Top 10 Terms You Should Know About Retirement Plans & Accounts, Part 1

Retirement Plans & Accounts, Part 1

Retirement is something that seems to be on everyone’s mind, at least to some degree.  And if it isn’t, it should be because all of us will be retiring at some point in the future and we need to be financially prepared.  Whether you want to become financially independent and retire early, or if you are planning for a more traditional retirement in your later years, there are a whole host of financial issues that need to be addressed.  I get more questions about retirement planning and investing in retirement accounts than probably anything else.  What is the best way to save for retirement?  What percentage of my income should I be saving?  How much do I need to save for retirement?  What accounts should I be investing in?  Is it better to save in my 401(k) or a Roth IRA?  How much do I need to save for health care expenses?  What should I do if I am self-employed and don’t have a company 401(k)?  These are all excellent questions, but it is difficult to understand the answers if you don’t have the financial literacy required to interpret the terms used in the answers to these questions.  Developing this financial literacy is the goal of these FI Top Ten blog posts.  

Because there is so much to cover here, I’m going to break this FI Top Ten subject of retirement plans and accounts into three separate posts: Parts 1, 2, and 3.  I actually had a hard time limiting it to 30 terms.  I didn’t want to go overboard on how in depth we get and lose people along the way, but I also wanted to review enough that it would cover most people’s situations and options.  30 terms seemed to be about the right balance.  The first post covers some broader terms as well as the categories that many specific retirement plans and accounts fall into.  The second post covers the basic terminology needed to understand the rules and specifics surrounding each different type of retirement account.  Finally, the last post answers basic questions about 10 different types of specific retirement plans/accounts and which ones you should consider.  

Pre-Tax

Pre-tax and post-tax are terms used quite extensively when discussing retirement accounts and planning, so I thought this would be a good place to start.  Let’s begin with pre-tax.  You may hear phrases like pre-tax contribution, pre-tax dollars, or pre-tax account.  If you aren’t familiar with what pre-tax means, you are already lost.  So let’s make sure you have a firm grasp on this so you can keep up with all those fast talking financial advisor types.  What pre-tax really refers to is your money (usually money in your paycheck) before taxes have been taken out or deducted.  I always feel it is easier to understand through an example, so let’s start there.  

Let’s assume you make $120,000 per year and get paid monthly at a rate of $10,000 per month. For some this may seem very high, for other’s too low, but it makes the math easier so let’s just go with it. Let’s also assume you have an overall effective income tax rate of 20%, meaning your federal and state income taxes average out to 20% of your taxable income (again, for easy math).  I will be ignoring FICA taxes here (Social Security and Medicare) for simplicity.  Your gross monthly income before taxes are taken out is $10,000.  At this point these are “pre-tax dollars” since we haven’t taken out any taxes yet.  If there were no tax deductions (like contributions to a pre-tax retirement account or a health insurance premium payment), your taxable income would equal your gross income and would also be $10,000, so you would owe $2,000 in taxes (20% of $10,000), and your paycheck amount would be $8,000.  However, you are more financially savvy and on the path to FI, so you decide to contribute $1,500 to your company’s 401(k) each month, which is a pre-tax retirement account.  This means we will make a pre-tax contribution (before taxes are taken out) with pre-tax dollars.  So, going back to your gross monthly income of $10,000, we will take out $1,500 in pre-tax dollars to make this pre-tax contribution to your 401(k), which now reduces your taxable income to $8,500.  Based on your 20% effective tax rate, you now only owe $1,700 in taxes (20% of $8,500).  Your final paycheck will now be $5,800 after the $1,500 401(k) contribution and the $1,700 in taxes.  By contributing to a pre-tax retirement account, not only do you save $300 in taxes today, but you also invest $1,500 for your future.  Hopefully that helps you understand the idea of “pre-tax,” but if not, read this through a couple more times.  

It is important to note that these pre-tax retirement accounts, like 401(k)s, 403(b)s and traditional IRAs, are also referred to as tax-deferred accounts.  That’s because even though you don’t have to pay taxes on the money now, you are deferring payment of taxes until the time the money is withdrawn.  The money you invest in these accounts will grow tax-deferred (meaning you don’t owe taxes every year while the money grows in the account).  However, once you begin to withdraw these funds, it is taxed like ordinary income.  

In general, proponents of financial independence always advise you to maximize contributions to pre-tax accounts first, so you don’t have to pay taxes today.  Then, when you do begin to withdraw funds from these accounts in the future there are multiple clever (and legal) strategies to minimize the amount of taxes you will have to pay (all to be discussed in future posts).  

Post-Tax or After-Tax

This is a term that should feel more familiar to most because this is how we typically deal with money.  All of the money we cash from our paychecks is post-tax or after-tax money (these terms are synonymous), which is essentially how much you have left after paying your taxes.  This means the money you use for all of your normal day to day needs, such as buying groceries, going on vacation, or making a car payment is paid for with post-tax dollars.  When you put money into a savings account or a normal taxable brokerage investment account, these are also post-tax dollars.  

Like pre-tax, you will also hear terms like post-tax contribution and post-tax or after-tax accounts.  With regards to retirement savings, this is typically associated with a Roth IRA or a Roth 401(k).  Unlike pre-tax contributions and accounts, when you make post-tax contributions to a post-tax account like a Roth IRA, you will not be able to deduct the amount you contribute to reduce your taxable income.  This means you are paying taxes on the money first, and then contributing those post-tax dollars to a Roth account.  The upside of this choice is that now your money will never be taxed again.  It can grow within the account tax-free, and when you withdraw the funds in the future, you don’t have to pay any further taxes.  Let’s go back to our above example with a monthly gross income of $10,000 and a 20% effective tax rate.  Instead of contributing to a 401(k), you like the idea of a Roth IRA and decide to contribute $500 a month, which will add up to the maximum amount in 2019 of $6,000 over the course of the year.  Because this is a post-tax contribution, we can’t use it to reduce your taxable income and you will still owe $2000 in taxes (20% of $10,000).  This results in a $7,500 paycheck after paying $2000 in taxes and contributing $500 to your Roth IRA with post-tax dollars.  

After learning about post-tax contributions to accounts like a Roth IRA and the fact you never pay taxes on that money again, many people are convinced this is the way to go.  While there definitely are some great benefits to this, the reality is that it depends on several factors, and I will get into this a little more in part 3 of this series as well as other posts.  

Vesting

Before discussing the various categories of employer sponsored retirement plans, it is important to understand the term vesting.  Vesting is a term commonly used in association with employer sponsored retirement plans and is a strategy used to encourage employees to stay with their company.  Vesting refers to the portion of funds contributed by your employer that are yours when you choose to leave the company.  If you are fully vested, you have full rights to these funds when you leave.  Most companies have a graduated vesting schedule that increases over time.  For example, your company may increase the amount you are vested by 20% each year, so after 5 years, you are fully vested.  If you decide to leave your company after only 2 years, you will only receive 40% of the funds your employer has contributed on your behalf.  Some companies, however, have an all or nothing policy.  If this were set at 5 years and you left before that, you would receive none of the employer contributions.  So, it is important to know your company’s specific vesting policy and schedule.

Vesting can apply to any retirement plan in which there are employer contributions, including defined benefit plans, profit sharing plans, and defined contribution plans.  However, vesting only applies to employer contributions; any funds you personally contribute to a retirement plan remain yours regardless of when you may leave the company.  

Defined benefit plans

A defined benefit plan is an employer sponsored retirement plan in which your employer contributes all of the funds, decides how to invest it, and then promises you a fixed regular payment after you retire usually based on your salary and how long you worked there.  These are very valuable to employees because they provide a reliable and consistent form of income during retirement.  Unfortunately, defined benefit plans are becoming less and less common in recent years, mainly because the employer shoulders all of the responsibility of funding the plan and companies are always trying to cut costs.  Defined benefit plans are being replaced with defined contribution plans (see below).  If your company still offers a defined benefit plan consider yourself very lucky.  Often all you have to do is show up to work, do your job and you are automatically enrolled in the plan, although sometimes you have to work at the company for 1-5 years before you are fully vested.  Two basic types of plans fall under the umbrella of defined benefit plans: pensions and cash balance plans.  

Pensions

A pension is one type of defined benefit plan.  Unlike defined contribution plans, you typically don’t have to contribute any money from your paycheck into the plan, it is all paid for by your employer.  Your employer (or more likely professionals hired by your employer) also makes all of the decisions about how the money is invested.  When you retire you are guaranteed a payout based on your salary and years of employment.  The higher your salary and the more years you work for your employer, the higher your payout amount will be.  This is typically determined by a simple formula and is thus “defined,” as implied by the type of benefit plan it falls under.  Your payout is not determined by how investments in the plan perform.  Thus, the company has the burden of making sure payments are made as promised to retirees regardless of market return.  Due to the complexity and expense of these plans, they are increasingly rare.  Most government employees still have a pension plan, but only a small percentage of employees working for private corporations continue to have a pension.  

If you are lucky enough to work for an employer with a pension plan (check with your HR department if you don’t know), usually you don’t have to do anything special to qualify for it; you are automatically enrolled.  You just need to come to work and do what you were hired to do.  Despite automatic enrollment, you may have to work for your employer for some period of time, usually 3-5 years, before receiving the full benefits of the plan (fully vested).  The payout you receive at retirement can usually be collected as a lump sum payment or a monthly check in the form of an annuity.  You can elect to receive regular monthly payments until you die (life only annuity) or payments until both you and your spouse die (joint and survivor annuity), or some variation on these themes.  While it may seem more appealing to continue receiving payments until both you and your spouse die, choosing this option will decrease the monthly payments.  

There are several important factors to consider if you have a pension.  First, if you retire early you may be required to wait until age 65 to begin receiving pension payments, although this may vary by plan.  If your plan allows earlier payment, these are typically significantly reduced payments compared to receiving your full benefit if you had waited to age 65.  Second, if you decide to leave your employer, your pension benefits are not portable, meaning they cannot be transferred to another employer or another type of retirement account.  If you leave your employer earlier than retirement, you need to get back in touch with your employer when you want to receive your benefit and apply for it.  Third, you cannot increase the amount contributed to or paid out by your pension; it is a defined benefit.  This is important because for many people it will not be enough to fully support them in retirement and will require that they have other sources of savings/income.  Fourth, most pension plans are protected by federal insurance through the Pension Benefit Guaranty Corporation.  So if your company goes out of business, this insurance guarantees you will still get a pension.  However, it will likely be a lesser amount.  Finally, your pension payments will be counted as income, and as such will be subject to federal and state income taxes.

Cash balance plans

Cash balance plans are the other common form of defined benefit plan.  Like a pension, cash balance plans are typically fully funded by your employer and all investment choices in the plan are the employer’s responsibility.  However, cash balance plans differ from pension plans in how the benefit is defined.  While pensions typically use a simple formula based on salary and years of service to determine the payout benefit, a cash balance plan gives you a “pay credit” each year based on a percentage of that year’s salary (5% seems to be most common) and an “interest credit” which assigns an interest rate to the balance.  This ultimately results in a stated account balance, and the estimated future account balance when you are 65 is how your final benefit is defined.  Your final benefit does not change based on the performance of the employer’s investments, allowing this to remain as a defined benefit plan.   Many companies have switched their defined benefit plans from pensions to cash balance plans because they typically result in smaller long term monthly payouts to retirees.  

Here are some other key points to consider for cash balance plans in how they compare to pensions.  Like pensions, you typically need to wait until retirement age to receive your benefit.  At that point you can choose to receive your benefit as a lump sum or as a lifetime monthly payment (lifetime annuity).  Most cash balance plans are also federally insured by the Pension Benefit Guaranty Corporation.  Because payouts for cash balance plans tend to be less than pensions, a cash balance plan alone is likely not enough to fully fund your retirement.  A major key difference between pensions and cash balance plans, is that cash balance plans are portable.  This means that if you leave your job, voluntarily or not, you can take your cash balance plan benefit and apply it to your new employer if they offer a cash balance plan, or you can roll it over into an IRA.  

Defined contribution plans

Defined contribution plans are the types of employer sponsored retirement plans that people will be most familiar with today.  This type of plan includes 401(k)s, 403(b)s, 457(b)s, and Thrift Savings Plans.  Less common examples include Profit Sharing Plans and Employee Stock Ownership Plans (ESOPs). Given that these plans are much less expensive for employers and frees them from the long term obligation of paying employees throughout their whole retirement, defined contribution plans have for the most part replaced defined benefit plans.  In most ways, they are usually the exact opposite of defined benefit plans.  Rather than the retirement benefit being defined, the contribution is defined, with no guarantee of any end benefit.  With defined benefit plans the employer contributed all of the funds; with defined contribution plans the bulk of contributions typically comes from the employee. Investment decisions are usually made by the employee as well, not the employer. 

Here’s how most of these plans generally work.  Employees must voluntarily elect to take money out of their paychecks to contribute to defined contribution plans.  This is done by first electing what percentage of your salary you would like to contribute.  This amount is then automatically deducted from your paycheck and deposited into your account.  This money is then invested according to what investment choices you have made.  Each plan will have a limited selection of investment options to choose from.  Some plans will have much better options than others, and some plans will have much lower or higher fees than others.  Most employers also offer to match a portion of an employee’s contributions (see below).

Defined contribution plans are qualified tax-deferred retirement plans.  This means the money contributed to these plans is pre-tax money (as discussed above) so you can deduct the amount you contribute from your total gross pay thereby reducing your taxable income.  The invested contributions will then grow in a tax-deferred manner, meaning you don’t have to pay taxes each year while it grows in the account.  However, when the money is withdrawn at retirement, it is then subject to income taxes, regardless of whether it was from the original contribution, dividends, or capital gains.  If you want to withdraw the money before age 59 1/2, there is a 10% penalty in addition to the income tax owed, so this is generally a bad idea.  Defined contribution plans are also subject to required minimum distributions (RMDs).  This will be discussed in more detail later, but just understand that Uncle Sam wants his cut of the money, so at age 70 1/2 you are required to start withdrawing money out of the account, which then forces you to pay the income tax on it.  

While not as great as the aforementioned defined benefit plans, defined contribution plans are actually a pretty good thing and for many of us, it is all we have.  So, we should really take advantage of them.  They offer a tax deduction now, free money through employer matching, and tax-deferred growth of the investments. 

Employer Match

As part of most employer sponsored defined contribution plans, the employer offers to match a portion of the employee’s contributions.  I interpret this as employers doing “their part” in replacing defined benefit plans.  While it is nowhere near the amount contributed with defined benefit plans, it is still quite substantial and essentially free money.  Employer contributions typically match 50 cents to $1 of every dollar you contribute up to a percentage of your salary, usually up to 3-6%.  For example, let’s say you make $50,000 per year and your employer will match dollar for dollar up to 5% of your salary.  So, for every dollar you contribute to your plan up to $2,500, your employer will also contribute up to $2,500.  Not too bad.  

Why do people always refer to the employer match as “free money?” Well, it is essentially a 100% instant return on your investment.  You won’t find that kind of return anywhere else.  Plus, both the money you contributed AND the matched money from your employer can now grow in a tax-deferred manner in the account.  This is a pretty great deal.  As a result, one of the most consistent pieces of financial advice you will hear is to contribute enough to your defined contribution plan every year to get the full employer match.  

Profit sharing plans

A profit sharing plan is a type of employer sponsored retirement plan that gives employees an incentive to produce for the company.  Like defined benefit plans, only the employer contributes money to the plan; but that is really where the similarities end. Profit sharing plans are technically defined contribution plans because it is the contribution that is defined and follows guidelines, not the benefit (there is no guaranteed benefit). However, its attributes make it somewhat of an outlier compared to other plans in this category. Profit sharing plans are structured such that employer contributions are discretionary, meaning the amount employers contribute to the plan on a quarterly or annual basis can change based on profits.  So when the company does well and is more profitable, more money can be contributed to the plan and employees can share in those profits.  This gives employees a sense of ownership in the company and an incentive to boost profits.  The employer makes decisions about how total contributions to the plan are allocated among its employees.  This must follow a formula which is typically based on an employee’s compensation relative to total compensation for the company, but the formula must not discriminate in favor of highly compensated employees.  In 2019 the contribution upper limit is the lesser of 25% of an employee’s compensation or $56,000.  Employees may have some input regarding how these funds are invested in some plans, but more often than not the employer makes these decisions as well.  These funds are invested in a qualified tax-deferred retirement account, so withdrawals can be made at age 59 1/2 and taxes must be paid when the money is withdrawn.  Funds are also subject to RMDs at age 70 1/2.

Employer discretion is a key component of profit sharing plans, so they may appeal to companies with variable cash flow, as well as to smaller companies.  When profits are down, the employer is not required to contribute to the plan.  However, government regulation does require that contributions to the plan be “recurring and substantial.”  There are no restrictions on business size when establishing a profit sharing plan.  

Profit sharing plans can be a great benefit if your company offers one.  As far as employer funded plans go, it may not be as good as a pension or cash balance plan, but there is not much you have to do on your end.  You still just come to work and do your job the best you can.  When the company does well, you do well.  Because employer contributions are discretionary and thus somewhat unpredictable, I would look at this type of retirement plan as more of a bonus rather than your foundation for retirement. 

IRAs

IRA stands for Individual Retirement Arrangement per the IRS, but most sources on the web call them Individual Retirement Accounts.  Either way, the key words here are individual and retirement.  An IRA is an individual investment account designated for building retirement savings separate from any employer sponsored retirement plan you may have.  While there are a number of different types of IRAs, including traditional IRAs, Roth IRAs, spousal IRAs, rollover IRAs, self-directed IRAs, SEP IRAs, and SIMPLE IRAs (which will each be discussed in Part 3 of this post series), they all have similar characteristics that help you save on taxes while saving for retirement.

Each type of IRA has its own specific rules governing important characteristics of the account including contribution eligibility, annual contribution limits, tax deduction limits based on income, timeline for withdrawals, penalties for early withdrawal, etc.  Since there are so many IRA choices, it is important that you understand these specific rules and regulations before choosing which one might be right for you.  Based on your situation, it may be more advantageous to fully fund an IRA rather than a 401(k) above the company match, or vice versa.  We will discuss these scenarios in future posts.  

Conclusion

That concludes Retirement Plans & Accounts, Part 1.  I hope I didn’t lose too many of you along the way.  I know some of this stuff can be pretty dense, but it is important to know as you plan for your future and continue on the path to FI.  After you have given your brain some time to rest and digest this information, please go on to Retirement Plans & Accounts, Part 2.