The Starting Point:  Retirement Plans

A retirement plan, as its name implies, is an agreement between two entities (on the one hand an individual or a group of people, the other being a financial institution like a bank or credit union) to provide people with an income when they are retired and no longer earning a salary.

There are two basic types of retirement plans:  defined benefits or defined contribution plans.

Defined benefits plans have been around for some time; social security programs (which are administered by governments from ‘forced’ contributions from employers and employees) are examples of defined benefit plans.  The primary element of a defined benefits plan is the guaranteed payout after retirement; the amount of payout is computed based on a fixed formula.  For example, a plan may be computed on the basis of the last amount of salary an employee has been receiving multiplied by the number of years he or she has been working; then, the product is multiplied by a factor called the accrual rate.

Defined contribution plans such as IRAs and 401(k)s, are based on the contributions made by an individual into an account with a financial institution like a bank, broker, or mutual fund in which contributions may be invested in many types of securities such as stocks, bonds, money market funds, and CDs.  Returns on investment are credited to the individual’s account and the monies generated can be accessed upon retirement.

Individual Retirement Accounts or IRAs

As mentioned, the IRA is one form of a defined contribution plan.  It is unique because of the tax advantages incorporated to encourage savings.  IRAs and 401(k) plans have become increasingly popular in recent years, displacing the once-popular pension plans offered by employers as part of their hiring and benefits packages.

One of the reasons for IRA’s popularity is the fact that individual account holders can choose what to invest in, be it stocks, bonds, CDs, mutual funds or a combination to meet the account holders personal objectives. In effect, IRA grants individual users more responsibility in fiscal management instead of delegating the same to some faceless corporation or entity.

Legislation has also played a role by relaxing the restrictions on the types of investments into which IRAs may be invested.  Since IRAs also offer tax advantages, this makes the IRA even more attractive as a retirement savings option.

Roth IRAs

Roth IRAs are a form of the conventional IRA concept.  Under the law sponsored by Senator Roth, Roth IRAs can be invested in a wide variety of instruments, ranging from securities to derivatives, certificates of deposits and other, non-typical investment instruments.  As with conventional IRAs, Roth IRAs have detailed eligibility and filing requirements.  However, there are also differences between traditional and Roth IRAs, especially in terms of taxes and procedures.