What Is the Three-Legged Stool for Retirement? Meaning and Overview
Explore the balanced approach to retirement planning with the three-legged stool: Social Security, employer plans, and personal savings.
Retirement planning is a critical element of financial well-being, and the “three-legged stool” model illustrates the primary sources of retirement income: Social Security, employer-sponsored plans, and personal savings and investments. Each leg contributes to financial stability in retirement, and relying on just one or two may not suffice to maintain a desired standard of living. Balancing these components effectively is essential for a secure retirement.
Social Security
Social Security is a cornerstone of retirement income, offering a government-backed safety net. Established in 1935, the program provides monthly benefits based on an individual’s earnings history and the age benefits are claimed. Funded through payroll taxes, the system operates on a pay-as-you-go basis, with current workers supporting retirees. As of 2024, the Social Security tax rate is 6.2% for employees and employers, up to a wage base limit of $160,200.
The age at which benefits are claimed significantly affects the amount received. While the full retirement age (FRA) is 67 for those born in 1960 or later, benefits can begin at age 62 at a reduced rate. Delaying benefits past the FRA increases payouts by up to 8% annually until age 70. This decision depends on factors such as life expectancy, financial needs, and other income sources.
Employer-Sponsored Plans
Employer-sponsored plans are the second pillar of retirement income, helping employees build savings through structured programs. These plans are divided into defined benefit plans and defined contribution plans, each with unique advantages and responsibilities.
Defined Benefit Plans
Defined benefit plans, or traditional pensions, guarantee a specific monthly benefit upon retirement, calculated using factors like salary history and years of service. Governed by the Employee Retirement Income Security Act of 1974 (ERISA), these plans set minimum standards to protect participants. Employers bear the investment risk and must ensure plans are adequately funded. The Pension Benefit Guaranty Corporation (PBGC) insures benefits up to certain limits if a plan becomes insolvent. In 2023, the maximum guaranteed benefit for a 65-year-old retiree in a single-employer plan is $6,750 per month. While predictable, these plans are becoming less common as employers shift to defined contribution plans to reduce liabilities.
Defined Contribution Plans
Defined contribution plans, such as 401(k) and 403(b) plans, have become more prevalent due to their flexibility and shared responsibility. Employees contribute a portion of their salary, often with employer matches, up to certain limits. For 2024, the 401(k) contribution limit is $23,000, with an additional $7,500 catch-up contribution for those aged 50 and older. Retirement income from these plans depends on the performance of investments chosen by participants, making active management crucial. Contributions are made pre-tax, reducing taxable income, but withdrawals are taxed as ordinary income. Early withdrawals before age 59½ may incur a 10% penalty, underscoring the need for careful planning.
Personal Savings and Investments
Personal savings and investments represent the third leg of retirement planning, allowing individuals to customize their financial strategies based on their goals and risk tolerance. This category includes individual retirement accounts (IRAs), Roth IRAs, brokerage accounts, and real estate investments, each with specific tax implications, risks, and returns.
The choice between traditional and Roth IRAs depends on anticipated tax scenarios. Traditional IRAs offer tax-deferred growth, with contributions potentially deductible under IRS rules, while Roth IRAs provide tax-free withdrawals in retirement if conditions are met. For 2024, the contribution limit for both IRA types is $7,000, with a $1,000 catch-up contribution for those aged 50 and older. This decision requires careful consideration of current income, expected retirement tax bracket, and possible legislative changes.
Beyond IRAs, brokerage accounts offer access to a wide range of investments, including stocks, bonds, and mutual funds, which can be tailored to growth, income, or balanced strategies. Real estate investments can also provide rental income and potential appreciation but require due diligence, understanding of market conditions, and awareness of liquidity challenges.