When it comes to retirement planning, the best advice is start early. Every year you’re saving and contributing to your pension plan can mean a lot more income in your golden years. Start early, and if you’ve not yet started planning for retirement, start today.
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Every country has various pension plans available to its citizens, and discussing all of them just isn’t possible (see the major options in the US, Canada, and the UK in the “Useful Links” section below). Some are mandatory, others are voluntary. You need to look at a few choices and ask the right questions about them. What works for someone doesn’t work for everyone. Your situation is unique.
A Few General Considerations
No matter where you are, or how old, there are a few things to consider when looking at pension plans. If you have some choice available to you, do some homework and ask some questions.
- Comparison shop: Pension plans are sometimes available via your employer, insurance companies, banks, and other financial institutions. Compare them as you would any big purchase (different brand names, different stores, different pros and cons). Ask to see a key facts document for any plan you’re seriously considering. Use comparison websites that allow you to directly compare different plans from different sources.
- Can you afford it? Consider the fees and amounts involved in any one plan. Do you have to make regular contributions (each and every month), and if so, can you afford them? Can you skip a payment, and if so, is there a penalty for that? Is it possible to vary the contribution amount (especially important for people with fluctuating income like freelancers)? Look into other fees, too, like management fees (and when they are payable if they exist). Make sure you understand exactly what you’re getting into and how much it will cost you.
- Ask about how the money is invested. You might not want to contribute to a plan that relies heavily on bonds, for example. Or maybe you do. It’s important to ask and know, and then determine if it complies with your needs and beliefs.
- Time Restrictions. Is there minimum time before you can withdraw money from the plan? If there is, what happens if you withdraw before then (usually some sort of financial penalty, but you need to know exactly how much)?
- Taxes. How is the money taxed?
A Quick Example
In the United States, most people contribute to a 401(K) plan through their employer. A defined amount is automatically deducted from their pre-tax paycheck (and employers often match a percent of that amount). In recent years, employees at many companies have had the option to choose a Roth 401(K) plan, which is similar in almost every way, save for one very important difference. A 401(K) contribution is tax deferred, meaning no tax is paid on the money until it is withdrawn from the plan. A Roth 401(K) contribution is post-tax, meaning the employee pays the income tax first, and there is no tax on the money down the road. Both plans have a contribution limit set by the IRS ($17,500 for 2014), both plans have a withdrawal age of 59.5 years (employees must be at least that age before they begin drawing money from the plan), and both plans carry a 10% penalty for any withdrawal before then.
The decision to go with a Roth vs. a traditional 401(K) comes down, just to the tax issue.
In a traditional 401(K), the income is taxed at the time of withdrawal after age 59.5. If someone believes they will be in a lower tax bracket at that time, it may be the wiser choice. Likewise, if they have a high salary now, they can benefit from the tax deductible contributions, as your 401(K) contributions lower your income for that tax year (if your salary is $100,000, and you make the maximum contribution of $17,500, your taxable income becomes only $82,500).
A Roth 401(K), on the other hand, sees your salary taxed each year at the full amount. Your contribution goes into the pension plan, giving you tax-free growth and withdrawal after the age of 59.5. For someone not making a lot of money, and therefore in a low tax bracket, a Roth 401(K) would make sense. Pay the tax now - at the lower rate - and be done with it.
Other Useful Links
Pension Plan Options (USA)
It’s all about your individual situation. Where you are in your career, how much you’re currently making, and your opinions on the future. Shop around, ask questions, and consider your financial goals before making any decision. You can’t always easily change your mind later, so choose wisely.
See also: How to Return to Work after Retirement
Photo Credit: Ken Teegardin, via Flickr