Heroes Finance 101: Understanding Retirement Plans
Written by Robert Patrick Lewis on 12/01/2017
Gone are the days of our parents and grandparents in which retirement after working for a company for twenty years earned you a gold watch, pension and comfortable golden years. The removal of pension plans from most major companies has angered many, but if you put yourself in the shoes of the owners and/or managers of those companies it makes sense.
Pension plans were created when the average lifespan was decades shorter than they are today, and while breakthroughs in health and medical technology have helped our society by allowing us to live longer and watch our grandchildren grow up, it’s causing great strain on those financial plans which are being pushed longer than ever anticipated.
I’m a rather stubborn and an “if you want something done right…” kind of guy, so I prefer not to leave too many important things completely in the hands of others, if possible. This is especially important for city, government or highly unionized workers who are approaching retirement and depending entirely on their pension to see them through their years.
One of the very first actions that companies and cities who declared bankruptcy over the past few years took was to restructure their pension plans due to the large strain they were putting on their balance sheets. While I think this was a diabolical and unfair thing to do for those people who held up their end of the bargain with their employers, I hope that this article will help you understand that it is quite simple to put your retirement plans into your own hands, and you won’t have to depend entirely on anyone else.
I hope that you enjoyed and took something away from last month’s article, “Stocks and the Stock Market,” and our mission here is to accomplish the same objective of helping our Heroes to understand their investments and retirement plans.
And for those of you who don’t already have a retirement plan from your employer, to understand why they are simple to set up, good planning for your future, what they are and what the differences are between the options available.
I would like to add that understanding retirement plans has a special place in my heart. As I wrote in the introductory article for this series, it was discovering that I knew next to nothing about these differences that set me out on my journey to learn everything about investments that I could.
There are a multitude of retirement plan options available, each with their own pros and cons. Please leave comments on the Heroes Media Group social media pages if you take something valuable away from this series, this article or feel that I left something out.
And as always, understand that this series does not replace advice from a professional regarding your account and investments. While I am a licensed financial advisor and independent investor, every person and their investments are different based on a number of variables. This series is meant to help lead you in the right direction and understand what you’re looking at when meeting with a financial professional, but should not act as a standalone for your investment portfolio and/or decisions.
So without further ado, let’s get to understanding your retirement plans!
Retirement Plans and the IRS
Do the numbers and names of various retirement plans seem confusing to you? They are, even to savvy investors and financial professionals for one simple reason: they were created by the IRS, who by their very nature seem determined to be as confusing as possible!
The numbers and names used to represent many of our retirement plans are numbered in accordance with their section of IRS regulations. Some of those which you may have heard of are 401(k), 457(b), 403(b) and 401(a).
There are stories behind each of these different programs and how they were created, but I received feedback from the last article that it was a bit too long-winded. So in respect for your time if anyone finds something here which interests them, there is enough information online to lead you in the right direction to do some research of your own.
What is the purpose of a retirement plan and its designation?
At a high-level view, there are four basic types of investments available to the public in terms of taxation:
- Tax deferred
- After tax
- Tax exempt
These groupings refer to taxes, or more specifically at which point taxes are taken from your investments. Because as we all know “the only things certain in life are death and taxes,” and so we must pay attention to this detail because it is important when allocating your investments.
As a financial advisor I have met many clients and potential clients who had calculated their retirement investments without subtracting the taxes which would be taken out, so I implore you to please pay close attention to this part. If you are a good American and save for your retirement diligently but do your math incorrectly, you can end up with a very bad surprise when you need it most.
While almost all investments are taxable, what we define here as taxable investments are those which are taxed on a regular basis. For example, when I buy or sell a stock in a regular trading account, I have a form which must be reported to the IRS every year based on those sales, and any profits or losses that I make.
Selling a property falls under this radar as well, as it is not treated as a special circumstance under the IRS provisions, unless of course you buy another property and invest those earnings directly into the new property.
Tax deferred Investments
These beauties are where the majority of retirement plans reside, especially those which are titled “traditional” investments (versus “Roth” plans). We will go into greater detail about these later in the article.
The basic premise is this: a tax deferred investment allows you to defer the taxes until you withdraw the money. You can set these plans up to take money directly from your paycheck and into your retirement plan without being touched by taxes on the way. This is great, because it means that your investments are allowed to grow based off the principal every year, unhindered by taxes.
Here’s an example of why this is so important. Using simple numbers to work it out, let’s say you have $100 invested, your tax rate is 10% and you are earning a 10% return. If your $100 grows by 10% this year, you will have $110 at the end of the year. But if the tax man comes to take his due at the end of the year, those 10% earnings are wiped out in your tax bill, setting you back at $100.
But if your money is in a tax deferred plan, the 10% is not taken out until you withdraw the money. So if you gain 10% this year you have $110 at the end of the year, and your principal now becomes $110. If you earn 10% the following year you would then have $121 ($110 x 1.10%). The following year, maintaining that same rate of return, you would have $133.10 ($121 x 1.10%). This is called “compound interest” and it’s a beautiful thing!
Most plans in this category have a required age which you must reach before you can withdraw the money without penalty, typically 59 ½. There are other situations where you can withdraw early (first time home buyer, qualified college expenses, etc) but let’s just keep 59½ as the standard.
As I described earlier, I’ve heard more than a few people who calculated their retirement needs and savings based off these numbers alone, which is a drastic mistake.
When you do start withdrawing money, it is taxed as normal income (as long as you wait until 59 ½). So let’s say that you were a good saver and have $1,000,000 in your traditional IRA or 401(k) when you reach 59 ½
Based on typical calculations, you expect to need $50,000 per year to live on, and expect this money to last you 20 years ($1,000,000 / $50,000 = 20). But you forgot to take out taxes, and this causes a major predicament.
If the income tax bracket for $50,000 income were 10%, and you don’t have any other income stream besides that retirement plan you will be hit with a $5,000 tax bill every year when you withdraw the money ($50,000 X 10% = $5,000).
Spreading that out over the 20 years you plan to have left, that’s $100,000 gone from your initial pot, which could drastically change your plans over the long run.
Now, that being said your investment will continue to grow (hopefully, if the market is on your side) while you keep principal in there, but your growth will diminish at an exponential rate as you withdraw money, the opposite of the formula we did earlier to calculate the growth (as your principal reduces so does the gross amount of interest you earn on it).
So while tax deferred investments are a great way to grow your nest egg, just remember that when you’re calculating how much you anticipate needing in retirement you must deduct the extra money for taxes.
After tax plans are also named for the time which the IRS gets involved. In a tax deferred plan, the money can go from your paycheck directly to the investment without being touched by taxes.
In an after tax plan (Roth plans are a popular version), you pay taxes on your income and then put the after tax money into your investment.
So why would someone do this if the traditional exists and is allowed to grow without taking taxes out?
The Roth plans are great because although you pay your income tax on the front end, you don’t have to pay taxes on it in the back end. The reason this is so great is that you can know exactly what your tax rate is right now, but have no way of knowing what it will be 20 or 30 years in the future when you will be withdrawing it.
Just as in our previous calculations, this money is allowed to grow without taxes being taken out (you’ve already paid them), but differently than the traditional plans you do not have to plan for taxes being taken out when you withdraw. This means that what you see is what you get, and if you save $1,000,000 in a Roth plan you can plan to be able to take $1,000,000 out when needed, barring any future changes in government and IRS regulations.
Cash value life insurance is another great example of this, as the money you withdraw from them is also after tax and not encumbered by taxes when you take money out of the plan, if done correctly.
While these are not a retirement plan on their own, many mutual funds exist in which you can choose tax exempt options. So if your retirement plan offers these as an investment, it’s important for you to understand.
Municipal bonds are considered tax exempt, as you do not pay taxes on their gains. Now this is an important point: between state and federal taxes you will still pay one (unless you are in the great states like Texas that have zero state income tax).
A simple phrase can be used to remember how these work: “they tax themselves but not the other.” This means that if you buy a city or state bond, you will pay the city or state taxes on those gains (unless you’re in Texas, Florida or another zero state income tax state), but will not have to pay federal taxes on the gains.
Likewise, if you buy a federal municipal bond you will pay federal taxes on it but not state/city.
These are great investments for the super-wealthy who have a large amount of invested capital and want to reduce their taxes on gains, but not so much for the average investor. The returns are typically small, but they are generally considered extremely stable and will create a constant income stream.
Also, if you are already in a tax advantaged retirement plan the added benefit of reducing taxes may not matter, based on which type of plan you have. But as I said they are considered stable investments, so they are also attractive to risk-averse investors.
Traditional vs Roth
I briefly touched on both traditional and Roth plans previously, but there are a few more specific differences between the two which are important to note. I will cover these points in the IRA section, as they are the most popular plan that offers both options.
However, please be aware that although typically used in describing IRA’s some employers also offer Roth plans in their 401(k) and others, so be sure that you ask when starting a new job if that is available.
Defined Benefit vs Defined Contribution
You will see the terms defined benefit and defined contribution in the various descriptions of retirement plans and the rest of this article. These are one of the few things the IRS gets involved in that are actually quite well named.
A defined benefit plan is just that: the benefits you will received are defined, as in a pension where you will receive a specified monthly payment for the rest of your life, regardless of what the market does (this will change, however if your company goes bankrupt and restructures their finances under Chapter 11 bankruptcy protection laws).
A defined contribution plan is just that: the only thing defined is your contribution, or how much money you elect to put in the plan every month. The amount you will have in retirement is then based off your contributions, your investment choices and the performance of those investments over time. The ball is in your court.
Now that we have the basic definitions in order, let’s dive into the specific plans themselves, what they are and what they mean.
A 401(k) plan is a retirement plan sponsored by your employer. There is no requirement stating that every employer must offer them, but there are advantages for the employer so most large firms have them. As stated above, it is possible for an employer to offer both traditional and Roth 401(k) plans, so make sure you are clear on the options when you fill out your retirement plan paperwork.
Although these plans are sponsored by an employer, if you own your business you may also start one of these, both for your employees and for yourself (Solo K discussed below).
The 401(k) plan is essentially an agreement between an employer and their employee on taking compensation in either cash (paycheck now) or deferring it (or a portion of it) to the 401(k) plan. These are considered defined contribution plans, meaning the amount of money you have or put into it are based on your contributions.
Some employers choose to match some or all of your contributions, and if yours does I highly suggest taking them up on the offer, if you can afford it. There is no such thing as a free lunch, but this is pretty darn close!
In 2017, the maximum amount of money you can contribute to your 401(k) plan is $18,000. In the year which you turn 50 you are allowed to contribute an extra “catch up” contribution of $6,000 per year. If your employer matches contributions, the maximum allowable contribution is $54,000 (in 2017) for the combined contributions, unless you are age 50 or older in which it is $59,000.
Most 401(k) plans have a set portfolio from which you can choose to invest in, and they run the gamut of large to small. I’ve seen huge companies who only have a small array of investments from which to choose, and other small companies which offer a wide variety.
They typically include mutual funds and index funds (and if it’s a publicly traded company, their own stock), but they may also include stocks, bonds and other investments as outlined in the plan.
There are four basic situations concerning distribution of a 401(k), meaning one of these must be met in order for you to withdraw your money without penalty:
- Separation from the employer (by retirement, death, disability or separation of service)
Once you have separated from your employer, there are a few options for what you can do with the money in your 401(k):
- Leave your money in the plan (some employers may have a vested minimum amount required to do this)
- Cash out. This should be considered a last option, as your employer is required to keep a portion for taxes and you will be hit hard.
- Rollover into a new employers plan.
- Rollover into a personal plan (annuity or IRA). Most major brokerages allow you to create an IRA completely online, and the process of rolling over your 401(k) into an IRA is pretty simple. And since they’re both tax-deferred accounts, there typically won’t be any tax issues.
2. Employee attainment of age 59 1/2
3. When the employee faces a hardship as defined by the plan
4. Upon termination of the plan
401(k) plans also offer the ability to take a loan against the money, but that is a little more advanced than we have time for in this article. Just know that it is an option, and if you feel like it may be something you’re interested in speak with a financial professional or your HR team.
Solo 401(k) — also referred to as a “solo k”
If you are a sole proprietor or small business owner, you may take advantage of a Solo 401(k). As mentioned above the 401(k) is an agreement between the employer and employee, so what if you are your own boss?
The Solo K is available to employers with no employees besides themselves or their spouse. There are both tax advantages and reporting advantages to this (the Solo K doesn’t fall under ERISA reporting guidelines), so if this is something that interests you, speak with a financial professional about the specifics.
IRA’s are next in popularity, and as with the 401(k) they come in both the traditional and Roth varieties. IRA stands for Individual Retirement Account, and while your employer may sponsor one, these can be started on your own without your employer.
I should add that it is also possible to have more than one of these at a time. For example, I’ve had a 401(k), traditional IRA, Roth IRA and Employee Stock Purchase Plan (ESPP) all at the same time. But I have four kids and will need a substantial amount of money to send them all to college and not be in the poorhouse when I retire, so I probably put more into retirement than most would deem necessary.
Here’s a great Wikipedia link for the background of the IRA, if you’re interested:
One of the more interesting aspects of an IRA are the investments which you may hold in them. While a 401(k) is limited in investments to the plan your employer chooses, an IRA is open to many different types.
Of course stocks, mutual funds and bonds are available, but there is also a company named Birch Gold Group which will allow you to put gold, precious metals or bitcoin into your IRA.
The rules for traditional and Roth IRA’s are as follows (rules here are for 2017):
- There is no income ceiling (not matter what your income you can use a traditional
- You must begin to withdraw money, in increments mandated by the IRS, by age 70 ½
- You cannot invest in the plan if you are older than 70 ½
- Contributions to your plan are tax deductible on both state and federal taxes for the year in which you make the contribution
- No required time between first contribution and first withdrawal
- Contributions to your traditional plan reduce your taxable income in the contribution year (meaning the amount of income you pay taxes on is lowered)
- If you are under 59 ½ you may withdraw $10,000 without penalties to purchase your first home, pay for qualified higher education expenses or other hardships (you will still pay taxes on the distribution as normal income, but not the early withdrawal penalty)
- Modified Adjusted Income ceiling of $133,000 (as of 2017 if you make more than $133,000 you cannot use a Roth plan unless you use the back door method, described below)
- No required withdrawal within the plan owner’s lifetime
- No age requirement on additional investments
- No tax breaks for contributions
- Your first Roth contribution must be made a minimum of 5 years before your first withdrawal (or else you will incur a tax penalty)
- No taxable income advantages
- Contributions (but not earnings) may be withdrawn penalty free at any age, even before 59 ½ (you can take the money you’ve put in, but not the interest it’s gained)
- If you are under 59 ½ you may withdraw $10,000 without penalties to purchase your first home, pay for qualified higher education expenses or other hardships (you will still pay taxes on the distribution as normal income, but not the early withdrawal penalty)
Those are the two standard IRA’s, but there are also a few other types of special situations which may be available to you, so I’d like to briefly touch on them in case you have the opportunity to take advantage of one.
A SEP IRA is one developed by business owners (typically small businesses) who want to provide retirement options to their employees but don’t want to go the 401(k) route. An important rule of the SEP is that all employees must receive the same benefit.
In a SEP IRA the employer may choose to make tax deductible contributions on behalf of their employees, including to the owners themselves. An employer can choose to contribute to the employees plan or not, but if they do it must be in the same percentage of compensation to all employees under this plan.
So if you have a few rock stars and a few dull rocks who you of course want to reward according to their performance, perhaps this isn’t the plan for you.
Savings Incentive Match Plan for Employees (SIMPLE) IRA
This plan allows employees to contribute part of their pre-tax compensation to the plan. The benefit of the SIMPLE is that, well, it’s simple.
The administrative overhead and costs are very low and easy, but there is a catch. On the SIMPLE, employers are required to make either matching contributions based on the employee’s contribution amounts, or non-elective contributions even if the employee didn’t contribute themselves.
While I mentioned earlier that pensions are all but done for, the Keogh is just that. If you own your own business, a Keogh is a way for you to pay yourself a pension through your company. These are available to self-employed persons or unincorporated businesses, and because of the way companies are taxed differently than people can be very tax-advantageous if you can afford it.
These can be either defined benefit or defined contribution plans, which you must set up in advance. One of the defined benefit version of this is a profit-sharing plan, and the company does not have to be profitable in order to set money aside for it. If this interests you as much as it does me, speak with a financial professional about starting one for your business.
Annuities get a bad rap sometimes, but in our current environment of increasing life lengths I think it’s a pretty good idea to have one of these on standby if you can afford it. There are many types and variations of annuities out there, but the basic definition of an annuity is a contract between you and an insurance company to pay you in the future.
Most annuities are set up to guarantee you a stream of income from retirement until you die; the reason I think this is important is because it doesn’t matter if you live 5 years or 50 years, it will be a constant stream of income.
And although I am loathe to mention the lottery anywhere in an article about retirement plans, choosing the “X dollars for the rest of your life” option over the lump sum is basically an annuity (a guaranteed stream of income for the rest of your life).
And by the way…if you ever do hit the lottery, always take the lump sum. I’ve had several finance classes where we’ve mathematically worked this out. I’m not saying that annuities are bad, but $100 million dollars in hand is always going to be better, unless you have a lot of meth-addict family members or hip hip entourages that will spend it immediately. It’s called “the time value of money,” and we can get into that in a later article.
But I digress…
The amount of money varies by how much you use to fund it, how long the actuaries expect you to live, age at which you begin to withdraw and many other factors. There all kinds of variations on the formula based on which company you choose, and all of the biggest insurance companies offer them.
Some people don’t trust annuities because they think it’s “too good to be true.” But if you understand how an annuity works, it really isn’t. It’s an “everyone wins” situation. And since the purpose of this series is to explain complicated financial situations in easy to understand pieces, let’s dig in.
Insurance companies have some of the smartest investment professionals that money can buy. Warren Buffett loves own insurance companies because they have massive “floats,” which is also how annuities work.
Both cash value life insurance and annuities work on the same principle: statistically, the insurance actuaries can tell about when, barring any unseen circumstances, you will die (of natural causes). Both cash value life insurance and annuities take that amount of time and figure they can gain X% return on your lump sum (annuity) or monthly payment (cash value life insurance), and agree to give you a portion of it 10, 20 or 30 years in the future.
Essentially, you’re giving them your money to invest for a few decades with a promise not to touch it until then. In their game, if they can make a 30% return and pay you back 10, 20 or 25%, they win. And since they have some of the smartest investors money can buy, they usually win.
Next time you’re in New York, swing by Manhattan and see how many of the tallest buildings have the names of insurance companies on them. They’re doing pretty well.
Another great part about an annuity is that it’s pretty simple to roll just about any investment plan into one. So if you have a significant 401(k) or IRA from your employer, you can do this with minimal paperwork and ensure you’ll have a constant stream of income until you die.
These plans are not available to everyone, but boy are they nice. And since a large portion of the Heroes community falls into the requirements to have one, I thought it would be worth mentioning just in case you do.
A 457(b) retirement plan is an employer sponsored, tax favored retirement account only available to local government employees (including police, firefighters and other civil service employees). I had access to one of these working in a hospital as well, so if you think that you may have access, do yourself a favor and ask your HR department if you do.
These accounts are sort of like a 401(k) in that they are tax deferred, and money can be taken directly from your paycheck to fund them. Unlike a 401(k), however, if you leave your employer or retire before 59 ½, you won’t be hit with the 10% penalty for early withdrawals.
You can generally contribute up to $18,000 to this plan annually, unless you are 50 or older and qualify for the “catch up” contributions mentioned in the 401(k) section (an additional $6,000 per year). Some employers also offer a special deal within three years of retirement in which you can contribute twice the annual limit, or $36,000!
But the amount you contribute may not exceed your annual compensation…but if you are part of a two-income household and one of you has access, you could contribute 100% of your salary to this plan if it doesn’t exceed those guidelines.
Some employers match your contributions, but they are not required to. Also, not all government employers offer 457’s, and some non-profits offer 403(b)’s instead, which we’ll get into next.
A 403(b) plan is a tax advantaged retirement plan for public school and nonprofit employees, as well as some ministers (a few more members of the Heroes community)!
This is another defined contribution plan, meaning you define how much you put in. These are similar to the 401(k) plan, and come in three basic varieties:
- An annuity contract from a life insurance company
- A custodial account invested in mutual funds
- A retirement income account for church employees that invests in mutual funds or annuities
Your employer may choose to match your contribution or not, and may have a tax advantage for doing so. Another benefit to the 403(b) is the 15 year catch up rule. If you have been with the same non-profit for at least 15 years and have contributed less than $5,000 per year on average, your employer may offer a plan in which you can add an additional $3,000 per year for 5 years.
The contributions and distributions here are similar to the 401(k), and you may have one of these on top of a 401(k) or IRA.
I know that was a lot to take in, and believe me, it was a lot to put out. But I truly find joy in helping people understand their finances. Money can’t buy you happiness, but it can buy you options and a much better quality of life in your final years.
This was a broad overview of many of the available plans out there, and at the end of the day I hope that you understand it’s not really all that confusing, and that no matter what job you have or how much money you make there are options out there for you to take control of your future…at least the retirement savings part of it.
The market will go up, it will go down, but over the long term if you invest whatever you can diligently every month, whether it be $5, $50, $500 or $5,000 it can help lead you to a brighter future. Even putting that in a stable investment that offers small returns but has low volatility (meaning it has about the same return over the long run) will leave you in a better place than doing nothing.
And if not for you, do it for your kids. Lord knows they’re going to need it as the world gets more expensive every day.
So thank you for going along with me on this journey, I hope you learned something. Please leave comments or questions on the Heroes Media Group website, Facebook, Twitter or Instagram pages if you enjoyed this article, hated it or feel that I left something out.
Until we meet again next month…
Robert Patrick Lewis is a Green Beret OIF/OEF combat veteran with 10th SFG(A) and is an award-winning author of “The Pact” and “Love Me When I’m Gone: The True Story of Life, Love and Loss for A Green Beret In Post-9/11 War.” He is an MBA candidate (Southern Methodist University – Class of 2018) and licensed Financial Advisor. Follow him @RobertPLewis on Twitter or on his RobertPatrickLewisAuthor Facebook page.