The Most Common Retirement Plans

Many different types of retirement plans exist and each serves a little different purpose for a different demographic. From different types of pension plans to individual retirement accounts (IRAs), here are some of the most common retirement plans and their pros and cons.

The most common type of retirement plan is the pension plan. A pension is essentially a retirement plan that provides people with an income when they are no longer earning a regular paycheck from being employed. It is a tax-free savings vehicle that can accrue funds for later use as retirement income. Two of the most popular pension plans are the Defined Benefit Plan and the Defined Contribution Plan.

Defined Benefit (DB) Plans are formulaic and independent of potential stock market returns. This type of retirement plan uses a formula including the employee's pay, years of employment, age of retirement, and several other factors to determine the net retirement pay per month. Final Average Pay (FAP) plans are the most popular; the average salary over the final years of an employee's career determines the benefit amount. Plans can be either funded or unfunded, with the unfunded option being made possible through current social security dollars. One of the huge positive factors in choosing a Defined Benefit Plan is that it is has very reliable returns and the state of the market doesn't matter because retirement payments are calculated far in advance. Like a bond, it is predictable but will not gain any more value than previously calculated.

Defined Contribution Plans require contributions to be paid into an individual account for each person and contributions are invested, and returns on that investment are credited to or debited from each individual account. Once retired, the individual may withdraw retirement income, and some choose to purchase an annuity which contributes to providing income. This is a relatively risky type of retirement income option because it relies entirely on the stock market. Depending on the value of the investment where the cash has been placed, it could have a gain or loss after the initial investment.

Hybrid plans are also available, meaning that individuals can tailor their retirement plan to meet their needs. Some cash may be set aside while some may be invested. While less risky than the Defined Contribution Plan and more risky than the Defined Benefit Plan, the hybrid is a good match for those who are investment savvy or who have more cash available in a Defined Benefit Plan than what they need.

Individual Retirement Accounts (IRAs) are also a common retirement plan vehicle. Several different types exist: Roth IRA, Traditional IRA, SEP IRA, SIMPLE IRA, and Self-Directed IRA. The most common of these is the Roth IRA, which requires contributions to be made with after-tax monies, there is no tax impact, and withdrawls are usually tax-free. Of all the retirement plans, the Roth IRA is arguably the most tax friendly and flexible, allowing for pre-retirement withdrawls that are usually not penalized.

As with all financial vehicles, be sure to consult with a financial and legal professional to determine what is best for you.