It’s best to begin saving for retirement sooner rather than later to ensure that your 65-year-old self is as financially secure as possible. But all the jargon associated with retirement plans can make them almost impossible to comprehend. It’s time for some clarity. Here are 10 retirement terms we’ve made easy for you to understand.
Find out now: How much money should I set aside for retirement?
With tax-deferred retirement plans, you won’t have to pay taxes until a later time period. Usually the goal is that when you do pay taxes on this money in the future, your income will be lower so you will be in a lower tax bracket. This means you avoid paying taxes on money when you are in a higher tax bracket and ultimately pay less money in taxes.
An Individual Retirement Account is a retirement plan that you can set up on your own. IRAs come with tax benefits and the type that you qualify for depends on the job you have and how much money you make. There are restrictions on how much money you can contribute to an IRA within a year and you might be penalized for withdrawing money from it before you reach the age of 59 ½ .
Related Article: IRA vs. 401(k)
Traditional IRAs are tax-deferred, so you contribute to them with pre-tax money. This year, you’ll be able to set aside up to $5,500 (and $6,500 if you’re at least 50). If you qualify for a tax deduction, the amount that you add to your traditional IRA will be deducted from your total income and you’ll pay less money to the IRS.
3. Roth IRA
A Roth IRA is almost the exact opposite of a traditional IRA. You add money to a Roth IRA post-tax, and when you begin using your funds as a retiree you won’t owe any additional income taxes. Unlike with traditional IRAs, you have the option of using the money from your Roth IRA before you turn 59 ½ without facing a penalty, as long as your reason for doing so is valid and fits within specific guidelines (such as using the money to buy your first house). This retirement account is not for the wealthy — it’s only available to people with incomes below a certain threshold.
SEP (Simplified Employee Pension) IRAs are retirement accounts for small business owners, entrepreneurs and self-employed people. Only employers can make contributions. SEP-IRAs are tax-deferred and let you contribute more money (up to $53,000 or 25 percent of your income) than you can through other IRA accounts.
5. SIMPLE IRA
The Savings Incentive Match Plan for Employees (SIMPLE) IRA is a tax-deferred plan for self-employed individuals and small business owners that’s automatically tax deductible. Contributions can come from both employees and employers, and employers must add money to this retirement account even if their employees fail to set aside funds.
6. 401(k) Plan
Many companies offer 401(k) retirement plans. With traditional 401(k) plans you contribute a certain percentage of your paycheck before taxes. Much like with traditional IRAs, you’ll owe income taxes when you retire and remove money from your account. Prior to retirement, you won’t pay as much money in taxes because contributing to a traditional 401(k) reduces your taxable income. On the other hand, Roth 401(k) plans mimic Roth IRAs — you’re using your taxed income upfront, so you don’t have to pay any taxes when you withdraw it in retirement.
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An annuity is an investment resulting in regular payments from an insurance company that can be a retirement saving strategy. Insurance companies may pay you back immediately (immediate annuities) or over the course of multiple years as your tax-deferred investment grows from interest (deferred annuities). Annuities may take the form of bonds earning a fixed interest rate or they can be a mixture of investments that earn interest based on the market.
8. Defined Benefit Plan
This type of plan offers a set benefit amount to an employee when he or she retires based on factors such as income and the number of years served at a company. Defined benefit plans, such as pensions, are funded almost entirely by employers.
9. Defined Contribution Plan
Employees and employers make scheduled payments toward defined contribution plans, like a 401(k). When the employee retires, his or her benefit package depends on its return on investment.
Vesting is ownership. Vesting refers to the money in your plan that actually belongs to you rather than your employer. Your employer may have a program where he or she matches the dollar amount that you’ve reserved for retirement, but your employer’s money won’t automatically be yours. If this is the case, you’ll likely have a vesting schedule that shows how long you’ll have to work at your company before you’re fully vested. Your goal is to become fully vested so that you own 100 percent of your retirement funds.
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