What Is The Difference Between a Pension and 401(k) Plan?

What Is The Difference Between a Pension and 401(k) Plan?

A 401(k) plan is a retirement plan in which employees contribute to a tax-deferred account via paycheck deductions (and often with an employer match). A pension plan is a different kind of retirement plan, in which a company sets money aside to give to future retirees.

Over the past few decades, defined-contribution retirement plans like the 401(k) have steadily replaced pension plans as the private-sector, employer-sponsored retirement plan of choice. While both a 401(k) plan and a pension plan are employer-sponsored retirement plants, there are some significant differences between the two.

Let’s take a deeper look at the difference between pension and 401(k) plans, the advantages and disadvantages of each, and how companies decide to offer a pension vs 401k—or, a 401k vs pension.

How are 401(k) Plans Different from Pension Plans?

Pension plans and 401(k) plans are both valuable employee retirement benefits. The first step to making the most of an employer retirement plan is understanding the differences between them.

Funding

Employees typically fund 401(k) plans, while employers typically fund pension plans.

Investments

Employees can choose investments (from several options) in their 401(k), while employers choose the investments that fund a pension plan.

Value

The value of a 401(k) plan at retirement depends on the performance of the investments when the employee retirees. Pensions, on the other hand, guarantee a set amount of income for life.

What Is a Pension and How Does It Work?

A pension plan is a type of retirement savings plan where an employer contributes funds to an investment account on behalf of their employees. The earnings become income for the employees once they retire.

There are two common types of pension plans:

•  Defined-benefit pension plans, also known as traditional pension plans, are employer-sponsored retirement investment plans that guarantee the employee will receive a set benefit amount upon retirement (usually calculated with set parameters, i.e. employee earnings and years of service). Regardless of how the investment pool performs, the employer directs pension payments to the retired employee. If the plan assets aren’t enough to pay out to the employee, the employer is on the hook for the rest of the money.

According to the IRS, contributions to a defined-benefit pension plan cannot exceed 100% of the employee’s average compensation for the highest three consecutive calendar years of their employment or $230,000 (for 2021).

•  Defined-contribution pension plans are employer-sponsored retirement plans to which employers make plan contributions on their employee’s behalf and the benefit the employee receives is based solely on the performance of the investment pool. Like 401(k) plans, employees can contribute to these plans, and in some cases, employers match the contribution made by the employee. Unlike defined benefit pension plans, however, the employee is not guaranteed a certain amount of money upon retirement.

When it comes to pension plan withdrawals, employees who take out funds before the age of 59 ½ must pay a 10% early withdrawal penalty as well as standard income taxes. This is similar to the penalties and taxes associated with early withdrawal from a traditional 401(k) plan.

Pension Plan Advantages

The main advantage for employees in pension plans is that this is extra retirement income from your employer. An employee does not need to contribute to a defined-benefit pension plan in order to start receiving consistent payouts upon retirement.

Other advantages of pension plans include:

Tax savings

IRS-qualified pension plans provide tax benefits to contributors, whether employers or employees. In many instances, contributions occur with pre-tax dollars.

Higher contribution limits

When compared to 401(k)s, defined-benefit pension plans have significantly higher contribution limits and, as such, present an opportunity to set aside more money for retirement.

Compound interest

Compound interest is interest earned on the initial investment as well as on subsequent interest, which accumulates over time. The sooner a person starts investing in a pension plan, the more they can benefit from compounding interest.

Decreased market risk

The market risk for a pension vs. 401(k) is significantly lower because a defined-benefit pension plan means a guarantee of lifetime income.

Payroll deduction savings

Much like 401(k) contributions, defined-contribution pension plan contributions are withheld directly from an employee’s pay. This makes it simpler and more straightforward to save money for retirement than manually transferring funds into a separate account.

What Is a 401(k) and How Does It Work?

A traditional 401(k) plan is a tax-advantaged defined-contribution plan where workers contribute pre-tax dollars to the investment account via automatic payroll deductions. These contributions are sometimes fully or partially matched by their employers, and the investment earnings are not taxed until the employee reaches the retirement age of 59 ½.

With a 401(k), employees and employers may both make contributions to the account (up to a certain IRS-established limit), but employees are responsible for selecting the specific investments. They can typically choose from an array of offerings from the employer and include a mixture of stocks and bonds that vary in levels of risk depending on when they plan to retire.

The IRS considers the removal of any 401(k) funds before the age of 59 ½ an “early withdrawal.” The penalty for removing funds before that time is an additional income tax of 10% of the withdrawal amount (there are exceptions, notably a hardship distribution, where plan participants can withdraw funds early to cover “immediate and heavy financial need”).

Recommended: 401a vs 401k: What’s the Difference?

401 (k) Contribution Limits

To account for inflation, the IRS periodically adjusts the maximum amount an employer or employee can contribute to a 401(k) plan.

•  For 2021, annual employee-only contributions can’t exceed $19,500 for workers under 50, and $26,000 for workers over 50 (this includes a $6,500 catch-up contribution).

•  The total annual contribution paid by employer and employee is capped100% of compensation or $58,000 for workers under 50, $64,500 for workers over 50, or 100% of employee compensation—whichever is less.

Some plans allow employees to make additional after-tax contributions to their 401(k) plan, within the contribution limits outlined above.

Recommended: 5 Ways to Rebuild Your Retirement Savings

401(k) Plan Advantages

While a 401(k) plan might not offer as clearly-defined a retirement savings picture as a pension plan, it still comes with a number of upsides for participants who want a more active role in their retirement investments.

Self-directed investment opportunities

Unlike employer-directed pension plans, in which the employee has no say in the investment strategy, 401(k) plans offer participants more control over how much they invest and where the money goes (within parameters set by their employer). Plans typically offer a selection of investment options, including mutual funds, individual stocks and bonds, Exchange Traded Funds (ETFs), and non-traditional assets like real estate.

Tax advantages

One of the biggest benefits of participating in a 401(k) plan is the tax savings. Contributions to a 401(k) come from pre-tax dollars through payroll deductions, reducing the gross income of the participant and allowing them to pay less in income taxes overall. Also, 401(k) plan participants don’t pay taxes on their gains, so they can grow even more money over time.

Employer matching

Many 401(k) plan participants are eligible for an employer match up to a certain amount, which essentially means free money.

Why Did 401(k) Plans Largely Replace Pension Plans?

The percentage of private sector employees whose only retirement account is a defined benefit pension plan is just 3% today, versus 60% in the early 1980s. The majority of private sector companies stopped funding traditional pension plans in the last few decades, freezing the plans and shifting to defined-contribution plans like 401(k)s.

When a pension fund isn’t full enough to distribute promised payouts, the company still needs to distribute that money to plan participants. In several instances in recent decades, pension fund deficits for large enterprises like airlines and steel makers were so enormous they required government bailouts. Upon filing for bankruptcy, these employers forfeited responsibility for their retirement plan obligations and shifted the burden to US taxpayers.

To avoid situations like this, many of today’s employers have shifted the burden of retirement funding to their workers.

401(k) vs. Pension: Which Is Better?

When considering a pension versus a 401k, most people prefer the certainty that comes with a pension plan.

But for those who seek more control over their retirement savings and more investment vehicles to choose from, a 401(k) plan could be the more advantageous option.

In the case of the 401(k), it really depends on how well the investments perform over time. Without the safety net of guaranteed income that comes with a pension plan, a poorly performing 401(k) plan has a direct effect on a retiree’s nest egg.

Can You Have a Pension Plan and a 401(k) Plan?

Yes. A person can have both a pension plan and a 401(k) plan, but usually not from the same employer. If an employee leaves a company after becoming eligible for a pension and opens a 401(k) with a new employer, their previous employer will still maintain their pension, though the employer will no longer pay into the account. An employee can still access their former retirement account linked to the previous employer in order to use pension funds.

Beyond Employer-Sponsored Plans: The IRA

A traditional Individual Retirement Account, or IRA, is another tax-advantaged investment option you can use to save for retirement. One major benefit of an IRA is that anyone can set up an IRA, whether they’re self-employed, work part time, or already have a 401(k) with an employer and want to save extra retirement funds.

IRAs have a larger investment selection and offer significant tax advantages. In the case of Roth IRAs, there are no penalties for withdrawing funds before the age of 59 ½.

The only catch, of course, is that with an IRA there is no employer to offer matching contributions. In addition, the contribution limits are lower than 401(k) limits. For 2021, contributions to traditional IRA plans are capped at $6,000 for individuals under age 50, and $7,000 (using catch-up contributions) for people over age 50.

Recommended: IRA vs 401(k)–What Is the Difference?

The Takeaway

Pension plans are employer-sponsored, employer-funded retirement plans that guarantee a set income to participants for life. On the other hand, 401(k) accounts are employer-sponsored retirement plans through which employees make their own investment decisions and, in some cases, receive an employer match in funds. The post-retirement payout varies depending on market fluctuations.

While pension plans are far more rare today than they were 30 years ago, if you have worked at a company that offers one, that money will still come to you after retirement even if you change jobs, as long as you stayed with your company long enough for your benefits to vest.

Some people have both pensions and 401(k) plans, but there are other ways to take an active role in saving for retirement. An IRA is an alternative to 401(k) and pension plans that allows anyone to open a retirement savings account. IRAs have lower contribution limits but a larger selection of investments to choose from.

An online retirement account with SoFi Invest® puts you in the driver’s seat by helping you set your goals, diversify your portfolio, and get solid advice every step of the way. You can use the account to open an IRA and start investing in stocks, exchange-traded funds, and other types of investments.

Find out how SoFi Invest® can help with your personal retirement goals.

Photo credit: iStock/Sam Edwards



SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
Advisory services are offered through SoFi Wealth, LLC an SEC-registered Investment adviser. Information about SoFi Wealth’s advisory operations, services, and fees is set forth in SoFi Wealth’s current Form ADV Part 2 (Brochure), a copy of which is available upon request and at adviserinfo.sec.gov .

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When Can You Withdraw From Your 401(k)?

If you’re the kind of take-charge retirement planner who’s diligently contributing to a 401(k) fund, receiving matching contributions from your employer, and watching your savings start to stack, you might find yourself wondering “When can I withdraw from my 401(k) account?”

The answer depends on a number of factors including your age, whether you’re still working or already retired, if you qualify for a hardship withdrawal, whether it makes sense to take out a 401(k) loan, or rollover your 401(k) into another account.

What Are The Rules For Withdrawing From a 401(k)?

Because 401(k) accounts are retirement savings vehicles, there are restrictions on exactly when investors can withdraw 401(k) funds. Typically, account holders can withdraw money from their 401(k) without penalties when they reach the age of 59½. If they decide to take out funds before that age, they may face penalty fees for early withdrawal.

That being said, there are some circumstances in which people can reach into their 401(k) account before 59½. Each plan should have a description that clearly states if and when it allows for disbursements, hardship distributions, 401(k) loans, or the option to cash out the 401(k).

What Age Can You Withdraw From 401(k) Without Penalty?

The rules about the penalties for 401(k) withdrawals depend on your age, with younger workers generally facing higher penalties for withdrawals, especially if they’re not yet retired.

The IRS provision known as the “Rule of 55” allows account holders to withdraw from their 401(k) or 403(b) without any penalties if they’re 55 or older and leaving their job in the same calendar year.

In the case of public safety employees like firefighters and police officers, the age to withdraw penalty-free under the same provision is 50.

Under the Age of 55

When 401(k) account holders are under the age of 55 and still employed at the company that sponsors their plan, they have two options for withdrawing from their 401(k) without penalties:

1.   Taking out a 401(k) loan.

2.   Taking out a 401(k) hardship withdrawal.

If they’re no longer employed at the company, account holders can roll their funds into a new employer’s 401(k) plan or possibly an IRA.

Between Age 55–59 1/2

The Rule of 55, as previously mentioned, means that most 401(k) plans allow for penalty-free retirements starting at age 55, with the exception of public service officials who are eligible as early as 50. Still, there are a few rules to consider around this particular IRS provision:

1.   Account holders who retire the year before they turn 55 are subject to a 10% early withdrawal penalty tax.

2.   If account holders roll their 401(k) plans over into an IRA account, the provision no longer applies. A traditional IRA account holder cannot withdraw funds penalty-free until they are 59 ½.

3.   Once a 401(k) account holder reaches 59 ½, access to their funds depends on whether they are retired or still employed.

After Age 72

In addition to penalties for withdrawing funds too soon, you can also face penalties if you take money out of a retirement plan too late. After age 72, you must withdraw a certain amount, known as a “required minimum distribution (RMD),” every year, or face a penalty of up to 50% of that distribution.

Withdrawing 401(k) Funds When Already Retired

If a 401(k) plan holder is retired and still has funds in their 401(k) account, they can withdraw them penalty-free at age 59 ½. The same age rules apply to retirees who rolled their 401(k) funds into an IRA.

Withdrawing 401(k) Funds While Still Employed

If a 401(k) plan holder is still employed, they can access the funds from a 401(k) account with a previous employer once they turn 59 ½. However they may not have access to their 401(k) funds at the company where they currently work.

401(k) Hardship Withdrawals

Under certain circumstances, 401(k) plans allow for hardship withdrawals or early distributions. If a plan allows for this, the criteria for eligibility should appear in plan documents.

Hardship distributions are typically only offered penalty-free in the case of an “immediate and heavy financial need,” and the amount disbursed is not more than what’s necessary to meet that need. The IRS has designated certain situations that can qualify for hardship distributions, including:

•  Certain medical expenses

•  Purchasing a principal residence

•  Tuition and educational expenses

•  Preventing eviction or foreclosure on a primary residence

•  Funeral costs

•  Repair expenses for damage to a principal place of residence

The terms of the plan govern the specific amounts eligible for hardship distributions. In some cases, account holders who take hardship distributions may not be able to contribute to their 401(k) account for six months.

As far as penalties go, hardship distributions may be included in the account holder’s gross income at tax time, which could affect their tax bill. And if they’re not yet 59 ½, their distribution may be subject to an additional 10% tax penalty for early withdrawal.

Taking Out a 401(k) Loan

Some retirement plans allow participants to take loans directly from their 401(k) account. If the borrower fulfills the terms of the loan and pays the money back in the agreed upon timeframe (usually within five years), they do not have to pay additional taxes on it.

That said, the IRS caps the amount someone can borrow from an eligible plan at either $50,000, or half of the amount they have saved in their 401(k)—whichever is less. Also, borrowers will likely pay an interest rate that’s one or two points higher than the prime.

Coronavirus-related 401(k) Loans and Withdrawals

While the Coronavirus Aid, Relief, and Economic Security (CARES) Act offered special withdrawal allowances for 401(k) plan holders in 2020, most of the early withdrawal penalties have returned in 2021.

However, the CARES Act has expanded a relief provision into 2021 that allows 401(k) plan holders who meet qualified disaster requirements to borrow up to $100,000 from their 401(k) account (up from $50,000 in 2019) in a 401(k) loan and defer those loan payments for a year. In 2020, a third of Americans with retirement savings dipped into them during the crisis.

Additionally, the COVID-Related Tax Relief Act , passed in December 2020, allows 401(k) account holders to make relief withdrawals if they are taxpayers in a qualified disaster area and have suffered a financial loss due to that disaster.

Cashing Out a 401(k)

Cashing out an old 401(k) occurs when a participant liquidates their account. While it might sound appealing, particularly if a plan holder needs money right now, cashing out a 401(k) can have some drawbacks. If the plan holder is younger than 59½, the withdrawn funds will be subject to ordinary income taxes and an additional 10% penalty tax. That means that a significant portion of their 401(k) would go directly to the IRS.

Rolling Over a 401(k)

Instead of cashing out an old 401(k), account holders may choose to roll over their 401(k) into a different retirement account, like an IRA. In many cases, this strategy allows participants to continue saving for retirement, avoid unnecessary penalty fees, and reduce their total number of retirement accounts.

The Takeaway

Certain factors like age, employment status and hardship eligibility determine whether you can make a withdrawal from your 401(k). The CARES Act and other legislation provides some early 401(k) withdrawal relief and a little wiggle room for taxpayers in qualifying disaster areas.

In cases where plan participants do not meet age requirements for withdrawing 401(k) funds penalty-free, they can still take out a 401(k) loan, cash out a pre-existing 401(k) plan, or rollover their 401(k) into a different retirement account.

SoFi Invest® is a simple way to rollover your 401(k) into an IRA. You can take control of your retirement savings with SoFi’s active or automated Traditional, Roth, and SEP IRAs, plus you can access real human advisors who’ll help you every step of the way.

Ready to roll over that 401(k)? Learn more about retirement investing with SoFi.



SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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Pros & Cons of the F.I.R.E Movement

Most people dream of the day that they clock into work for the very last time.In most cases, we imagine that’ll be when we’re a little more gray around the ears, but what if you could take the freedom and independence of retirement and experience it, say, thirty years earlier?

That’s the basic principle of the Financial Independence Retire Early (F.I.R.E) movement, a community of young people who aim to live a lifestyle that allows them to retire in their 30s or 40s rather than their 60s and 70s.

While it may sound like the perfect life hack, attempting to live out this dream comes with some serious challenges. This article will review the basic tenets of the F.I.R.E. movement and talk about the tactics people use to achieve their goal of early retirement.

These pros and cons can help you determine whether any strategies from the FIRE movement are a fit for your lifestyle.

What Is the FIRE Movement?

F.I.R.E stands for “financial independence, retire early,” and it’s a movement wherein people attempt to gain enough wealth to retire far earlier than the traditional timeline would allow.

The movement traces its roots to a 1992 book called “Your Money or Your Life” by Vicki Robin and Joe Dominguez, and started to gain a lot of traction, particularly among millennials, in the 2010s.

In order to achieve retirement at such a young age, F.I.R.E proponents devote 50% to 75% of their income to savings. They also use dividend-paying investments in order to create passive income streams they can use to support themselves throughout their retired lives.

Of course, accumulating the amount of wealth needed to live for six decades or more without working is a considerable feat, and not everyone who attempts F.I.R.E. succeeds.

F.I.R.E. vs. Traditional Retirement

F.I.R.E. and traditional retirement both aim to help people figure out when they can retire, but they have major differences.

Retiring Early

Given the challenge of saving enough for retirement even by age 60 or 70, what kinds of lengths do the advocates of the F.I.R.E. movement go to?

Some early retirees blog about their experiences and offer tips to help others follow in their footsteps. For instance, Mr. Money Mustache is a prominent figure in the F.I.R.E. community, and advocates achieving financial freedom through, in his words, “badassity.”

His specific advice includes reshaping simple (but expensive) habits—like eliminating smoking cigarettes or drinking alcohol, and limiting dining out.

Of course, the basic premise of making financial freedom a reality is simple on its face: spend (much) less money than you make in order to accumulate a substantial balance of savings.

Investing those savings can potentially make the process more attainable by providing, in the best-case scenario, an ongoing passive income stream. However, many people who achieve F.I.R.E. are able to do so in part because of generational wealth or special circumstances that aren’t guaranteed.

For instance, Mr. Money Mustache and his wife both studied engineering and computer science and had “standard tech-industry cubicle jobs,” which tend to pay pretty well—and require educational and professional opportunities not all people can access.

In almost all cases, pursuing retirement with the F.I.R.E. movement requires a lifestyle that could best be described as basic, foregoing common social and leisure expenses like restaurant dining and travel.

Traditional Retirement

Most working people expect to retire sometime around the age of 65 or so, which is also when traditional retirement accounts and benefits start to kick in. For those born after 1960, Social Security benefits can begin at age 62, but at a significantly lesser amount than if they wait to reach 67, their full retirement age, to file.

They typically save much of their retirement funds in specialized, tax-incentivized retirement accounts, like 401(k)s and traditional IRAs, which carry age-related restrictions that have a de facto impact on most folks’ retirement age. For example, 401(k)s generally can’t be accessed before age 59 ½ without incurring a penalty.

Even a traditional retirement timeline can be difficult for many savers. Recent data from the Federal Reserve shows that approximately a quarter of Americans have no retirement savings whatsoever.

Still, nearly 40% of Americans want to retire before they reach age 55, according to a survey from Hearts & Wallets. Online calculators and budgeting tools can help you determine when you can retire—and are customizable to your exact retirement goals and specifications.

Recommended: How Much Should You Have Saved for Retirement by 40?

Financial Independence Retire Early: Pros and Cons

Although financial independence and early retirement are undoubtedly appealing, getting there isn’t all sunshine and rainbows. There are both strong benefits and drawbacks to this financial approach that investors should weigh before undertaking the F.I.R.E. strategy.

Pros of the F.I.R.E. Approach

Benefits of the F.I.R.E. lifestyle include:

•  Having more flexibility with your time. Those who retire at 35 or 40, as opposed to 65 or 70, have more of their lifetime to spend pursuing and enjoying the activities they choose.

•  Building a meaningful, passion-filled life. Retiring early can be immensely freeing, allowing someone to shirk the so-called golden handcuffs of a job or career. When earning money isn’t the primary energy expenditure, more opportunities to follow one’s true calling can be taken.

•  Learning to live below one’s means. “Lifestyle inflation” can be a problem among many working-age people who find themselves spending more money as they earn more income. The savings strategies necessary to achieve early retirement and financial independence require its advocates to learn to live frugally, which can help them save more money in the long run—even if they don’t end up actually retiring early.

•   Less stress. According to a study by the American Psychological Association , money is one of the leading stressors for nearly two-thirds of Americans. Gaining enough wealth to live comfortably without working could wipe out a major cause of stress, which could lead to a more enjoyable, and healthier, life.

Cons of the F.I.R.E. Approach

Drawbacks of the F.I.R.E. lifestyle include:

•  Unpredictability of the future. Although many people seeking early retirement thoroughly map out their financial plans, the future is unpredictable. Social programs and tax structures, which may figure into future budgeting, can change unexpectedly, and life can also throw wrenches into the plan. For instance, a major illness or an unexpected child could wreak havoc on even the best-laid plans for financial independence.

•  Some find retirement boring. While never having to go to work again might sound heavenly to those on the job, some people who do achieve financial independence and early retirement struggle with filling their free time. Without a career or specific non-career goals, the years without work can feel unsatisfying.

•  Fewer professional opportunities. If someone achieves F.I.R.E. and then discovers it’s not right for them—or must re-enter the workforce due to an extenuating circumstance—they may find reintegration challenging. Without a history of continuous job experience, one’s skill set may not match the needs of the economy, and job searching, even in the best of circumstances, may be difficult.

•  F.I.R.E. is hard! Even the most dedicated advocates of the financial independence and early retirement approach acknowledge that the lifestyle can be difficult—both in the extreme savings strategies necessary to achieve it and in the ways it changes day-to-day life. For instance, extroverts might find it difficult to forgo social activities like eating out or traveling with friends. Others may find it challenging to create a sense of personal identity that doesn’t revolve around a career.

Investing for F.I.R.E.

Investing allows F.I.R.E. advocates—and others—to earn income in two important ways: dividends and market appreciation.

Dividends

Shareholders earn dividend income when companies have excess profits. They’re generally offered on a quarterly basis, and all one has to do to earn them is simply hold shares of a stock.

However, because dividend payments depend on company performance, they’re not guaranteed, those relying on them to live should have other income sources (including substantial savings accounts) as a back up income stream.

Market Appreciation

Investors can also earn profits through market appreciation when they sell stocks and other assets for a higher price than what they initially paid for them.

Even for those who seek retirement at a traditional pace, stock investing is a common strategy to create the kind of compound growth over time that can build a substantial nest egg. There are many accounts built specifically for retirement investing, such as 401(k)s, IRAs, and 403(b)s.

However, these accounts carry age-related restrictions and contribution limits which means that those interested in pursuing retirement on a F.I.R.E. timeline will need to explore additional types of accounts and saving and investing options.

For example, brokerage accounts allow investors to access their funds at any point—and to customize the way they allocate their assets to maximize growth.

The Takeaway

Whether you’re hoping to retire in a traditional fashion, shorten your retirement timeline, or are just looking to increase your wealth to achieve shorter-term financial goals, like buying a new car—investing can be one of the most effective ways to reach your objectives.

A great way to get started is by opening an account on the SoFi Invest® brokerage platform. SoFi Invest allows members to learn the ropes as they go, joining a community of other people interested in finance who are doing the exact same thing—and who are invited to gather at exclusive events and educational experiences.


SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Typical Retirement Expenses to Prepare For

Sleeping in until noon. Spoiling the grandkids with gifts and freshly baked cookies. Traveling around Western Europe to sip wine and eat croissants. Many people dream about how their retirement years will play out. These goals are 100% attainable—as long as retirees have saved enough during their working years.

Unfortunately, not all Americans know what to expect when it comes to cost of living during their retirement years, and they may not know how to budget for typical expenses in retirement like housing and transportation. It can be difficult to transition from a saving mindset to spending, once you’ve stopped working.

Here’s a look at typical retirement expenses so individuals can get a handle on how much they’re likely to spend, how much they need to save for retirement, and figure out when they can retire.

Average Retirement Expenses

Americans aged 65 and older spend an average of $48,106 per year, or $4,008.83 per month, according to the Bureau of Labor Statistics. More specifically, those aged 65 to 74 spend $52,928 annually, while spending drops for people aged 75 and older spend to $41,471 annually.

Retirees typically spend less than the American average, which is $61,749 per year, or $5,145.75 per month. Retirees even tend to spend less than people nearing retirement aged 55 to 64, who spend $66,139. The typical budget for a retirement couple needs to cover that amount every year for a retirement that could stretch over two or three decades.

Recommended: Average Retirement Savings by Age

Drilling down to specific categories can help retirement savers determine benchmarks for their own budget.

Housing and Living Expenses

Housing and living expenses, such mortgage payments, insurance, and maintenance costs, are typically among the highest costs retirees will face.

In 2021, Americans aged 65 and older spent an average of $4,847 annually on housing-related costs, including property tax, maintenance, repairs, insurance and other expenses. On average, utilities, fuel and public services cost an additional $3,743, and miscellaneous costs related to household operations were another $1,219. Renters spent an average of $2,471 per year on their dwellings.

These expenses can vary dramatically by location and housing type. For example, housing costs are typically much higher in a coastal California community than in a cooler real estate market in a state with relatively low property taxes, such as Wyoming, South Carolina, or Colorado.

Transportation

Many retirees want an action-packed retirement full of entertainment, socializing, visiting family and traveling the country. That means that transportation costs can be a major factor in retirement expenses, especially early in retirement.

Americans spend an average of $10,160 per year getting from point A to point B, but retirees spend a little less. Those over age 65 spend an average of $6,618 annually on transportation, or $551.50 per month. People aged 65 to 74 spend $7,851 per year, and people 75 and older spend $4,963 per year. These numbers cover everything from buying a car to filling up the gas tank to purchasing a bus pass, and could be significantly higher for those who spend a lot of time traveling.

Retirees who don’t own a car may still need to factor the cost of public transportation into their annual retirement costs. Buses, taxis, and trains cost older generations an average of $441 per year.

Healthcare

Americans’ healthcare costs—including health insurance, medical services, medical supplies, and prescription drugs—increase as they grow older. With age comes aching joints, injuries from falling, and sometimes chronic diseases like arthritis, diabetes, or Alzheimer’s. On average, Americans spend $5,204 on healthcare per year, but this is one area where retirees spend more than their younger peers.

People over age 65 spend an average of $6,719 per year, or $559.91 per month, on healthcare. Those aged 65 to 74 pay $6,792, and people aged 75 and older spend slightly less—$6,619.

Costs vary from person to person depending on their genetics, injuries, and lifestyle choices. For example, if heart disease runs in the family or you are a smoker, you may want to save extra for retirement healthcare costs.

If you have a high deductible health insurance plan, consider saving with a health-savings account (HSA), which offers tax-advantaged savings to specifically cover healthcare costs.

Food

People over age 65 spend $6,303 annually, or $525.25 monthly, buying food. Those aged 65 to 74 spend $6,992 per year, and those over 75 spend $5,294. This includes both food at home and at restaurants and fast food chains.

An individual’s food costs will vary depending on their diet and habits. For example, people who buy organic vegetables will likely spend more on produce than people who don’t. There’s also a good chance that eating at home more frequently will cost less than eating out five times per week.

Entertainment

Having fun isn’t just for the young. People over 65 spend an average of $2,282 annually on entertainment, or $191.16 monthly, on fees and admissions to places like museums, theater performances and movies. Entertainment expenses also include hobbies and food and toys for pets.

People aged 65 to 74 spend $2,556 per year. Once they hit age 75, however, the amount they spend on entertainment drops to $1,889, perhaps as mobility decreases.

4 Steps to Set Up a Retirement Budget

Once you’ve got an idea of what your retirement expenses will look like, you can start to save and budget for them in a comprehensive way. Since every retirement looks different, there is no average retirement budget, but these are the steps to create a budget that works for you.

Here are some easy steps to take to get a head start on your retirement budget, so that you know how much you need to save.

Step 1: Make a List of Expected Monthly Expenses

Most expenses can fit into one of three categories: fixed, variable, and one-time. Fixed expenses are things like mortgage/rent, property taxes, and your car payment.

Others, like some utility bills, might be variable, changing from month to month. Likewise any meals and entertainment expenses, medical expenses, pet care and personal care expenses may be variable.

One-time or non-recurring expenses are costs that don’t occur regularly. These might include a new roof, a vacation, or a wedding. You may want to set some money aside for unexpected emergencies (like that new roof), and have other funds earmarked for non-essential, one-time expenses (like a wedding or vacation).

Gather this information from bank statements, credit card statements, receipts and bills. Take a look at what you spend now, then deduct expenses you won’t have at retirement (perhaps you’ll eliminate a car payment or pay off your mortgage by then). Tally what’s left to get an estimate of your projected expenses and create a line-item budget.

Step 2: Estimate Retirement Income

Take a look at projected monthly withdrawals from Social Security, retirement accounts, pensions, real estate investments (like a rental property), and any savings or part-time income. Total them up to figure out what your monthly income will be.

Step 3: Compare Expected Expenses to Expected Income

In an ideal world, your expected income will be a larger number than your expected expenses. There are two ways to reconcile expected retirement expenses with expected retirement income: Either reduce expenses, or increase income.

Is downsizing a possibility? What about going from two cars to one? Perhaps streamlining entertainment expenses? On the other hand, increasing the amount you save can be helpful in bringing anticipated retirement costs and retirement income into balance. Or ,you may consider taking on a part-time job when you retire to increase your monthly income.

Step 4: Contribute to a Retirement Account

You may already have retirement savings in your company-sponsored 401k plan or a similar retirement plan. But those who don’t have access to one, or want to increase their savings can also save in an individual retirement account like a Traditional IRA or Roth IRA.

The earlier you start saving, the better, so you can take advantage of the power of compound interest, the returns you earn on your returns. Let’s say you make an initial investment of $1,000 into your IRA and add an additional $100 each month for a year. At the end of the year, you’d have $2,200, right?

Not so fast. You may have contributed only $2,200 to your IRA, but if your account earns an average rate of 8% compounded annually, you have actually saved $2,280.

Compounding interest grows exponentially. After five years you’ve contributed $7,000 to your account, but saved $8,509.25. After a decade, you’ve contributed $13,000 but saved $19.452.80.

Step 5: Figure Out When You Can Retire

Once you know how much you need, and how long you’ll need to save to get there, you can make a plan for a realistic timeline for when you can actually retire. Keep in mind that the plan will likely change over time as you get closer to retirement, depending on how much you’re able to save and how your retirement goals change.

The Takeaway

Budgeting for retirement can feel overwhelming, but taking it step by step allows you to create a plan for a retirement you’ll enjoy.

Ready to start saving to cover your retirement expenses? Consider an investment account on the SoFi Invest® Brokerage Platform. Investors can buy stocks, exchange-traded funds, cryptocurrency, and even fractional shares. SoFi members also have access to SoFi Financial Planners who can provide personalized insights and financial advice so members can make the most of their retirement savings.

Learn more about how SoFi Invest can help you save for retirement.


SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Third Party Brand Mentions: No brands or products mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third party trademarks referenced herein are property of their respective owners.

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How the 4% Retirement Rule Works

After decades of saving for retirement, many new retirees often find themselves facing a new challenge: Determining how much money they can take out of their retirement account each year, without running the risk of depleting their nest egg too quickly.

One rule of thumb used by some professionals is “the 4% rule.”

What Is the 4% Retirement Rule?

This “rule” suggests that retirees start by withdrawing 4% from their overall nest egg, and adjust that dollar amount each year based on inflation.

Because the withdrawals would at least partly consist of dividends and interest that continue to accrue, the entire amount withdrawn each year would not totally come out of the principal balance.

This post will explore this rule in more depth, including how it originated, misconceptions some people have about the rule, the potential risks associated with it, and whether it’s still a viable strategy today.

Origination of the 4% Rule

Many people think that the 4% rule ensures that a retiree won’t run out of money in their retirement, but Bengen came up with the 4% in rule in 1994, based on an analysis of investment data going back to 1926. Bengen used this historical data to determine the maximum safe withdrawal amount that a retiree could sustainably take out for each rolling 30-year time frame.

Because this withdrawal percentage reflects what has happened in the past, this may or may not accurately predict what will happen now and in the future.

Also, in 2005, Bergen revisited his calculations and expanded his sample portfolio to include small cap stocks. He found that with this additional asset class, he could increase the annual withdrawal amount, so it is now also referred to as the 4.5% rule.

Common 4% Rule Misconceptions

Many mistakenly believe that Bengen’s rule will ensure that a nest egg last all the way through retirement, but Bengen’s calculations, he was not determining a percentage that would help to ensure that someone’s retirement savings would last a lifetime. Instead, he was calculating what withdrawal level would result in retirement funds lasting a minimum of 30 years.

Another common misconception focuses on how to calculate the 4%, with some people believing that the percentage should be calculated each year at the current principal balance. In Bengen’s formula, it should only be calculated once, based on the principal balance of the retirement funds when the person first retires.

So, if the balance was $500,000 at the point of retirement, then the maximum annual withdrawals would be $20,000. If the starting balance was $1 million, then it would be $40,000, and so forth.

Here are two more things to consider: Bengen used sample portfolios that contained 50% stocks and 50% bonds.

Portfolios with different investments of varying percentages would likely have different results, depending on that portfolio’s risk level.

And, because success in this theory is defined as having money left over after 30 years—meaning, any money whatsoever—Bengen’s definition of success may not align with that of a typical retiree. For example, if, after 30 years, a retiree had $10 left in a retirement fund, then the 4% (or 4.5%) rule would be considered a success. Would a retiree who might live five years longer (or more!), without any more money to withdraw, consider this a successful management of funds?

Risks of the 4% Rule

One challenge associated with this rule, as noted above, is that it only addresses 30 years’ worth of time. So, if someone’s life expectancy goes beyond 30 years post-retirement they could find themselves out of money.

Other challenges can exist for retirees who have chosen investments that have higher risks than average ones. In that case, they may need to take a more conservative withdrawal approach, particularly in the years immediately following their retirement because a market downturn could have a bigger impact on the value of those portfolios.

If retirees take a larger withdrawal, especially early on, this lowers the principal in a way that will affect compound interest throughout retirement years. If this happens, then the retiree can’t simply pick up with the 4% rule from that point on. On the other hand, if a retiree spends much less in a given year, the rule doesn’t adjust for that either.

Is the 4% Rule Too Conservative?

Some financial professionals believe that the 4% rule is too conservative, assuming that the United States doesn’t experience a significant economic depression. Because of that, retirees may be too frugal with their retirement funds and not necessarily live life as fully as they could.

Others say, this rule doesn’t take into account any other sources of income retirees may have, such as Social Security, company pensions, or an inheritance.

So, what’s the right withdrawal strategy to take? It depends. The most appropriate withdrawal strategy for any individual will depend on their unique goals and financial picture.

Starting to Invest for Retirement

It’s never too early to start investing for retirement. This can be challenging for young professionals with other financial goals, including things like paying down student loans or saving up for a house downpayment.

Recommended: How Much Should I Have Saved by 30?

But, starting sooner rather than later can make a huge difference in accumulating savings, perhaps hundreds of thousands of dollars of a difference. And whether you follow the 4% rule or not, the more you have saved for retirement, the more you’ll be able to spend in those years.

To get yourself on track for retirement, consider putting your retirement savings in these accounts:

401(k) or other forms of workplace retirement plans

With a workplace plan, employees typically contribute part of a paycheck, using pre-tax dollars, up to $19,500 per year into their retirement account. Those age 50 and older can contribute an additional $6,500. Companies sometimes offer a “match,” which means that the employee’s contribution gets matched up to a certain percent by the employer. This account is tax deferred, meaning no taxes are paid on the funds until they are withdrawn. However, withdrawing these funds early—generally before age 59 ½,—could trigger an additional 10% early distribution tax.

SEP IRA, SIMPLE IRA or Solo 401(k)

These are retirement plan options for people who are self-employed.

Traditional IRA (individual retirement account)

This is a tax-deferred retirement account, one that’s not tied to the workplace. So, this is also an option used by freelancers and other self-employed people, as well as people who don’t have 401(k) accounts at work. Contribution limits for an IRA for people under age 50 are capped at $6,000 annually; those who are 50 or older can contribute up to $7,000 each year. This account also has a 10% tax penalty for early withdrawal.

Roth IRA

This is another form of retirement account that’s not connected to the workplace, and contribution limits are $6,000 annually. The taxation system for a Roth IRA, however, is different, with income taxes paid in advance on contributed money. But, when retirees withdraw funds, the money is not taxed. Not everyone qualifies for a Roth IRA (there are income limits) but it can be an option for those who are employed by a company as well as those who are self-employed.

Ways to Save for Retirement

If it seems challenging to save for retirement, given your other expenses, a good first step is to create a budget that works for your income and expenses, and includes contributions to a retirement account.

This should be a reasonable budget—meaning that it’s realistic, one that can be adhered to. It makes sense to review this budget regularly, perhaps every few months, and adjust as needed.

In situations where employers offer a 401(k) plan with a contribution match, then it can be a wise move to participate in this program. Matches, remember, are essentially free cash.

Also, consider which expenses you can cut back to make room for higher contributions. Are there online subscriptions or fee-based apps you can cancel? Can you get a better deal on your cell phone plan? Insurance policies?

Can you consolidate your credit cards into a lower-rate personal loan? Once you’ve paid off your credit card balance or personal loan, consider putting the money from those bills into the retirement account?

What about getting a side gig? You can use special skills, such as photography, copyediting, or cooking, to earn extra money that can go toward additional retirement contributions.

The Takeaway

At its core, the 4% rule represents a percentage that retirees are able to withdraw from their savings annually and have them last a minimum of 30 years. For example, someone following this rule could withdraw $20,000 a year from a $500,000 retirement account balance.

However, different people have different dreams for retirement. Some want to travel the world, while others want to spend time with family at home. Some may have other financial responsibilities, like helping a grandchild pay for college. What matters most is that each person plans for the retirement they want to experience.

Given those variations, 4% makes more sense as a guideline than as a hard-and-fast rule for retirees. Having as much flexibility as possible in planning for withdrawals, means saving as much as possible first. A starting place for many people is their workplace 401(k), but that’s not the only place you can save for retirement. Those who don’t have access to a workplace retirement account can save in an IRA or a plan for the self-employed.

You can start an IRA–or a taxable account–by opening an account on the SoFi Invest® brokerage platform. Use it to build a portfolio including stocks, exchange-traded funds, and even cryptocurrency. You can take a hands-on approach with Active Investing, or a hands-off one with Automated Investing. Plus, fractional shares allow you to start fractional share investing. You can select your favorite companies and invest in them, without needing to commit to buying a whole share.

Interested in investing in your retirement? SoFi offers many options, all with no trading fees.


SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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