What Are the Three Legs of the Three-Legged Stool?

The “three-legged stool” serves as a widely recognized metaphor in retirement income planning. It illustrates the importance of diverse income sources for financial stability in retirement. Relying on a single source can lead to an unstable financial future, much like a stool lacking sufficient support. A balanced approach, encompassing multiple components, creates a more secure financial foundation for later years.

Social Security as a Foundation

Social Security is a federal social insurance program, providing foundational financial support during retirement. Its primary purpose extends beyond just retirement income, also offering disability benefits and survivor benefits to eligible individuals and their families. This program is funded primarily through dedicated payroll taxes, known as Federal Insurance Contributions Act (FICA) taxes or Self-Employed Contributions Act (SECA) taxes.

For most employed individuals, both the employee and employer each contribute 6.2% of wages up to an annually adjusted taxable maximum for Social Security, and an additional 1.45% for Medicare, with the self-employed paying both portions. These collected payroll taxes are entrusted to the Old-Age and Survivors Insurance (OASI) and Disability Insurance (DI) Trust Funds. Social Security is designed to provide a basic level of income, often supplementing other retirement savings rather than fully replacing pre-retirement earnings.

Benefit calculations are based on an individual’s earnings history, their Average Indexed Monthly Earnings (AIME) over their 35 highest-earning years. The Social Security Administration (SSA) indexes past earnings to account for changes in the cost of living, ensuring that benefits reflect the actual value of past contributions. While Social Security provides a reliable income stream, it is not sufficient to maintain one’s pre-retirement lifestyle.

Employer-Sponsored Retirement Plans

Employer-sponsored retirement plans are the second leg of the retirement stool, offering various vehicles for employees to save for their future. These plans generally fall into two main categories: defined benefit plans and defined contribution plans. Defined benefit plans, often referred to as pensions, promise a specified monthly income in retirement. The benefit amount is determined by a formula considering an employee’s salary and years of service.

In a defined benefit plan, the employer bears the investment risk, responsible for ensuring promised benefits are paid, regardless of market performance. Conversely, defined contribution plans, such as 401(k)s, 403(b)s, and 457 plans, involve contributions from employees and sometimes employers into individual investment accounts. For these plans, the retirement income an individual receives depends on the total accumulated balance, which is influenced by the amount contributed and the investment performance of the account.

Common examples include 401(k) plans, widely available in the private sector, where employees can defer a portion of their salary on a pre-tax basis, and employers may offer matching contributions. 403(b) plans are offered to employees of public schools, certain charitable 501(c)(3) tax-exempt organizations, and religious organizations. 457 plans are available for governmental and certain non-governmental tax-exempt employers, functioning similarly to 401(k)s or 403(b)s. Contributions to these plans grow on a tax-deferred basis, with taxes typically paid upon withdrawal in retirement.

Personal Savings and Investments

The third leg of the retirement stool consists of personal savings and investments, funds individuals save and invest independently, outside of Social Security or employer-sponsored plans. This component provides individuals with greater flexibility and direct control over their retirement funds. Common vehicles for personal retirement savings include Individual Retirement Accounts (IRAs), which come in various forms such as Traditional and Roth IRAs.

With a Traditional IRA, contributions are tax-deductible, and earnings grow tax-deferred until withdrawals in retirement, which are then taxed as ordinary income. Conversely, Roth IRA contributions are made with after-tax dollars; they are not tax-deductible, but qualified withdrawals in retirement are entirely tax-free. The choice between these IRA types depends on an individual’s current tax bracket versus their anticipated tax bracket in retirement.

Beyond IRAs, individuals can utilize standard brokerage accounts to invest in a range of assets, including mutual funds, exchange-traded funds (ETFs), stocks, and bonds. While these accounts do not offer the tax advantages of retirement accounts like IRAs or 401(k)s, they provide liquidity and diversification options. The income generated from personal savings and investments depends on the amounts contributed, the chosen investment vehicles, and their performance over time.