Financial planning is about shifting resources (money) to different times during a client’s life. It can be about moving a past tax burden to the future. We can shift resources to a future generation. Most of the time, the goal is focus a client’s resources on a future goal. This can range from something as simple as planning a family vacation or the purchase of a new home, to something as complicated as funding your retirement plans.
No matter what the goal is, the process remains the same. Financial advisors need to work with their client’s to build a plan to that goal. For the majority of my clients, the main focus has been on retirement planning. Luckily, the government has created a bunch of options that help savers work toward their retirement goals. Unfortunately, there are many options available. For every option, there are multitudes of complex rules.
What I’m going to talk about today is the available retirement options you have as an employee. I’ll cover the history and evolution of the retirement plans so that you’ll have an understanding of how these options came to be. I want the reader to walk away understanding the basic advantages of using these retirement plans. We’ll go over the choices you’ll have and discuss the pros and cons of each. In a future post, we’ll expand the conversation to include the many options available for self-employed folks as well as small business owners.
The History of Retirement Plans
Retirement is a fairly new concept. For the majority of human history, you had two options. You could work until the day you died, or you would put the burden of care on your children. Neither of these choices were optimal. As life expectancies around the world increased, more people were forced to uncertain years after work was no longer an option. To deal with this problem, Germany became the first county to adopt an old-age insurance program.
In 1881, Germany’s Chancellor, Otto von Bismarck, crafted the idea of a state run retirement plan. Later, in 1889, German Emperor William the First enacted the plan. In a letter to parliament, William wrote that his plan was that, “Those who are disabled from work by age and invalidity have a well-grounded claim to care from the state.” Bismarck’s motivation was to promote the well-being of workers in order to keep the economy operating at maximum efficiency.
Other countries adopted state run retirement plans for the same reason. By taking the worry and burden away from the population, countries were able to focus on economic expansion. As with all good social programs, the United States eventually adopted a state run Old Age, Survivor, and Disability Insurance (OASDI) program in 1935. Around the same time, many large companies began to adopt their own retirement pension plans. Large companies discovered that these plans encouraged their workers to perform better.
My Grandfathers Retirement Pensions
My Dziadzia (Juh-Jee – Polish for Great Grandfather) was an early adopter of an employer’s pension plan. I still recall him telling the story of how he got enrolled in the pension plan. He was working on the Fisher Body line in Detroit. One day, his boss had a talk with him. The boss told him he was getting a 5 cent raise, but he gave my Dziadzia the option to put the money away into the new retirement plan the company was offering. My Dziadzia figured that, since he hadn’t needed the money before, he didn’t really need it now. He opted to put the money away for retirement.
My other grandfather worked on the Cadillac line from 1945 until 1978. He too, took advantage of the retirement plan General Motors offered. Both them were hard workers, and stayed with the company their entire lives. They were paid a decent wage and knew they were secure in retirement. My great-grandfather passed away when I was 18, having enjoyed a long retirement. His wife continued to receive his pension and health benefits until she passed away 15 years later. My grandfather that worked at on the Cadillac line lived until the age of 94. Between the GMs pension plan and Social Security, my grandparents were able to fully enjoy retirement. They truly had the Cadillac of retirement plan benefits.
Pension plans like my grandparents received are known as define benefit plans. As the name suggests, you are told how much you can expect month to month during retirement. These plans represent the first evolution in corporate retirement planning. The companies would set money aside for future retirement benefits. The government gave corporations in the form of tax breaks to those that set up these pension plans. Worker productivity rose, standards of living rose, and economic output rose. It was a win win situation for everyone.
Our current Social Security system is structured similar to corporate pension plans. The similarities of the two created many issues for both the companies as well as our government. The first problem is the expense of setting up a pension plan. It costs both the government and the companies a lot of money to perform the actuarial calculations needed to properly fund a pension plan.
The second issue was the risk that pension plans place on their sponsors. Many pension plans invest in the stock or bond markets in order to grow the account for future beneficiaries. Taking the burden of risk away from the employee was a major benefit for employees, but that meant the company was responsible for any shortfalls in the account during times when the stock market was doing poorly. Between the costs of planning and the costs of funding pension payments during recessions, these plans were quickly becoming unaffordable.
Living (too) long and prospering
The largest issue with the defined benefit plan was the fact that people started living longer that could have been predicted when the plans were established. When my grandfather retired from Cadillac in 1978, the average life expectancy was around 73 years. GM funded his retirement for 20 years longer than expected. My great grandmother lived far longer than the company could have guessed when they first offered the plan in the 1950s.
Social Security faces the exact same issue. When the plan was passed into law, few people lived long enough to actually take advantage of the benefits. While Social Security has been slowly pushing back the full retirement dates, the original plan was meant to cover far fewer participants than we have now. Due to this flaw in design, Social Security is projected to fully deplete their reserves by 2034.
People will continue to live longer as medical advances continue. This means that financial advisors will have to plan on client’s living spending far more time in retirement. Additionally, advisors have to factor in the possibility of limited Social Security benefits in the future. Most companies have done away with their pension. Those that still have pension plans are at risk of going bankrupt. Government entities and schools are among the few employers that still provide these retirement plans. As long as the pension plan has cost of living adjustments, I typically recommend those who have that retirement benefit, stay with the plan.
For the rest of us, we’re on our own.
The defined benefit plans offer employees the most security in retirement. Between the high costs and a shift in corporate culture, most people now find themselves working with defined contribution plans. The defined benefit plan told you exactly how much you would have to live off of during your retirement. The defined contribution plan is based on how much an individual puts into, or contributes, to their retirement account.
Employers saved considerable amounts of money by switching over to a defined contribution plan. They no longer needed to pay for the expensive actuarial calculations needed to fund the plan. The investment risk shifted from the company to the employee, which saved the company from having cover the difference during market downturns. Many of the other benefits packaged along with the retirement pension also went away. The health care coverage my grandparents enjoyed in retirement is a rarity it today’s world.
The savings the companies received are at the expense of the employees. An employee only knows how much they are contributing to an account, but not how much money they’ll have at retirement. The employee now has to take on the investment risks themselves. The sense of security previous generations enjoyed is far more elusive under the new plans.
Time Value of Money
Luckily, people aren’t completely on their own. The financial planning profession came from consumers seeking answers that their employers once provided. Additionally, the government has stepped it to assist as well. The government has crafted tax advantaged plans that shift the tax burden for retirement. This allows people to reduce their taxes now and pay later on when they’re retired under a lower tax bracket. I’m going to discuss employee sponsored plans like the 401(k) as well as the individual retirement plans available. I’ll also compare and contrast both the Traditional retirement savings plans as well as the newer Roth accounts.
Before that, we need to understand a fundamental concept of financial planning. This is the time value of money. One hundred dollars today will not be able to but the same amount of stuff twenty years from now. Inflation roughly doubles to cost of goods every twenty years. This is the main reason we invest. We need to keep pace with inflation, and we would also like to money to grow in our accounts.
If you’re investing for the long haul, the more money you put away now will have a greater impact on your investment’s growth. This is where the government’s tax advantages retirement savings plan comes into play. When you look at your paycheck, your employer provides the net pay. Next to your net pay, they provide your gross pay. That is the amount you receive after all you taxes, insurance, and other expenses are taken out of your check.
What happens if you decide to invest the funds into a retirement account?
I want you to look at this picture. What you’re seeing is an illustration of tax advantaged savings next to saving without those incentives. This is $100 that you want to invest. The problem here is that you’ve had to pay up to $40 in taxes on the $100 you earned. Obviously, $60 isn’t going to grow as much as $100 would. This is where the government gives you a choice. You’re allowed to invest for retirement both pre and post-tax.
By deferring the taxes until a later time, the government, allows you to invest the full amount in the account. Looking at the green lines that illustrate growth over time, you can see that the pre-tax savings are worth far more than the after-tax savings. This is a traditional retirement savings account. You can save after-tax using either a taxable investment account or a Roth IRA, but we’re going to start with the advantages of savings pre-tax.
Employer Sponsored Defined Contribution Plans
Most people are quite familiar with the 401(k) plans. There are other, similar plans, such as the 403(b)7 plan, the 457, and so on. The names come from the Internal Revenue Code sections they are under. As familiar as these retirement plans are to people, they’ve only been around since 1978. Congress passed rules that allowed companies to structure retirement plans which employees could invest additional retirement funds into.
The funds were allowed to be invested pre-tax, meaning the employee could invest the full amount of money into the retirement account without taxes being withdrawn. Employees could deduct the amount from their current income, but they would eventually have to pay taxes on the funds when they withdrew them. To encourage people to keep their money in the retirement account, the government added a 10% premature distribution tax on any money withdrawn prior to age 59 ½.
Why defined contribution plans
The advantage of this was that employees were reducing their current tax burden. Later on, when they were retired, they would use these funds to pay for retirement expenses. Since you’re likely to be in a lower income tax bracket, deferring the ordinary income tax until retirement allowed the employee to reduce their overall lifetime tax expense. The companies establishing these retirement plans were also given tax incentives for setting up 401(k) plans.
Many companies offer a matching contribution up until a certain percentage of the employee’s contribution. This is free money for the employee! To get full access to the employer contribution, you have to work for a certain period of time, depending on the 401(k) rules established by the company. This free money is one of the main reasons to take advantage of the retirement plan. The other is the higher contribution limits than most other retirement plans. Currently, the 2016 contribution limit into a 401(k) is $18,000.
Even with the advantages of investing in a company sponsored retirement plan, there are major drawbacks to the retirement plan. The 401(k) was never intended to be a replacement for corporate pension plans; they were meant to supplement them. By shifting the retirement burden onto employees, corporations may have saved a bit of money, but they created the retirement crisis we’re now facing. The flaws with the 401(k) style retirement plan are so numerous, that the man who invested the plan says that it now fails most Americans.
Traditional Individual Retirement Accounts
While the General Motors pension planned paid off for their worker, other automobile manufactures weren’t so lucky. In the 1960s, Studebaker began shutting down operations. While the company was closing down factories, management began to realize that their pension fund was poorly funded, a fact that left many long time workers without their hard earned retirement income.
The Employee Retirement Income Security Act (ERISA) was passed in 1974 as a response to the problem of underfunded pension plans. One key provision in ERISA was the creation of the Individual Retirement Account (IRA), which allowed you to put $1,500 into a tax advantaged retirement account. Today, you can make a contribution of $5,500 (in 2016) with a $1,000 catch up provision for folks over the age of 65. Your contribution to an IRA is tax deductible, much like your 401(k), but only if qualified under the following IRS rules.
Roth Individual Retirement Accounts
The Taxpayer Relief Act of 1997 created a new form of retirement savings. The Roth IRA, named after the senator that created the retirement plan, allowed savers to put funds into a retirement account after taxes were paid. This meant that you were putting less money into your retirement account up front, but the advantage was that you were able to take out your money tax free after the age of 59 ½ (and there are no tax penalties prior to that on any contribution you withdraw). Eventually, the concept of after tax savings was adopted for company sponsored 401(k) plans.
As long as your income falls below the IRS limits below, you can put money into the retirement account. The contribution limits are higher than the limits in the Traditional IRA deductibility. An individual or household making in excess of the deductibility limit for the Traditional IRA may want to consider directing their retirement savings to the Roth IRA instead.
Which one works best?
The big question here is, which one works best? You have your company sponsored plan or an individual plan. You can choose between Traditional IRAs and Roth IRAs. There are pros and cons to each. There are times that each of these retirement plans makes sense. You could stick with one structure or use each one available. Since everyone is unique and is at different points in their life, the best recommendation I can make is to reach out you your financial advisor for guidance specific to your situation.
Employer Retirement Accounts – 401(k) 457, 403(b)7
In general, I’ll go over some generic advice on how I approach the use of the plans for my readers. First off, if your company offers a 401(k) style plan, I recommend you take advantage of it. A 401(k) is offered by a company, while a you will have a 403(b)7 working for a non-profit and a 457 plan if your working for a government agency. Most of these plans offer the matching contribution as incentive. If offered, you should always make a contribution in that gives you the full matching contribution amount. If your employer doesn’t offer a matching contribution, the 401(k) still has an advantage. These retirement plans all have a higher contribution amount compared to either IRA plans. Putting more away for retirement is always better for you.
Employer Plan problems
There are downsides to these retirement plans. The first is that investment selection is limited. Additionally, there is little in the way of personalized advice or guidance available. This makes it hard for many people to properly invest. I once had a client decide to invest his 401(k) in the hottest fund available based on the previous year’s results. Since a hot fund is typically at its peak, it usually has nowhere to go but down. After 12 years, the client had an average rate of return around 1% annually.
The lack of advice and guidance is one issue. Another problem is that any premature withdrawal is taxed at a mandatory 20%. While loan options are available, accessing funds in an emergency is difficult. Finally, the largest negative aspect of the 401(k) is the trustee. Company sponsored retirement plans are often held at large financial institutions. As an employee, you have no control over this.
You’ll have many jobs (and 401ks), but only one retirement. Your IRAs should be considered a destination account. Most people simply roll their 401(k) into an IRA with whatever company the retirement plan was held at. While it’s the easiest thing to do, it’s not always in your best interest. You may get lucky and find your account was held with a fairly benign discount broker like Vanguard or Fidelity, or you could find yourself dealing with salesman from one of the large Wall Street firms like Merrill Lynch. That could cause you to spend thousands of dollars on commissions directly from your retirement account.
Individual Retirement Account
Eventually, all of your 401(k), 457, or 403(b)7 accounts should find their way into an Individual Retirement Account. The IRA allows you full access to almost every investment option available. Additionally, a qualified financial advisor can work with you to make investment decisions, rebalance your portfolio, and plan out a savings strategy that will help you achieve your retirement goals. You can open an IRA with a bank, at a discount or full service brokerage firm, or with a Registered Investment Advisor such as myself.
The control over the investments is the biggest advantage of the IRA. The lower contribution amount is the major drawback. While you may have an IRA account open, I generally recommend that my clients take advantage of the higher contribution limits their employer plan offers. Once they have maximized the contributions into that account, and additional saving should next go into an IRA account.
Traditional and Roth Tax Strategies
After the choice between an employer sponsored retirement plan and an IRA has been made, the next choice is between pre-tax and post-tax savings. The main question is this; do I pay taxes now or later? The answer depends on your unique situation. In general, I look at the tax structures a couple different ways, so I’ll again offer generic advice. Reaching out to your financial advisor is best for you.
As mentioned, Traditional IRA structures reduce your current income today. You pay ordinary income on the withdrawals at retirement, which should hopefully put you into a lower tax bracket. A Roth IRA has you pay taxes now, with tax free distributions later on. The advantage here is tax free money in retirement. Also, we’re currently at historically low tax rates, which indicates that tax rates could be much higher in the future. That is one potential benefit of a Roth IRA.
When to use a Roth
From my perspective, the Roth IRA works best for people currently in a low income tax bracket. I also like using the Roth IRA for investors that are just starting out. Typically, they are in a lower tax bracket, but the other reason is that many newer investors don’t have an emergency fund built up. The Roth IRA allows you to pull your contributions out without taxes or penalty (though any growth withdrawn will be taxed and penalized).
Once an earner moves into a higher tax bracket, I would consider switching my client into a traditional retirement plan structure. The reason is that the contribution can be tax deductible. This lowers the amount of income the client will have to pay taxes on and may prevent them from moving into a higher tax bracket. You are not required to stay with one or the other tax shelter, so make changes as the situation dictates.
In the end, I recommend them having both tax structures. My reasoning is that this gives my clients two tax buckets to draw money from at retirement. These tax buckets help you coordinate your income needs with your Social Security payments. Above a certain income, Social Security benefits become taxable income. By having a taxable and tax free bucket of funds available at retirement, we can prevent the Social Security income from becoming a large tax burden. We would simply take enough income from the Traditional fund that would keep us below the threshold, then remove any additional living expenses from the Roth IRA.
In the End
If you’ve actually read all of this, bravo! I’m at about nine pages in length on Word alone. I’d expect more than a few people might just as well jump to the conclusion here. I understand that… even with the simplified version of available retirement planning options, there’s a ton of stuff to sift through. That’s why I always recommend dealing with a qualified tax advisor, preferably a Certified Financial Planner (CFP) working under the fiduciary standard.
The reason is that your time is valuable both now and in retirement. You can take the time to learn all of the nuances of the industry, but at that point you might as well get a job in finance. Working with an advisor allows you to get your time back. I write these posts not in the hopes you’ll go out and learn how to do everything on your own (indeed, I’d prefer it if you became my client), but rather to help make it easier for the reader to navigate the world of finance, investments, and retirement planning.