you may need life insurance if you are the primary breadwinner in the family and you need to ensure your income will be replaced should you pass away. Term life insurance is usually limited to income replacement, while whole life insurance also includes an investment component and builds cash value against which you can borrow. Whole life is usually a lot more expensive, and some financial professionals believe it is generally wiser for most breadwinners to purchase term life and use the extra funds to fund a retirement plan. Before purchasing any form of life insurance, consult with your financial planner to ensure you purchase the insurance that is right for you.
There are also long-term care and medical cost plans that can be tailored to specifically ensure that significant medical expenses won't affect your retirement years. All of these types of products can be useful, but it is unlikely that all of them are needed. Consider consulting with a professional financial planner to help determine what specialized products may be required or useful for your retirement plan.
Whether it's 401(k)s, IRAs, company pension plans, or some other combination of those vehicles and financial products, all are ways to put your monthly retirement fund contributions to work. Once you determine how much you want to contribute to your plan each month, determine which investment vehicles you have at your disposal and select those that best fit your financial profile.Retirement Planning: Tax Implications And Compounding