Planning for one's financial future can and should include retirement plans where provided by an
employer, over and above pension plans. There are also a number of individual options for retirement accounts that should be explored. I will first look at investment opportunities offered on-the-job.
Employer-Provided Plans
There are two types of employer-provided retirement plans, qualified and nonqualified. Qualified plans must meet tax code requirements, including being permanent, are set down in writing, are non-discriminatory in terms of coverage, and are available not just to highly compensated employees but to at least 70% of all others. These plans allow an employer to make tax deductible contributions – and sometimes nontaxable – on behalf of the employee, which is to the employer's benefit since it is usually deductible for the company. In addition, the investments grow tax free but will be subject to tax when they are withdrawn by the employee.
Nonqualified plans do not allow a deduction for income tax purposes for an individual's personal
contributions. However, even though the contributions are nondeductible, the accounts also grow tax-free.
Pension Plans
Companies can also offer pension plansto their employees see more:Special Savings Plans and Goals
http://conspecte.com/Economics/special-savings-plans-and-goals.html. These are known as either defined benefit or defined contribution plans. The distinction is really based on how much risk the employer takes in determining the payout made when a worker retires. In either case workers may be able to add their own money to what the company puts in on their behalf. These are nontaxable accounts and include those set up for workers in business, called 401Ks, and for employees of not-for-profit schools and hospitals, called 403Bs. In all these cases, funds can grow faster than when tax is periodically applied to the balances.
On one's own, you may also contribute to an annuity or your own Individual Retirement Accounts (IRAs), which also grow tax-free, whether or not you are also covered by a plan at work.
Annuities
An annuity is a contract between an individual and an insurance company in which the individual deposits money either as a lump sum or various amounts over time to be withdraw latter, usually in equal installments at retirement age. As shown above in company-provided retirement plans, annuities can be qualified plans, which mean that a deduction is allowed on the person's income tax return when the contribution is made. These accounts grow tax-free until withdrawn at retirement age.
There are two basic types of annuities, fixed and variable. For a fixed annuity, the insurance company provides a guaranteed rate for a period of time. However, the annuitant is exposed to the same risk as with any long-term investment: the insurance company can offer whatever the current rate proves to be, and that can be either lower or higher. You can purchase a provision for a floor on the rate, which means the company cannot pay below a rate you have set. You could also purchase a fixed death benefit which in effect makes it partly life insurance.
Variable annuities are more like mutual funds. The insurance company takes your money and invest it in separate accounts. These accounts can be stock, bonds, real estate, or fixed yield portfolio. Because these accounts are so much like mutual funds, they can perform well or poorly over time. At some point, an individual will begin to take payouts from the insurance company. These could be in the form of lump sum withdrawal or equal withdrawals for a person's lifetime or for a fixed period of time with a guarantee of a minimum amount of time. For example, I chose to take my Wisconsin State Teachers Retirement over my life alone but for a guaranteed 15 years. If I died before that time was up, my named beneficiaries would have received the remaining installments until the 15th year. I am now starting the 21st year of withdrawal so I won the gamble.
You can purchase what is identified as an immediate annuity, paying a lump-sum to the insurance company.
You would then begin receiving periodic payments usually within 60 days. For example, take the case of a large injury settlement where you might be disabled and unable to make a living doing your former job, you could elect to deposit this large settlement with the insurance company. Another example might be the death of your spouse, where you could choose to convert their life insurance proceeds to an annuity.
Other annuities are deferred annuities where you either contribute periodically to the contract or pay a lump sum with the withdrawal starting at a much later date. Most types of retirement plans are of this order. You contribute to the plan now during what is called the accumulation period with withdrawal at retirement age. These plans may be qualified (tax deductible now, accumulating tax free), or nonqualified with no tax deduction but almost always tax-free accumulation. At the point of withdrawal, the contract is annuitized and what are accumulation units are converted to annuity units. The number of units is fixed at this point.
There is an Assumed Interest Rate (AIR) made by the insurance company to predict the future value based on mortality tables. If the actual realized rate of return is higher than the AIR, the value of each annuity increases with the payout increases. The reverse is also true: if the realized rate of return is less than the AIR, the value of each annuity decreases and the payout goes down.
The tax consequence of these payments depends on several factors. If they are qualified plans, each amount received will be 100% taxable. If they are nonqualified plans, or nondeductible IRA's, each amount received will include a partial return of your basis which is nontaxable while the other portion will be taxable income. When the total basis (your initial contribution) has been recovered, each payment will 100% taxable. If because of death the annuitant will not recover all of his or her basis, a tax preparer will claim a miscellaneous itemized deduction, not subject to 2% threshold, equal to that unrecovered cost. The income tax consequences and the estate or gift tax consequences are different. To the extent that a gift transfer exceeds the annual $13,000 exclusion, a gift will be taxable with some of the lifetime credit being used up. Similarly, if the gross estate exceeds the remaining lifetime credit, the survivorship amount will be included in the estate tax. Annuities are not subject to probate administration because they have a designated beneficiary.