Chapter 19 – Retirement Accounts

Preparing for retirement is one of the largest financial tasks that a household must face. Fortunately, there are a number of very helpful types of retirement plans that can be used to help households reach your retirement goal. The benefits, rules, and restrictions of retirement plans are the topic of this lecture.

All retirement plans are classified as either defined benefit or defined contribution plans. Defined benefit plans more commonly called pensions. Defined benefit plans are plans in which the employee doesn’t have to contribute any of their own money. Rather, the employer guarantees to provide the employee with a specified benefit at retirement. The employer makes all investment decisions to make sure they have the funds to meet their guarantee. The only thing the employee needs to do is to make sure they are vested.

Vesting refers to the right of the employee to take full possession of the funds that the employer has set aside for the employee’s retirement if the employee is dismissed, resigns, or retires. So, for example, if you are 50% vested, then you will get to keep 50% of the pension funds your employer has contributed for you when you leave the company.

Vesting structures typically take one of two forms. The cliff form gives full vesting at a specific period of time. This type of vesting structure might say “the employee is fully vested within 3 years of employment”. The other vesting structure is called a graduated system. Under a graduated system, the level of vesting the employee has rises from 0 to 100% over time. Before you leave a company, make sure you know what your vesting status is so that you know how much of your pension you can take with you when you leave.

Defined contribution plans are plans where the employee makes their own contributions and select their own investments. The most common defined contribution plans are called 401(k)s, 403(b)s, and 457 plans. Any money you contribute to these plans are made pre-tax, meaning that you pay less taxes if when you deposit money into these accounts! The earnings also grow tax deferred, meaning that no taxes are due before the funds are withdrawn from the plan.

Employers often (but not always!) also make contributions to the plan in the form of a contribution match. They may match 50% up to 6%$ of your salary, for example. This means that for the first 6% of your gross income you contribute to your plan, you employer will contribute held of the amount that you contributed. Or the contribution may be 100% up to 3%. This means that for the first 3% of your income you contribute, the employer will also contribute the same amount.

The funds that the employer deposits for you as a match are subject to the same vesting rules as for pensions. The investment vehicles and investment allocation decisions for a defined contribution plan are all made by the employee. Because of the tax advantages of these plans, the government places limits on the amounts that you may contribute each year, based upon your income level. Up to date information on the contribution limits can be found through the links on the course website.

You can also have a tax advantaged retirement plan that is not connected to your employer. These plans are called IRAs, or individual retirement arrangements. A traditional IRA is taxed exactly the same as a 401(k); deposits are made pre-tax and grow tax deferred. The major difference is that you do not have any chance of getting any extra money contributed to your IRA from your employer, since you employer has nothing to do with this plan.

A Roth IRA is taxed in the opposite manner as traditional IRAs. In a Roth IRA, you have to pay taxes before you contribute your money. However, this lets your money grow tax free, and no taxes are required when you withdraw the funds. An IRA plan can be set up for any person, regardless of their employment status. Since this is a personal investment, all investment vehicle and allocation decisions are made by the owner of the fund. IRA’s also have annual contribution limits which you will need to be aware of.

Illustration of the Taxation of

Traditional and Roth IRAs

Traditional IRA’s and 401(k)s have rules regarding how you withdraw the money. The first rule is that you must begin making distributions before age 70 and a half. You also cannot withdraw the money before age 59 and a half without paying a10% tax penalty. The only except to this early withdrawal penalty is if you use the money for qualified education expenses for yourself, your spouse, your children, or your grandchildren, or if you use the money to purchase your first home. If you take early distributions, you will have to pay income taxes on the money you withdraw, whether or not you have to pay the 10% penalty.

A Roth IRA has no restrictions on when you must withdraw the money, but there are rules about how early you can withdraw the money. If the funds have been in the account for at least 5 years and you have a qualified reason for the withdrawal, then you do not have to pay any taxes or penalty to withdraw the money. If you do not meet these criteria, then you will have to pay taxes on the withdrawal, and may even face a penalty.

Keep in mind that tax laws change all the time, and the rule for retirement plans change just as often. Always be sure to check for changes in the rules and restrictions of retirement plans.

If you have the option to contribute to a 401(k) and claim an employer match, then you should almost always do so. If you do not, you are throwing away free money!

Let’s look at an example of how this works. Suppose your salary is $50,000 per year, and your employer will match 100% up to 6% of your income. If you do not contribute to the 401(k), then you get not match and have earned no free money. If you contribute just 2% of your income, then you have contributed $1,000 to your 401(k). Your employer will match that $1,000 100%, resulting in $1,000 in free money your employer has provided. If you contribute the full 6% of the match, then you contribute $3,000 and your employer matches that 100%, providing $3,000 in free money. If you have chosen to not contribute to your 401(k), you would have left $3,000 in free money unclaimed. You should contribute at least up the maximum that your employer will match so you can get all the free money that is being offered!

Check out Skill 7 in the workbook for detailed instructions and practice problems on how to determine you 401(k) match!

What should you do when you retire? There are several options. You should first begin withdrawing money from your 401(k) or IRA because of the rule that you must start at age 70 ½. After that you should start pulling out your Roth IRA funds. Purchasing an annuity with the funds you have in your account is a great way to protect yourself from outliving your money. Remember that once you retire, your goal changes from accumulating wealth, to making your wealth last as long as you live. Lifetime annuities are an efficient way to accomplish this goal. Yu may also want to consider getting an inflation adjusted annuity that will increase your payouts each year as prices increase. The guarantee that an annuity provides does not come for free. However, the costs of the annuity are often worth paying because an annuity is one of the only ways to guarantee that you will not outlive your accumulated wealth.

Lastly, we are going to talk about how much money you will need to retire. An exact figure can be difficult to determine, but there are four basic factors that will affect the amount that you will need.

1. Other sources of income in retirement. If you can collect from a pension and social security or are planning to work part-time in retirement, then you will need less money saved in your 401(k) or IRA.

2. The amount of your income you wish to replace. Retirees generally have reduced expenses because their children have moved out of the house and the house itself is often paid off. Because of this, most retirees need about 30% less income in retirement than they did before they retired in order to maintain the same standard of living.

3. How long you will be retired. You will be retired from the day you retire to the day you die. Consider your family history and how long your ancestors lived to get an idea of how long you might expect to live. Living longer means you will need more money! Your health in retirement will affect how much you need because large medical expenses will have to be funded out of your retirement accounts.

4. The age at which you will retire. Retiring early will extend how long you will be retired, but it will also affect how much income you get from social security, and the potential that you have to continue generating some kind of income even after you retire if it becomes necessary. When you are young, it is more important for you to focus on establishing the habit of saving, rather than trying to focus in on a specific dollar amount.

Retirement is the largest and often the most complex financial goal of a household. Careful consideration of the investment vehicles and retirement plans that you will use is the best way to make sure you can reach your retirement goals.

This is an excellent time to watch Lecture 12 from the course pack.

Definitions:

Retirement plan: financial arrangement designed to provide tax benefits to saving for retirement

Defined benefit plans: plans in which the employee doesn’t have to contribute any of their own money

Vesting: the right of the employee to take full possession of the funds that the employer has set aside for the employee’s retirement if the employee is dismissed, resigns, or retires.

Cliff vesting: vesting structure with full vesting at a specific period of time

Graduated vesting: vesting structure where the level of vesting the employee has rises from 0 to 100% over time

Defined contribution plans: plans where the employee makes their own contributions

Individual retirement arrangements (IRA): a tax advantaged retirement plan that is not connected to your employer

Traditional IRA: retirement arrangement where deposits are made pre-tax and grow tax deferred.

Roth IRA: retirement arrangement where deposits are made after-taxes.