Planning for retirement can sometimes feel like learning a new language, but improving your financial literacy can make the process less intimidating and help you prepare for retirement with confidence. Here we will demystify some of the most common yet confusing retirement terms to help you make sound financial decisions in your retirement planning.
1. Retirement Accounts: 401(k)s and More
Retirement savings vehicles can seem like an alphabet soup, but whether you plan to use an IRA, Roth IRA, 401(k), 403(b) or 457(b), all of these are just savings accounts with special tax features. While each type is distinct, they can all enable you to better manage your taxes.
With some account types, you contribute pretax dollars, which can make saving easier because you get a tax break. However, you'll most likely need to pay income tax on those funds when you ultimately withdraw the money. On the other hand, if you make contributions to a Roth account, you can prepay your taxes and potentially enjoy tax-free withdrawals in retirement. The rules with these accounts can be complicated, so check with your CPA or financial advisor before making major decisions about them.
Bonus term: The retirement plans above are also known as defined contribution plans because you determine (or define) how much you will contribute each year.
Annuities can work in several ways, but they're all insurance contracts you can use for retirement planning. The simplest form of annuity involves a stream of guaranteed lifetime income payments in exchange for an upfront lump sum or regular contributions. You can choose to receive an income for your life, and you can include a beneficiary such as a spouse, who would continue to get payments in the event of your death.
You don't necessarily need to convert your savings into an income stream. Annuities can also function as tax-deferred accounts that you simply invest in and withdraw from as needed. These accounts typically have guarantees that pay interest or provide the option to begin income payments in the future.
3. Tax Deferral
Retirement accounts and annuities typically offer tax-deferral, which means you wouldn't necessarily report income going to those accounts to the IRS as you earn it. Instead, you generally pay taxes on those accounts after withdrawing funds.
Whenever you shelter your earnings from taxes, there's a good chance that you'll have to pay taxes on that money eventually. However, Roth accounts and health savings accounts (HSAs) are exceptions, and you can potentially get tax-free withdrawals if you meet IRS requirements.
4. Rollover or Trustee-to-Trustee Transfer
A rollover happens when you move money from one retirement account to another. In many cases, this kind of transaction is not taxable as long as you follow specific tax rules, because you're keeping the money in tax-deferred retirement accounts. If you want to move your retirement savings to a different provider, you may have the option to do so. For example, you might want to move your money after leaving your job or if you've decided to pursue better investment options.
During a rollover, an investment provider will often issue a check — ideally made payable to your new investment provider — but with a trustee-to-trustee transfer, your investment providers coordinate everything and move the money through other means.
5. Social Security
Social Security is a government-backed system for providing retirement income and other benefits. When you stop working, there's a good chance you'll get Social Security income for the rest of your life, and it might make up a significant portion of your post-retirement income. During your working years, you probably paid into Social Security, and those payments will help to fund this income.
Your Social Security income depends primarily on how much you earn during your working years and how old you are when you begin receiving benefits. At age 70, recipients can qualify for the maximum benefit.
Even if you never worked outside your home, you might qualify for Social Security benefits. Spouses, widows and widowers, and even ex-spouses may be eligible to receive retirement benefits based on somebody else's work record.
A pension is a lifetime income from your employer. You might receive a pension after you stop working, especially if you've worked at the same place for a long time. Pensions often allow you to choose a beneficiary who would continue to get payments (or reduced payments) in the event of your death, enabling couples to plan for lifetime income.
If you worked for a government-related employer that never paid into Social Security, your pension might replace Social Security benefits. If you qualify for both Social Security and a government pension, your Social Security income might be reduced, so ask your employer what you can expect.
Bonus term: Pension plans are also called defined benefit plans because the plan specifies your income (or your benefit) in retirement.
Medicare is a federal health insurance program for people age 65 and over. If you're like most people, your employer provided health insurance during your working years or you purchased private coverage. But at age 65, the federal government often takes over.
With Medicare, you have numerous options, including plans that offer generous coverage levels and plans that help with prescription drug costs. An insurance professional can help you navigate these options and find coverage that fits your needs.
8. Long-Term Care
If you need help with daily living tasks, such as eating, bathing and moving around your home, you may benefit from long-term care. People often assume that Medicare or private health insurance would pay for this type of care, but that's generally not the case when you need care for an extended period. Medicare primarily pays for hospital visits, skilled medical care and prescription drugs, but custodial care coverage is limited.
It's critical to make a plan for times when illness, accidents or cognitive decline may result in the need for long-term care. You might consider investing in long-term care insurance and formulating a strategy with loved ones to budget for potential costs.
9. Mutual Funds
A mutual fund is a pool of money that combines your investment dollars with other people's savings. A single fund might invest in hundreds or thousands of different individual investments, making it easy for you to diversify. Each fund has an objective, so you can select a fund that's aligned with your investing goals. For example, you might choose a fund that invests in a broad mix of investments with the goal of being conservative, or you could opt for one that focuses on large companies around the world.
Expenses are always a concern for investors, and mutual fund fees can be high or low. Passively managed index funds tend to be the least expensive, but at some brokerage houses you may have to pay a modest fee to trade mutual funds.
10. Exchange-Traded Funds (ETFs)
An ETF is similar to a mutual fund. One crucial difference is that you can trade ETFs throughout the trading day, while mutual funds only trade once per day when the markets close. That might not matter if you're a long-term investor who doesn't try to time the market, but ETFs can be a useful and inexpensive investment tool in a variety of contexts. Because they trade like stocks, you can often buy and sell them with no transaction costs.
Expand Your Financial Knowledge
Now that you know some of the most important retirement terms, you can dig into the details of how they could come into play before and during your retirement. Becoming financially literate is an ongoing process, and with time and experience, these concepts will likely become less confusing.
Ultimately, retirement planning is about understanding your income sources, managing your assets and preparing for expenses. If you're ever unsure about something, speaking with a financial professional can help you sift through the complexity and gain confidence in your plans.