“The best time to start thinking about your retirement is before the boss does.” – Author Unknown
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Life is very unpredictable. No one knows when health will fail, jobs will be lost, or unexpected circumstances occur. One of the greatest benefits afforded workers is the ability to build retirement funds in a tax-efficient manner through the use of tax-deferred retirement plans.
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The early initiation of a retirement plan is a great wealth builder for workers who start as soon as possible after beginning a working career.
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How Could this be a Hard Decision for Young Workers?
Money placed in a tax-advantaged retirement plan is tax-deferred, the investing time horizon is longest at an early age, and current taxable income is reduced by the same amount of money invested. But, Present You has to give up present spending to save for a Future You that won’t appear for many years (see: HAVING A “PLAN”.) This is a problem for young workers that feel they need every dollar for current spending, saving for a home, travel, or any current need or desire.
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What are the Benefits of a Tax-advantaged Retirement Plan?
- Funds can grow quickly, as both principal and earnings are sheltered from taxation until funds are distributed.
- Dollars invested in qualified retirement plans reduce current taxable income (except for Roth accounts which are funded with after-tax dollars.)
- Most employer-sponsored plans are administered by the employer, and in many cases, the employer matches some percentage of contributions. Most plans are easy to join, relatively easy to navigate, and have simple contribution setup.
- Many employer-sponsored plans provide for auto-enrollment and automatic drafting of funds into the plan.
- Because contributions are protected by the Employee Retirement Income Security Act (ERISA), they are protected from personal litigation and judgments.
- Workers are allowed to join early, which allows for the greatest effect of compounding (see: INVESTMENTS AND COMPOUND INTEREST.)
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The Two General Types of Retirement Plans
The US Department of Labor states:
The Employee Retirement Income Security Act (ERISA) covers two types of retirement plans: defined benefit plans and defined contribution plans.
A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service – for example, 1 percent of the average salary for the last 5 years of employment for every year of service with an employer. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).
A defined contribution plan, on the other hand, does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee’s individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually. These contributions generally are invested on the employee’s behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.
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Different Retirement Plans
*Defined benefit plans– according to Bankrate.com:
Traditional pensions are a type of defined benefit (DB) plan, and they are one of the easiest to manage because so little is required of you as an employee. Pensions are fully funded by employers and provide a fixed monthly benefit to workers at retirement. But DB plans are on the endangered species list because fewer companies are offering them. Just 14 percent of Fortune 500 companies enticed new workers with pension plans in 2019, down from 59 percent in 1998, according to data from Willis Towers Watson. DB plans require the employer to make good on an expensive promise to fund a hefty sum for your retirement. Pensions, which are payable for life, usually replace a percentage of your pay based on your tenure and salary. A common formula is 1.5 percent of final average compensation multiplied by years of service, according to Littell. A worker with an average pay of $50,000 over a 25-year career, for example, would receive an annual pension payout of $18,750, or $1,562.50 a month.
Pros: This benefit addresses longevity risk – or the risk of running out of money before you die. “If you understand that your company is providing a replacement of 30 percent to 40 percent of your pay for the rest of your life, plus you’re getting 40 percent from Social Security, this provides a strong baseline of financial security,” says Littell. “Additional savings can help but are not as central to your retirement security.”
Cons: Since the formula is generally tied to years of service and compensation, the benefit grows more rapidly at the end of your career. “If you were to change jobs or if the company were to terminate the plan before you hit retirement age, you can get a lot less than the benefit you originally expected,” says Littell. What it means to you: Since company pensions are increasingly rare and valuable if you are fortunate enough to have one, leaving the company can be a major decision. Should you stay or should you go? It depends on the financial strength of your employer, how long you’ve been with the company and how close you are to retiring. You can also factor in your job satisfaction and whether there are better employment opportunities elsewhere.
*Defined contribution plans– (Information provided by dol.gov and irs.gov)
- A Profit Sharing Plan or Stock Bonus Plan is a defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution. A profit-sharing plan or stock bonus plan may include a 401(k) plan.
- A 401(k) Plan is a defined contribution plan that is a cash or deferred arrangement. Employees can elect to defer receiving a portion of their salary which is instead contributed on their behalf, before taxes, to the 401(k) plan. Sometimes the employer may match these contributions. There is a dollar limit on the amount an employee may elect to defer each year. An employer must advise employees of any limits that may apply. Employees who participate in 401(k) plans assume responsibility for their retirement income by contributing part of their salary and, in many instances, by directing their investments.
- An Employee Stock Ownership Plan (ESOP) is a form of defined contribution plan in which the investments are primarily in employer stock.
- A Cash Balance Plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance. In a typical cash balance plan, a participant’s account is credited each year with a “pay credit” (such as 5 percent of compensation from his or her employer) and an “interest credit” (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer. When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).
- Government Sponsored Retirement Plans– includes 401(a) government retirement plan, 403(b) tax-sheltered annuity plans, 457 deferred compensation plans, and certain grandfathered 401(k) plans adopted by a governmental entity before May 6, 1986.
- Individual Retirement Arrangements (IRAs)– A traditional IRA is a tax-advantaged personal savings plan where contributions may be tax deductible. A Roth IRA is a tax-advantaged personal savings plan where contributions are not deductible but qualified distributions may be tax-free. A Payroll Deduction IRA plan is set up by an employer. Employees make contributions by payroll deduction to an IRA (Traditional or a Roth IRA) they establish with a financial institution. A SEP is a Simplified Employee Pension plan set up by an employer. Contributions are made by the employer directly to an IRA set up for each employee. A SIMPLE IRA plan is a Savings Incentive Match Plan for Employees set up by an employer. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions, and the employer makes matching or nonelective contributions. A SARSEP – the Salary Reduction Simplified Employee Pension Plan – is a type of SEP set up by an employer before 1997 that includes a salary reduction arrangement.
- Simple 401(k) plan– A subset of the 401(k) plan is the SIMPLE 401(k) plan. Just like the SIMPLE IRA plan, this is a plan just for you: the small business owner with 100 or fewer employees. However, just as with the SIMPLE IRA plan, there is a two-year grace period if you exceed 100 employees, to allow for growing businesses.
All of the above retirement plans are very effective for building retirement funds. Because there is no tax drag on contributions or earnings before distribution both principal and earnings are compounded over time.
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What about RMDs and Taxable Distributions?
Similar to young workers, Retirement Plans can present problems for older workers who have faithfully contributed and are approaching retirement. For workers approaching retirement, proper tax planning is essential. At some point funds in tax-deferred retirement accounts are distributed. In most cases, when this occurs tax-advantaged distributions are treated as ordinary income and are taxed at ordinary income tax rates.
Currently, mandatory RMDs (Required minimum distribution) begin at age 72. This can present a tax dilemma for those unprepared for increasing taxable income, increasing taxes, and increased IRMAA (Income Related Monthly Adjustment Amount) surcharges added to Medicare premiums.
There are multiple strategies to mediate these problems. It is important to understand that the time to plan and address these strategies is well before RMDs begin. Increasing RMDs, along with claiming Social Security benefits, can create a scenario where the majority of Social Security benefits are exposed to taxation. This is termed the “Tax Torpedo” because it can damage or destroy tax planning for the unprepared. Many people approaching RMDs suddenly realize that they will become locked into ever-increasing RMDs, increasing tax exposure, and the “Tax Torpedo.” Advanced tax planning is critical at this stage to help avoid unnecessary tax exposure.
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Final Thoughts
- One of the greatest benefits afforded workers are tax-deferred retirement plans.
- Money placed in a tax-advantaged retirement plan is tax-deferred, the investing time horizon is longest at an early age, and current taxable income is reduced by the same amount of money invested.
- For a retirement plan to work best, young workers must forgo current dollars to invest for their future retirement.
- Funds invested in Retirement Plans can grow quickly, as both principal and earnings are sheltered from taxation until funds are distributed.
- Most current retirement plans are Defined Contribution Plans which don’t promise a specific amount of benefits at retirement.
- There are many variations of each type of Retirement Plan, and it’s incumbent on workers to understand their individual plan’s terms and conditions.
- Funds in tax-deferred retirement accounts are eventually distributed. Workers approaching retirement need proper tax planning.
- Multiple strategies exist to mediate RMD-related problems. It is important to understand that the time to plan and address these strategies is well before RMDs begin.
- Retirement Plans facilitate a successful, well-funded retirement if contributions are started early and proper tax planning is implemented before distributions to mediate taxes in retirement.
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