So, you’re finally ready to start adulting and create a solid plan for retirement. You jump in and are presented with a variety of exotic-sounding retirement saving plans: IRA, Roth 401(k), Cash-Plans, defined benefit pension plans…but what do they all mean and which one should you choose?
This article was put together to help you understand the major types of retirement plans and their advantages and disadvantages. It’s never too late or too early to start saving for retirement, but the sooner you take action, the easier it will be to build up a comfortable nest egg for the future.
Social Security And Retirement
As long as you’ve worked for at least 10 years in the United States, you are eligible for Social Security benefits. The amount of Social Security you receive depends on your eligibility and other factors. You can start collecting payouts after the age of 62. In fact, there’s a formula for working out how much Social Security benefits you’ll get. It is based on your 35 highest earning years in the workforce, adjusted for inflation. You can find out more and get an estimate of your Social Security payout via the Social Security Administration website.
The amount you’ll get from your social security benefits is not much. The average retirement benefits are little over $16,000 a year, and the maximum you can get is $32,444 a year. In order to be one of the lucky few who qualifies for the largest amount, you’ll have to be above the Social Security earnings ceiling for at least 35 years since the age of 22. In 2017 this was $127,200 — 35 years ago in 1982, it was $32,400.
Assuming you get the average amount, can you really sustain your retirement lifestyle on $16,000 a year? Could you visit all the destinations on your bucket list, provide for your loved ones, and live a lifestyle of comfort?
If you’ve got any doubts, it’s important to start your retirement plan. By setting aside a bit of money aside, you can work yourself up to a comfortable and enjoyable future.
NOTE: For the scope of this article, we’re going to assume you work in the private sector, as public pensions work a bit differently and are more complex. Public pensions have a different list of requirements and guarantees than those of the private sector. Contact your employer if you want more information on this.
Understanding Pensions vs 401K
Pensions are essentially savings accounts that receive contributions throughout your working life, and which payout in your golden years. They belong to a group of retirement savings plans called “defined benefit plans”. With pensions and defined benefit plans in general, the money you receive during retirement is based on a formula that includes your income and the number of years you worked. Basically, the longer you work, the more you get in retirement.
There are some defined benefit plan types you may come across:
- Funded Plans – In funded plans, contributions from you and your employer are invested into a trust fund that is completely dedicated to paying benefits to retirees. Since future returns are not guaranteed, there’s a possibility that the amount contributed won’t meet future obligations. Because of this, the fund is regularly assessed by an actuary to make sure that everything is ticking along nicely. If a plan doesn’t have an adequate amount of funding then it can become unqualified, which carries severe tax penalties for the employer. Therefore, it’s in your employer’s best interest to not gamble all your contributions away on the stock market or invest in risky mutual funds
- Unfunded Plans – Here, no funds are set aside for the purpose of paying benefits. Instead, the benefits are met immediately by contributions being made to the plan. This is how Social Security works – the payments made by the workforce today pay the benefits of the retired today. Most government-run retirement plans operate this way.
- Hybrid Pension Plans (Cash Balance (CB) or Pension Equity Plans (PEP) Plans – We’ll talk about these later. They’re essentially a combination of defined benefit & defined contribution plans.
- Final Average Pay (FAP) plans – Here, your monthly benefit in retirement is calculated by the number of years you worked multiplied by your salary at retirement and multiplied by a factor known as the accrual rate. Most large company and government agency defined benefit plans follow this formula. You may receive your benefits as a Single Life Annuity (SLA) for a single party or as a Qualified Joint and Survivor Annuity (QSJA) for married participants. You may also optionally receive your benefits as a lump sum.
401(k)s, on the other hand, are what is known as a “defined contribution plans”. A defined contribution plan is structured so that your retirement income is based on the above-mentioned formula (a formula that includes your income and the number of years you worked) and investment returns. Even if your pension (or other defined benefit plan) investments do extremely well, your contribution plan payments are generally fixed according to how much you’ve earned and how long you worked. 401(k) payouts, on the other hand, are dependent on the returns of the investments.
The money contributed to a 401(k) is invested over the long term, most commonly into stocks, bonds, and other securities. When you retire, you live off the investment returns.
401(k) contributions count as a tax deduction. The taxes are only differed, however, as you then need to pay tax when you withdraw from the plan after retirement. This is pretty useful if you are in a higher tax bracket, as contributing towards your 401(k) reduces your taxable income.
On top of that, by deferring tax payments to when you retire, you can ensure your retirement income is at a favorable marginal rate so you pay less tax overall.
This can seem complex but is actually quite simple; we’ll use an example to illustrate.
Let’s say Sarah is a Software Developer for a tech company, assuming 2017 tax brackets. She has an annual pretax income of $100,000, thus putting her in the 28% marginal rate. She contributes the maximum she can annually to her 401(k) plan – $18,000 in 2017 – lowering her taxable income to $82,000, putting her in the 25% marginal rate. Let’s compare what happens when she saves into her 401(k) versus when she doesn’t.
|Doesn’t contribute to 401(k)||Contributes to 401(k)|
|Annual Income before tax||$100,000||$100,000|
|Amount contributed into 401(k) before tax||$0||$18,000|
|Marginal Tax Rate||28%||25%|
|Amount Paid in Tax||$20,981.07||$16,238.25|
By contributing to her 401(k) plan, Sarah saves $4742.82 on her tax bill. She takes less money home before retiring, but the money she’s invested is still her money.
Upon retirement, Sarah works out she only needs $30,000 a year to live comfortably, so she withdraws this amount annually from her 401(k) plan. These withdrawals are taxed as income, and she pays the 15% marginal rate on this, meaning she gets a tax bill of $4033.60 during her retirement years.
By deferring her tax bill Sarah pays a lower tax rate on the income and has enough money saved up for retirement.
In a nutshell, a 401(k) and other defined contribution plans can save the amount of tax you pay on every dollar you earn over your lifetime.
Other than the 401(k) plan there are other types of defined contribution plans.
Individual Retirement Accounts (IRA) are an individual retirement plan that provides tax advantages for saving for retirement. There are several types of IRAs:
- Traditional IRA: Contributions are made before you pay tax. There are no tax impacts for any transactions or earnings within your IRA, and withdrawals upon retirement are taxed as income.
- SEP (Simplified Employee Pension) IRA: A provision which allows your employer to make retirement contributions to a Traditional IRA in your name. These tend to have less start-up and operations costs and are popular with small businesses.
- SIMPLE (Savings Incentive Match Plan for Employees) IRA: Here your employer makes matching contributions to the plan whenever you make a contribution. It’s simpler and has lower contribution limits than a 401(k), but only available to employers with less than 100 employees.
- Roth IRA: Instead of your contributions being made before you pay tax, your contributions are made after you pay tax. However, any withdrawals you make from your IRA upon retirement are tax-free.
The Roth 401(k) isn’t an IRA but bears mentioning. It mixes the advantages of a Roth IRA and a 401(k). Here your 401(k) contributions are made after you’ve paid tax, but your withdrawals upon retirement are tax-free. This is often useful for younger workers who are taxed at a lower income tax bracket but expect to be taxed at a higher marginal rate upon reaching retirement.
What’s Great About Pensions?
A pension has a range of advantages. The greatest one is that the amount you get upon retirement is a fixed amount, guaranteed by the formula you and your employer agreed upon at the beginning of the plan.
This offers a strong sense of security, as your retirement money is shielded from the turbulent world of the market. You can be sure that you won’t need to work past your retirement age.
The security of pensions vs 401(k)s really hit home for a lot of people after the financial crash of 2008. Many workers who had 401(k)s lost a majority of their retirement savings, which has forced a lot of people to work past retirement age. Funds invested in a pension are managed by qualified, professional investment advisors. This lowers the risk of lost assets.
What’s the catch?
A pension isn’t individualized. It involves a group of people contributing towards a fund, which guarantees payouts upon retirement. Contributed a quarter of your annual income towards retirement your entire life, and you die day one of retirement? Tough luck, you nor your beneficiaries of your will usually see any of that money. There are some exceptions, but these are usually limited to a few years of income. For example, a pension may state that beneficiaries inherit 10 years worth of pension payments you would have received.
This contrasts with a 401K, which you can pass on to your heirs if you haven’t used it all up by the time of your passing.
Additionally, a pension isn’t mobile, and you can’t necessarily take it with you when you move to a different employer. This wasn’t a problem for most of the 20th century when workers spent the majority of their professional lives with one employer. However, with job hopping becoming the norm, this can be a problem. 42% of millennials are changing jobs every 1-3 years compared to only 18% of Americans as a whole, it’s clear that lifelong employment as a norm is changing.
On top of that, pensions are rare. They’ve been on the decline since 1978 when 401(k)’s became a very popular method for companies to offer a retirement plan for workers. This is because companies don’t want the long-term liability of providing for their retired worker’s living needs during retirement. Oftentimes you might be offered over a dozen different types of retirement savings plans, and not a single one would be a pension.
What’s So Great About 401(k)s?
The biggest advantage of 401(k)s is that you can pass it on to your heirs. On top of that, defined contribution plans work well for a mobile workforce: it’s not hard to move your 401(k) over to your new employer.
401(k)s also have some financial upsides compared to pensions. If your 401(k) investments do really well, you get to reap all the rewards upon retirement.
Moreover, as we mentioned above, 401(k)s have generous tax schemes. By using a 401(k), you can lower the effective tax rate you pay on your income over your entire life. This way you keep more of what you earn.
They’re also widely available. Almost every employer in the USA offers a 401(k).
What’s the catch?
The terrifying disadvantage of a 401(k) is the prospect of not having enough in your plan to retire on.
This can happen for a variety of reasons. Either you didn’t save enough, maybe because you only started putting money towards your pension later in life, or maybe because you didn’t earn enough to set aside money.
401(k)s don’t always pan out as planned. This is what happened to millions of workers during the financial crash of 2008, who hadn’t diversified their portfolio and were hit hard by the stock market crash.
Hybrid Plans Try To Bridge The Gap
Retirement planning isn’t just split down the middle between pensions and 401(k)s. There are hybrid plans which mix the best of both worlds.
A cash-balance plan is the most popular of these hybrid plans. It’s a pension that resembles a traditional plan but has a lot of elements of a 401(k).
In a cash-balance plan, you don’t invest any money into the plan. Instead, your employer takes a portion of your salary and contributes towards it themselves, and you aren’t responsible for investing the money.
However, unlike a traditional pension, your retirement benefits aren’t calculated using a formula that looks at how long you worked and your final salary. It instead credits with your contributions and a set interest rate that is applied to your balance.
The true benefit of cash-balance plans is the portability. Unlike a typical pension, your cash-balance plan is portable, allowing you to move it as a lump sum into an IRA.
A pension gives you a guaranteed payout if you are loyal, but it isn’t portable and you can’t pass it on. A defined contribution plan like a 401(k) is individualized, meaning that you can take it with you when you change employers and pass it on if you don’t spend it all in retirement. But it also comes with more risk.
Hybrid plans try to marry the two so that you get the benefits of both, but all variety of defined benefit plans (like pensions and many hybrid plans) are on the decline. While you may be attracted to a defined benefit plan, they are very hard to find in the private sector, so often you may only have a choice among defined contribution plans.
The key element to choosing your retirement plan is to make a choice. The biggest danger is to delay action and lose critical years that you could have spent putting a little away to give yourself a lot in retirement. Remember the power of compound interest. If you’re using a defined contribution plan, the longer your savings have to compound, the more you get in retirement. Don’t delay. The imperfect action done today far outweighs the perfect action that is never taken.