Setting up a Retirement Savings Plan in the US

Defined Contribution Plans are covered by the Employee Retirement Income Security Act of 1974 (ERISA) and are funded by the employee, the employer, or both. They do not promise a specific amount of money per month; instead, they usually set a rate of, for example, 5% of annual earnings to be invested on the employee’s behalf. This means that employees are left with the contributions plus or minus investment gains or losses. Some examples of defined contribution plans include the 401(k) plans, the 403(b) plans, the employee stock ownership plans, and the profit-sharing plans. Let’s take a closer look at the 401 (k) plan, the most popular one.

THE 401 (K) PLAN

It is a cash or deferred arrangement in which employees accept to set aside a portion of their salary towards a retirement fund. Employees assume complete responsibility for setting up their retirement funds and increasing them by making their own investments. There’s a limit on how much of your salary you can defer per year. Learn more about it here.

There are 4 types of 401(k) plans:

• • The Traditional 401 (k). The employee makes contributions from his gross salary (before taxes are taken out) through payroll deductions. These contributions are then placed in a 401 (k) account and the employee chooses how to invest the money. Sometimes the employer may choose to make matching contributions up to a certain percentage.
• • The Safe Harbor 401 (k) plan. It works in a similar way to the Traditional 401 (K). However, here the employer makes contributions for each employee, which are 100% vested.
• • The Simple 401 (k) plan. It was designed to allow small and medium-sized businesses (with less than 100 employees) to offer cost-efficient retirement benefits to their employees. An an employee, you can choose to defer some compensation but your employer must also make a matching contribution up to 3% of what you pay, or a non-elective contribution of 2%.
• • Automatic enrollment 401 (k). In this plan, employers enroll their employees and invest the payments deducted from their wages in special investment accounts. The employer is also required to make employer contributions that are fully vested. Unless the employee makes it clear that they don’t want to contribute, or they wish to contribute a different amount, some employers may automatically enlist their employees in this type of plan with a set rate.

How to set up a Defined Contribution Plan

The first decision you’ll have to make is whether to set up the plan yourself or consult a professional or financial institution - such as a bank, mutual fund provider, or insurance company - to help you establish and maintain the plan.

Broadly speaking, you must follow four steps to get a tax-advantaged 401(k) plan:

• 1. Adopt a written plan in which you state what type of retirement savings plan you want to opt for.
• 2. Arrange a trust fund for the plan’s assets and designate a trustee to oversee contributions, plan investments, and distributions to and from the plan.
• 3. Develop a recordkeeping system to help you track and manage contributions, investments, expenses, etc.
• 4. Learn about your employer’s plan’s benefits and requirements. You can usually find this in the summary plan description (SPD) provided by your employer.

Every year, a plan’s annual report must be filed with the Federal government. This is known as Form 5500, which is generally completed and filed electronically by your employer or plan manager by using EFAST2-approved third-party software or using IFILE.

To learn more about form 5500 visit the official U.S Department of Labor webpage.

HOW DO PAYMENTS WORK?

By the time you retire, you’ll be able to choose the way your pension will get paid. You can opt for:

• • A single life annuity, which will allow you to receive a monthly payment until your death (payments are stopped afterwards).
• • A qualified joint and survivor annuity, by which you will receive a monthly payment until your death and your surviving spouse will continue to receive 50% benefits until their own death.
• • A lump-sum payment, which entitles you to receive the entire value of your plan in one installment (no further payments will be paid afterwards).

The Individual Retirement Savings Account (IRA) is a U.S. savings plan aimed at contributing pre-tax dollars towards retirement. Unlike other types of savings plans that involve an employer, the IRA is managed entirely by the plan holder.

There are four main types of IRA:

• • Traditional IRA contributions, which are deductible on your federal and local tax returns for the year you make the contribution. With traditional IRAs, you avoid taxes on the money you set aside in the account. Yet, when you reach retirement age, the income in the savings account becomes taxable.
• • Roth IRAs. They offer no tax breaks for contributions, but earnings and withdrawals are generally tax-free. Because Roth IRA contributions are made on an after-tax basis, it's a good idea to take advantage of the tax-free growth, especially if you're in a lower tax bracket.
• • Simplified Employee Pensions (SEP). They follow the same taxation rules as the Traditional IRA, but they are better suited for independent contractors, freelancers, and small-business owners.
• • Savings Incentive Match Plan for Employees (SIMPLE). It was designed for small businesses and self-employed individuals. This type of IRA follows the same tax rules for withdrawals as a traditional IRA.

HOW TO SET UP AN IRA

They can be obtained through any institution approved by the Internal Revenue Service (IRS), such as a bank, an investment company, an online brokerage, or a personal broker.

Just like with Defined Contribution Plans, your trustee, or the issuer of your individual retirement arrangement (IRA) will need to file form 5498 with the Federal government to report annual contributions. Learn more about this here.

HOW DO PAYMENTS WORK?

Once you have reached retirement age, you must contact the company where you have subscribed and arrange how you want to receive your payments with them. If you die before your IRA assets are exhausted, they will pass to the person you mentioned as your beneficiary when you set up the account. Because IRAs are meant for retirement savings, there is usually an early withdrawal penalty of 10% if you take money before your retirement age.