Retirement Options: Social Security, 401(k) Plans, and IRAs

Introduction and Statement of the Problem

Almost one-third of American workers are failing to prepare themselves for a comfortable retirement, according to a survey conducted by American Express. The national telephone survey of working adult men and women who had recently left or lost their jobs revealed that 30% did not invest for retirement in their company's 401(k) plan. The survey also revealed that 16% of participants rolled their money into an IRA, and the majority of those who did so said they would make the same decision again. Eleven percent of those surveyed reported cashing out of their retirement plan because they needed the money to pay off debt or cover everyday living expenses.

While these participants may have felt that their decisions were best for their situations, financial experts would have advised against them. Money invested in a 401(k) plan grows tax-deferred until withdrawn, which over time allows an investor to accumulate more savings for retirement. By law, individuals who withdraw a lump-sum distribution from their 401(k) before age 55 are assessed a 10% early withdrawal penalty, as well as federal and state income taxes. This means that early withdrawals cause serious harm to retirement funds. Nevertheless, a lack of knowledge and expertise causes many Americans to make poor choices regarding their retirement options.

Saving for retirement is a major challenge for millions of Americans today. With an abundance of retirement options—including tax-deferred retirement plans, 401(k)s, and IRAs—investors are often confused about which option will make the most of their savings dollars. This paper aims to provide a review of the fundamentals of these powerful retirement vehicles in order to give future retirees the information they need to start investing in their futures.

Saving enough money for retirement is one of the greatest financial challenges faced by individuals today. It requires careful planning, a commitment to regular investing, and an understanding of which retirement options are best suited to different needs.

According to experts, human beings are distinguished from other species by a unique ability to think ahead and plan for the future (The Motley Fool, 2003). While this is true, many people have a hard time thinking about the long-term future and adequately preparing for it. Many people are too busy living in the moment to realize that things have a way of changing quickly. In this regard, human beings share the immediacy found in many other species, which causes many to shrug off the tedious task of saving for retirement. However, understanding one's retirement options and planning ahead are keys to being ready for the future when it arrives. As The Motley Fool (2003) notes: "The younger you are, the more distant is retirement—and the more power you have at your fingertips in the form of compound returns over time. It's a paradox that you can work to your advantage."

David Braze, a specialist in retirement planning, suggests asking the following questions before evaluating retirement options (The Motley Fool, 2003):

How much will I need for my retirement in order to live comfortably? What are my goals? When should I start? What should I do? How much can I count on from Social Security? What costs might I run into once I've actually retired?

According to Braze, "These are the questions that we all need to ask; questions that we often wait too long to ask; questions that surface dimly on occasion, in a remote and dusty corner of the mind, a mind that is otherwise occupied with this minute's conversation, today's project, tonight's movie, and tomorrow's meeting" (The Motley Fool, 2003).

To understand which retirement options are best suited for various needs, it is important to first examine the major retirement plans available. Each of these options has positive and negative aspects, so investors must understand the advantages and drawbacks of all major retirement options in order to maximize their savings potential.

Purpose of the Study

Government, employer, and individually sponsored retirement plans are all good ways to save for retirement. In today's society, relying solely on Social Security appears to be a poor choice, as these programs are not likely to provide the same income level in the next decade. However, there are so many complex retirement options that investors often do not know where to begin. For this reason, this paper examines major retirement options that can help investors plan an enjoyable retirement. This research study aims to describe three major retirement options—Social Security, 401(k) plans, and IRAs—analyzing how each can be advantageous or disadvantageous, and ultimately determining which option offers the best solution for retirement investment.

Scope of the Study

As all types of retirement options appear to have flaws and many investors lack the knowledge to determine which options are best for their individual needs, existing research suggests a strong need for a clear and concise report on retirement options. This research paper examines the history of retirement options, existing research on various vehicles, the behavior patterns of investors, and the flaws and benefits of each option in order to determine which choices are best for individuals today.

Rationale of the Study

Most people dream of retiring while they are still young and healthy enough to enjoy the rewards of years of hard work (Starchild, 2002). However, these dreams usually require maintaining a standard of living at least as good as their current one. Fortunately, a variety of retirement options are available to help people meet their goals.

At age 65, the average man will live almost 19 more years, while the average woman will live another 22 years. The majority of the population will spend 25% to 30% of their lives in retirement, requiring substantial funds to maintain an enjoyable lifestyle. Social Security and pensions replace only 40% to 60% of the average retiree's pre-retirement income. A recent study indicates that individuals between the ages of 25 and 44 are saving only 34% of the amount needed to support their current lifestyle in retirement. The study suggests that individuals without a pension should have savings equal to approximately four to eight times their peak annual earnings, while those covered by a pension plan need approximately two and a half to six times their pre-retirement annual earnings. Only 57% of those eligible to contribute to 401(k)s do so, fewer than 15% of the 67 million workers eligible to contribute to a fully deductible IRA do so, and only 12% of the self-employed have retirement plans (Starchild, 2002).

According to Adam Starchild (2002), the word "retirement" carries many positive connotations. "Traditionally, retirement has signified a release from the drudgery of work. Retirement has always meant freedom and, with luck, an active, carefree leisure," he says. "It has meant rest, relaxation and the chance to pursue long-postponed dreams and ambitions." However, Starchild is quick to point out that there is another, less pleasant side of retirement, as it means giving up one's career. "Nobody likes to get benched and, on one level, retirement can seem just that. The idea of no longer enjoying a place in the workaday world can be downright disturbing," he adds. "In a society as geared towards work as ours, the place of someone who no longer works is poorly defined."

For the majority of the population, working becomes more and more difficult after the age of 60 (Starchild, 2002). Therefore, age 65 is the commonly accepted retirement age. However, in today's society, as the cost of living increases rapidly and government finances remain in an unstable state, retirement appears to be an uncertain reward for a lifetime of work. Social Security alone is no longer a guarantee of freedom from economic worries.

Individuals who fail to save for retirement may find themselves in a frightening position when the time comes (Starchild, 2002). Even those who have saved adequately often face serious challenges. Still, despite these concerns, most people perceive retirement as something to look forward to, and those who make the most of their retirement options often find it to be a pleasurable experience.

Today, the average man who lives to age 65 will probably live another fifteen years, and the average woman will probably live another twenty. As a result, the retirement phase of a person's life may encompass a third or more of his or her entire lifetime. These facts underscore the importance of saving for retirement and of understanding the options available.

Definition of Terms

Current tax rate — current marginal income tax rate.

Equity — ownership interest held by shareholders.

Financial planner — a professional who analyzes an investor's general financial situation and develops a plan to meet individual goals.

401(k) plan — a voluntary retirement plan offered to employees of a company that enables a specific percentage of before-tax earnings to be set aside and invested within a retirement plan. The funds and their growth are not taxed until withdrawn. The advantage of this deferral arrangement is that the percentage of money invested is deducted from personal income taxes and grows tax-deferred.

Individual Retirement Account (IRA) — a personal retirement tax shelter for which the government provides favorable tax benefits. An individual can invest up to $3,000 per year into an IRA. Depending on income level and whether they participate in an employer-sponsored retirement plan, investors may deduct the amount contributed. Once inside the IRA, money grows tax-deferred. Investors can use stocks, bonds, mutual funds, or other IRS-permissible investments as the investment vehicle.

Investment — the use of capital, including stocks, bonds, real estate, or limited partnerships, to generate returns.

Investment tax rate — expected marginal tax rate for investments.

Money market fund — a mutual fund that invests in paper-based commodities, including commercial paper, repurchase agreements, banker's acceptances, certificates of deposit, and other low-risk, low-yielding instruments.

Rate of return — expected rate of return on an investment.

Standard & Poor's 500 Index (S&P 500) — a broad-based measurement of 500 large companies from different sectors that trade on the New York Stock Exchange, serving as a benchmark for daily stock market performance.

Stock — ownership of a company represented in shares consisting of the company's earnings and assets.

Stock market — the organized trading of securities on various market exchanges.

Tax rate at retirement — expected marginal income tax rate at retirement.