PENSIONS, 401k’s, IRA’s
I have outlined here my thoughts about the more common sources of retirement income. I have personal experience of all of them. There are two main types: so-called “defined contribution plans” (for most of us this means 401k’s and / or IRA’s) and so-called “defined benefit plans” (old-fashioned employer pensions, which are unfortunately becoming less common; as well as social security). I shall discuss each of these in turn but, before doing so, I would mention three points:
401k Plans
Key points:
Many employers, large and small, offer 401k plans, (as does the firm where I spent my career) as a vehicle to help employees save for their retirement. In some organizations, a 401k plan is offered in addition to a pension plan but, in more and more, there is only a 401k plan. For some years now, Roth 401k plans have been allowed and are gaining in popularity; I discuss the distinction, and my personal preference, below.
401k plans are a tax-efficient way for employees to put away part of their salary to fund their retirement. In many cases the employer will also contribute to the plan by “matching” the employee’s contributions up to a certain level, in most cases no more than 6% of salary. Most financial advisors recommend that employees contribute to a 401k plan at least up to the point where one maximizes the company match. This is what I did. If one does not, one is leaving employer money on the table. Say the employer is willing to match up to 5%; in my opinion one should not contribute anything less than 5% of salary. The maximum contribution allowed by the IRS for 2019 is $19,000.
401k plans are normally managed for the employer by a fund management firm, who will generally offer a range of investment options from which to choose, such as money-market funds, stock and bond managed funds and (hopefully) index funds, as well as what are known as “target date funds” (where contributions are invested in a fund that matches one’s expected date of retirement, say a 2040 – 2044 fund.)
How does one select from these various investment options? My philosophy, consistent with my logic explained in the SAVINGS AND INVESTMENTS tab is as follows:
401k’s and Roth 401k’s
The principal difference between the two is that with a traditional 401k plan, one makes the contributions with pre-tax dollars (you pay tax on your salary afterdeduction of the 401k contribution) whereas with a Roth 401k, one makes the contribution with after tax dollars (you pay tax on your salary beforededuction of the Roth 401k contribution).
So why would anyone choose a Roth 401k when the tax taken out of one’s paycheck will be higher? The answer lies in what happens when one retires and starts to draw funds from the account. With a traditional 401k, the funds withdrawn are treated as regular income for tax purposes and one pays tax at standard rates - on both the original contributions and the income and capital gains that have accrued over the years. On the other hand, with a Roth 401k tax has already been paid on the contributions, and the income and capital gains made over the years are tax free – there is no tax to pay on funds withdrawn, you keep all of it.
In theory if one’s individual tax rate is higher now than it will be when one will withdraw the funds in retirement, a traditional 401k may be preferable. A Roth 401k is preferable if one’s tax rate in retirement will be the same or higher than when one made the contributions. The reality is we cannot know about our future tax rates. My preference, therefore, is to contribute to a Roth 401k if offered, to the extent one can afford, and pay the tax now, knowing there will be no more tax to pay in retirement. If one cannot afford to contribute to a Roth 401k as much as one would like because of the additional tax burden, many employers who offer a Roth 401k will allow employees to split their contributions and contribute to both.
For both types of 401k there are rules on when withdrawals have to commence, which I am not going to get into here to keep things as simple as I can.
I would add that there are a few situations where I would recommend not putting money into an employer’s 401k plan. A friend of mine joined a small company that had a 401k plan, but no company match at all, did not offer a Roth 401K option, and the only investment options were high cost managed funds – all things that are unattractive to me. I asked how long she expected to be with this company and was told no more than two or three years. My suggestion was not to join the 401k plan and to rather fund her IRA to the full extent, something I discuss below.
Changing jobs
The question often arises as to what to do with a 401k account when one leaves a job. There are often three options:
As I said at the beginning, avoid having the funds paid out to you now; these are funds for retirement. Of the three options, I prefer to immediately roll 401k accounts from former employers into one’s own IRA. As I discuss below, I think we should all have an IRA and, if one rolls 401k balances into it when changing jobs, one knows where the money is and won’t have to contact a former employer’s HR department years down the road. The funds will be under your control.
Individual Retirement Accounts (IRA’s)
Key points:
In my opinion, just about all of us should have an IRA once we enter the workforce and contribute whatever we can from year to year. In this way, we can supplement our retirement funding, in a tax efficient way, beyond a 401k account. If one does not work for an organization that offers a 401k plan, all the more important to have an IRA. I have had one for many years.
Subject to income limitation rules, which are adjusted from time to time by the IRS, contributions to a traditional IRA are made with pre-tax dollars (you pay tax on your income after deduction of the IRA contribution.) The maximum contribution for 2018 is $6,000, and $7,000 if you are over 50. One pays income tax at standard rates when one starts to withdraw funds from the IRA, which one can start to do without penalty from around age 60 and one is required to do from around age 70.
There are also Roth IRA’s, which work much like Roth 401k’s described above. Contributions to Roth IRA’s are made with after-tax dollars(you pay tax on your income beforededuction of the Roth IRA contribution.) With a Roth IRA, tax having been paid on the contributions, there is no further tax to pay on funds withdrawn in retirement, you keep all of it, including the all the income and capital gains earned over the years. An added benefit: unlike a traditional IRA there is no requirement to start withdrawals at a certain ago. You can even leave your Roth IRA to your heirs and they will normally not have any income tax to pay on withdrawals.
Above certain levels of income, the IRS does not allow taxpayers to contribute to a Roth IRA, but everyone can contribute to a traditional IRA and convertthe funds to a Roth IRA and pay income tax on the amount converted. This is what I have done. (By the way, if the original IRA contribution was not tax deductible because the taxpayer’s income was over the IRS income limit for deductible IRA contributions, the conversion is not taxed.)
There is much I like about Roth IRA’s. My preference, therefore, is to fund a Roth IRA to the extent one can afford, and pay the tax now, knowing there will be no more tax to pay in retirement. If one is above the income limit for Roth IRA’s, or circumstances are such that one needs the tax deduction now, by all means contribute to a traditional IRA. Any time up to retirement one can convert part or all of the IRA balance to a Roth IRA and pay the tax on the conversion. Subsequent growth in the balance, once it is in a Roth IRA, will be tax-free. My preference is to start conversions as soon as one can afford to do so.
Finally, how should one invest one’s contributions to an IRA or Roth IRA? I follow the same rules as with a 401k, as discussed above. I do not invest in money-market funds. While one has many years to retirement, my preference is to invest heavily in stock funds. As one gets closer to retirement one can move some of the investment to bond funds to reduce volatility. Again, I stuck to index funds with their lower fees, rather than managed funds, for the reasons I explain under SAVINGS AND INVESTMENTS.
Pensions
Key points:
As mentioned earlier, private sector employers have been moving for years to offering only definedcontribution plans,so they can peg their cost of providing retirement benefits, as are some government entities. Yet, some of us are lucky enough to work for organizations that still provide pension benefits in retirement via defined benefit plans.
A pension is essentially a commitment on the part of an employer to pay a pre-determined amount to an employee, usually monthly, in retirement. The amount is often determined by the number of years of employment, level of compensation prior to retirement and age at retirement. Some pension plans build an inflationary element into the benefit and, in some, payments can continue until after the death of the retiree until a spouse or other named beneficiary passes away.
Pensions are extremely valuable, in my view, as the investment risk rests with the employer. Unlike with 401k’s and IRA’s, the individual does not have the responsibility of deciding how to invest funds to be drawn upon to pay retirement benefits; that responsibility rests with the employer. If the value of the invested funds in a pension plan drops, the employer has to make good the shortfall to ensure that pension payments can be met. What is not to like about that?
With some pension plans, however, one has to make a critical decision at the time of retirement, and that is whether to take a lump-sum payout, instead of receiving a monthly pension. One would then roll over the lump sum (which could be quite large) tax-free to one’s IRA. The process is a bit complicated, so I won’t get into the mechanics.
I would think carefully before taking a lump sum for a couple of reasons:
The amount of the lump sum alternative, if offered, is usually determined actuarially using average life expectancies so, in theory, one is no better or worse off taking the lump sum if one invests the funds appropriately (to obtain the returns the actuaries used in their calculations) and one lives that “average” life span. If one lives a lot longer one would generally be better off collecting the pension, if one passes away soon after retiring one would generally have been better off taking the lump sum. The problem is we don’t know how long we will live. I would only consider taking a lump sum if I was in poor health at the time of retirement or seriously lacked longevity genes in my family. It is also nice to simply continue receiving a regular check in retirement to pay the monthly bills, even if the amount is much less than when one was working. This is, however, an area where it may be worth obtaining professional advice.
I would make an exception if one works just a few years for a company that provides a pension, in which case the monthly pension one will receive upon reaching retirement age may not be very much. In a case like that, if offered a lump sum, it might be simpler to take it and roll it into an IRA – it just keeps things simpler.
Social Security
Key point:
If one can wait until 70 to start drawing social security, for most of us this is a good thing to do.
Social security is another form of defined benefit, it is a type of pension from the federal government, also for life. The social security program also has survivor benefits, which I won’t discuss here to keep things simple. Employers and employees pay social security premiums during a person’s working life and one draws the benefits upon reaching retirement age. The benefits are increased periodically for inflation.
There are no lump sum options with social security, so the biggest decision is when to start drawing benefits, which one can do any time from age 62 to 70, whether still working or not. When one starts is essentially neutral from an actuarial standpoint – whatever age one starts, one will ultimately receive the same benefit if one lives an “average” life span. Starting at 70 one will receive considerably higher monthly payments than if one starts at 62 but will receive them for eight years less. The “crossover point” is in one’s early eighties.
Like a pension, social security can serve as “insurance” against living a long life. I started drawing social security at age 70. If one can afford to wait until then and live off other income, perhaps from a part-time job if no longer working full-time, or even savings, I believe this can be the best strategy better for most of us. If one lives to one’s nineties, many of us will find our savings depleted by then, just at a time when our health declines and medical and long-term care expenses can peak, so would it not be better to have higher social security benefits coming in every month by waiting to start drawing until 70? The point about one’s state of health, which I mentioned above under pensions, of course, applies to social security as well. Waiting is not best for some of us.
Many people, though, need the monthly payment before 70 because they are no longer working, have limited savings and do not have a choice. Some financial advisors say rather start drawing on a 401k or IRA, before touching social security, because the investments in those accounts can go down as well as up, whereas monthly social security payments only go up if one waits. When to start drawing social security, or from a 401k or IRA, is a crucial decision and it may be worth obtaining advice from a personal financial advisor. Decisions on when to start drawing benefits are also more complicated if one is married and both spouses have entitlement to benefits.
- It is never too early to start putting money away for retirement. If one invests $5,000 at age 25 and doesn’t touch it, and it grows at, say, 5% per annum, it will be worth around $35,000 by the time one is 65. As I discuss below, with a Roth IRA that appreciation of $30,000 will be tax free.
- At all costs avoid drawing money from these accounts before retirement – one will be faced with a tax bill - and do not take loans against them. This money is to provide income to live on in retirement.
- Most of us should not rely solely on the sources of retirement income discussed below to provide sufficient income to live comfortably in retirement. It is desirable to supplement this income with other savings accumulated up to the point of retirement. See my discussion of SAVINGS AND INVESTMENTS for my approach to saving.
401k Plans
Key points:
- If an employer offers a 401k plan, one should contribute to it at least to the point where one obtains the maximum company matching contribution.
- Until one is nearing retirement, I think it is best to invest heavily in stocks, my preference is low-cost index funds; later one can switch some of the money to bond funds.
Many employers, large and small, offer 401k plans, (as does the firm where I spent my career) as a vehicle to help employees save for their retirement. In some organizations, a 401k plan is offered in addition to a pension plan but, in more and more, there is only a 401k plan. For some years now, Roth 401k plans have been allowed and are gaining in popularity; I discuss the distinction, and my personal preference, below.
401k plans are a tax-efficient way for employees to put away part of their salary to fund their retirement. In many cases the employer will also contribute to the plan by “matching” the employee’s contributions up to a certain level, in most cases no more than 6% of salary. Most financial advisors recommend that employees contribute to a 401k plan at least up to the point where one maximizes the company match. This is what I did. If one does not, one is leaving employer money on the table. Say the employer is willing to match up to 5%; in my opinion one should not contribute anything less than 5% of salary. The maximum contribution allowed by the IRS for 2019 is $19,000.
401k plans are normally managed for the employer by a fund management firm, who will generally offer a range of investment options from which to choose, such as money-market funds, stock and bond managed funds and (hopefully) index funds, as well as what are known as “target date funds” (where contributions are invested in a fund that matches one’s expected date of retirement, say a 2040 – 2044 fund.)
How does one select from these various investment options? My philosophy, consistent with my logic explained in the SAVINGS AND INVESTMENTS tab is as follows:
- Do not invest in money-market funds; we are talking about funding one’s retirement so, unless one is close to retirement and wants stability of capital, one needs a better return than the pittance that is earned from a money-market fund. Be careful, as some 401k plans default to investing in a money-market fund if employees fail to make an investment selection.
- While one has many years to retirement, invest heavily in stock funds. As one gets closer to retirement one can move some of the investment to bond funds to reduce volatility. I stuck to index funds with their lower fees, rather than managed funds, for the reasons I explained under the SAVINGS AND INVESTMENT tab. Many, but not all, employers offer both in their 401k plans. If the employer is a public company and allows employees to invest in the company’s stock, most advisors recommend investing no more than a small percentage of contributions in company stock.
- For those who prefer to put their 401k on “autopilot” consider a target date fund that matches one’s expected year of retirement, if one is offered. A word of caution: watch the fees; these are really “funds of funds,” in that there are investments in stock and bond funds underneath an umbrella fund. Over time, funds are moved from the stock to the bond category. As a result, there are two layers of fees and, if the underlying funds are managed funds, the fees can be quite high, and these eat into returns. Some target date funds are value for money, in my opinion, others are not. Personally, I avoided them, firstly because I preferred to choose the underlying funds myself rather than have a fund manager do it, secondly, I preferred to have a higher percentage in stocks than target date funds tend to select for a given age. At the same time, I was able to invest in funds with lower fees than I could find with a target date fund.
401k’s and Roth 401k’s
The principal difference between the two is that with a traditional 401k plan, one makes the contributions with pre-tax dollars (you pay tax on your salary afterdeduction of the 401k contribution) whereas with a Roth 401k, one makes the contribution with after tax dollars (you pay tax on your salary beforededuction of the Roth 401k contribution).
So why would anyone choose a Roth 401k when the tax taken out of one’s paycheck will be higher? The answer lies in what happens when one retires and starts to draw funds from the account. With a traditional 401k, the funds withdrawn are treated as regular income for tax purposes and one pays tax at standard rates - on both the original contributions and the income and capital gains that have accrued over the years. On the other hand, with a Roth 401k tax has already been paid on the contributions, and the income and capital gains made over the years are tax free – there is no tax to pay on funds withdrawn, you keep all of it.
In theory if one’s individual tax rate is higher now than it will be when one will withdraw the funds in retirement, a traditional 401k may be preferable. A Roth 401k is preferable if one’s tax rate in retirement will be the same or higher than when one made the contributions. The reality is we cannot know about our future tax rates. My preference, therefore, is to contribute to a Roth 401k if offered, to the extent one can afford, and pay the tax now, knowing there will be no more tax to pay in retirement. If one cannot afford to contribute to a Roth 401k as much as one would like because of the additional tax burden, many employers who offer a Roth 401k will allow employees to split their contributions and contribute to both.
For both types of 401k there are rules on when withdrawals have to commence, which I am not going to get into here to keep things as simple as I can.
I would add that there are a few situations where I would recommend not putting money into an employer’s 401k plan. A friend of mine joined a small company that had a 401k plan, but no company match at all, did not offer a Roth 401K option, and the only investment options were high cost managed funds – all things that are unattractive to me. I asked how long she expected to be with this company and was told no more than two or three years. My suggestion was not to join the 401k plan and to rather fund her IRA to the full extent, something I discuss below.
Changing jobs
The question often arises as to what to do with a 401k account when one leaves a job. There are often three options:
- Leave your account with your former employer’s 401k plan.
- Roll the account over to a new employer’s 401k plan.
- Roll the account over to your own IRA.
As I said at the beginning, avoid having the funds paid out to you now; these are funds for retirement. Of the three options, I prefer to immediately roll 401k accounts from former employers into one’s own IRA. As I discuss below, I think we should all have an IRA and, if one rolls 401k balances into it when changing jobs, one knows where the money is and won’t have to contact a former employer’s HR department years down the road. The funds will be under your control.
Individual Retirement Accounts (IRA’s)
Key points:
- Open an IRA and contribute to it every year; this is especially important if one does not have access to a 401k plan.
- Roth IRA’s have a number of attractive features and should be considered in addition to, or as an alternative to, a traditional IRA.
- Until one is nearing retirement invest heavily in stocks, ideally via low-cost index funds, later one can switch some of the money to bond funds.
In my opinion, just about all of us should have an IRA once we enter the workforce and contribute whatever we can from year to year. In this way, we can supplement our retirement funding, in a tax efficient way, beyond a 401k account. If one does not work for an organization that offers a 401k plan, all the more important to have an IRA. I have had one for many years.
Subject to income limitation rules, which are adjusted from time to time by the IRS, contributions to a traditional IRA are made with pre-tax dollars (you pay tax on your income after deduction of the IRA contribution.) The maximum contribution for 2018 is $6,000, and $7,000 if you are over 50. One pays income tax at standard rates when one starts to withdraw funds from the IRA, which one can start to do without penalty from around age 60 and one is required to do from around age 70.
There are also Roth IRA’s, which work much like Roth 401k’s described above. Contributions to Roth IRA’s are made with after-tax dollars(you pay tax on your income beforededuction of the Roth IRA contribution.) With a Roth IRA, tax having been paid on the contributions, there is no further tax to pay on funds withdrawn in retirement, you keep all of it, including the all the income and capital gains earned over the years. An added benefit: unlike a traditional IRA there is no requirement to start withdrawals at a certain ago. You can even leave your Roth IRA to your heirs and they will normally not have any income tax to pay on withdrawals.
Above certain levels of income, the IRS does not allow taxpayers to contribute to a Roth IRA, but everyone can contribute to a traditional IRA and convertthe funds to a Roth IRA and pay income tax on the amount converted. This is what I have done. (By the way, if the original IRA contribution was not tax deductible because the taxpayer’s income was over the IRS income limit for deductible IRA contributions, the conversion is not taxed.)
There is much I like about Roth IRA’s. My preference, therefore, is to fund a Roth IRA to the extent one can afford, and pay the tax now, knowing there will be no more tax to pay in retirement. If one is above the income limit for Roth IRA’s, or circumstances are such that one needs the tax deduction now, by all means contribute to a traditional IRA. Any time up to retirement one can convert part or all of the IRA balance to a Roth IRA and pay the tax on the conversion. Subsequent growth in the balance, once it is in a Roth IRA, will be tax-free. My preference is to start conversions as soon as one can afford to do so.
Finally, how should one invest one’s contributions to an IRA or Roth IRA? I follow the same rules as with a 401k, as discussed above. I do not invest in money-market funds. While one has many years to retirement, my preference is to invest heavily in stock funds. As one gets closer to retirement one can move some of the investment to bond funds to reduce volatility. Again, I stuck to index funds with their lower fees, rather than managed funds, for the reasons I explain under SAVINGS AND INVESTMENTS.
Pensions
Key points:
- If you work for an employer that provides pension benefits, this is extremely valuable as pensions are paid for life.
- I would think carefully before taking a lump sum, if offered, at the time of retirement.
As mentioned earlier, private sector employers have been moving for years to offering only definedcontribution plans,so they can peg their cost of providing retirement benefits, as are some government entities. Yet, some of us are lucky enough to work for organizations that still provide pension benefits in retirement via defined benefit plans.
A pension is essentially a commitment on the part of an employer to pay a pre-determined amount to an employee, usually monthly, in retirement. The amount is often determined by the number of years of employment, level of compensation prior to retirement and age at retirement. Some pension plans build an inflationary element into the benefit and, in some, payments can continue until after the death of the retiree until a spouse or other named beneficiary passes away.
Pensions are extremely valuable, in my view, as the investment risk rests with the employer. Unlike with 401k’s and IRA’s, the individual does not have the responsibility of deciding how to invest funds to be drawn upon to pay retirement benefits; that responsibility rests with the employer. If the value of the invested funds in a pension plan drops, the employer has to make good the shortfall to ensure that pension payments can be met. What is not to like about that?
With some pension plans, however, one has to make a critical decision at the time of retirement, and that is whether to take a lump-sum payout, instead of receiving a monthly pension. One would then roll over the lump sum (which could be quite large) tax-free to one’s IRA. The process is a bit complicated, so I won’t get into the mechanics.
I would think carefully before taking a lump sum for a couple of reasons:
- One is then faced with making the investment decisions, and if the market value of the investments decline, one’s retirement assets will be worth less. As one is now retired there aren’t as many years for the value of the investments to recover as was the case when one was younger.
- A pension is an annuity payment for life; it is like “insurance” against running out of money should one live to a great age. Running out of money is potentially more of an issue for people dependent on defined contribution planslike 401k’s and IRA’s, which could be the case if one takes a lump sum.
The amount of the lump sum alternative, if offered, is usually determined actuarially using average life expectancies so, in theory, one is no better or worse off taking the lump sum if one invests the funds appropriately (to obtain the returns the actuaries used in their calculations) and one lives that “average” life span. If one lives a lot longer one would generally be better off collecting the pension, if one passes away soon after retiring one would generally have been better off taking the lump sum. The problem is we don’t know how long we will live. I would only consider taking a lump sum if I was in poor health at the time of retirement or seriously lacked longevity genes in my family. It is also nice to simply continue receiving a regular check in retirement to pay the monthly bills, even if the amount is much less than when one was working. This is, however, an area where it may be worth obtaining professional advice.
I would make an exception if one works just a few years for a company that provides a pension, in which case the monthly pension one will receive upon reaching retirement age may not be very much. In a case like that, if offered a lump sum, it might be simpler to take it and roll it into an IRA – it just keeps things simpler.
Social Security
Key point:
If one can wait until 70 to start drawing social security, for most of us this is a good thing to do.
Social security is another form of defined benefit, it is a type of pension from the federal government, also for life. The social security program also has survivor benefits, which I won’t discuss here to keep things simple. Employers and employees pay social security premiums during a person’s working life and one draws the benefits upon reaching retirement age. The benefits are increased periodically for inflation.
There are no lump sum options with social security, so the biggest decision is when to start drawing benefits, which one can do any time from age 62 to 70, whether still working or not. When one starts is essentially neutral from an actuarial standpoint – whatever age one starts, one will ultimately receive the same benefit if one lives an “average” life span. Starting at 70 one will receive considerably higher monthly payments than if one starts at 62 but will receive them for eight years less. The “crossover point” is in one’s early eighties.
Like a pension, social security can serve as “insurance” against living a long life. I started drawing social security at age 70. If one can afford to wait until then and live off other income, perhaps from a part-time job if no longer working full-time, or even savings, I believe this can be the best strategy better for most of us. If one lives to one’s nineties, many of us will find our savings depleted by then, just at a time when our health declines and medical and long-term care expenses can peak, so would it not be better to have higher social security benefits coming in every month by waiting to start drawing until 70? The point about one’s state of health, which I mentioned above under pensions, of course, applies to social security as well. Waiting is not best for some of us.
Many people, though, need the monthly payment before 70 because they are no longer working, have limited savings and do not have a choice. Some financial advisors say rather start drawing on a 401k or IRA, before touching social security, because the investments in those accounts can go down as well as up, whereas monthly social security payments only go up if one waits. When to start drawing social security, or from a 401k or IRA, is a crucial decision and it may be worth obtaining advice from a personal financial advisor. Decisions on when to start drawing benefits are also more complicated if one is married and both spouses have entitlement to benefits.
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