Retirement and investment terms can be confusing; their names rarely give an accurate description of what they are, and most of our friends and neighbors will offer differing opinions on each type of account. Pensions, 401Ks, IRAs and Roth are all retirement vehicles, but they are not the same.
Structural Differences in Retirement Accounts
Retirement vehicles can be divided into 3 unique types as follows:
A Pension Plan is unique. It is a retirement plan in which your employer promises you a certain monthly or annual payment when you retire; typically, these benefit payments are promised for life, but there are usually other options offered. The unique aspect of a pension is that you do not own the money in the plan. All you “own” is the promise your employer has made to you. If your employer gets into financial trouble, this pension promise can be reduced significantly in bankruptcy.
You don’t make any contributions, you don’t control the investment decisions in the plan, and you just wait until you’re allowed to start collecting on the promise. When you start collecting those payments, they are taxed as regular income.
401Ks and IRAs
The second type consists of 401Ks and IRAs. Each is a retirement account to which you contribute, and you own the money inside each account (with a few limitations listed below). When you contribute to a 401K or to an IRA, the contribution is usually deducted from your taxable income. As the money inside the 401K or IRA grows, it is exempt from taxes. When you withdraw the money for retirement, you are taxed on the amount of the withdrawal as if it were income you received from a job. It becomes your “retirement salary” in a sense.
Employers can also contribute money to a 401K on your behalf. If they do, the employer is entitled to limit your ownership of the money they contribute. You always own 100% of the money you contribute, but a very common employer “vesting” schedule would look like this:
In the vesting example above, when you have worked for your employer 6 years, you own 100% of all the money in the account. You’ve always owned your money, but now you own the employer’s money as well.
The last type consists of Roth IRAs. There are various forms of Roths, but the critical components are the same. You own 100% of the money you contribute. If your employer contributes, there may be a vesting schedule similar to the one above. For tax purposes, you do not get to deduct contributions from your income. However, as the money grows inside the Roth it is exempt from taxes, and when you withdraw money from your Roth, there is no tax. In terms of tax treatment, the Roth is the “flip side” of the IRA.
The critical tax differences are illustrated below:
How Much Can You Contribute
Each of these retirement vehicles has contribution limitations. Pensions are limited by a complex formula, but it applies to your employer. Remember, only the employer is making a contribution to your pension.
401Ks have the largest contribution limit. While these specific limits will no doubt change a bit from year to year, the relative difference has remained roughly the same for a number of years and is likely to remain so. For 2020, the limits are:
401Ks – maximum contribution of up to $19,500 from your salary or bonus. If 50 years or older, $26,000. There are no income limitations on the contribution amount.
IRAs & Roths – maximum contribution of up to $6,000. If 50 years or older, $7,000. Unfortunately, there are potential income limitations to your IRA/Roth contribution. Check with your tax preparer, but depending upon how much you make, your contribution level may be restricted.
As you can see, even if you’re not subject to income limits, the 401K allows you to contribute on a tax-deductible basis more than 3 times the amount you can contribute to an IRA or Roth. If you’re lucky enough to work for an employer who offers a matching contribution, we would strongly advise that you contribute the maximum amount your employer will match. If you don’t, your walking away from almost-free money. We say, “almost” because you must remain employed long enough to fully vest the employer’s contribution.
Investing Your Retirement Funds
While a traditional pension plan does not allow you to take control of the investments in the plan, all the other retirement vehicles provide you with a significant degree of control. How you invest your money is a critical issue – too big to be handled thoroughly here – but a few guidelines will help.
Market Uncertainty and Inflation
Pay attention to the two primary risks – market uncertainty and inflation. Everyone knows that stocks and bonds come with some amount of risk. But too few people realize that inflation poses a major risk to your financial future. At just 3% average annual inflation, the purchasing power of your retirement nest egg will be cut in half in 22 years. You can’t just sit in a money market account and overcome inflation; you must engage the markets.
Timing the Markets
You can’t time the markets. Nobody has done this successfully over the long-term. Market timers may seem to be “winning” for a period of time, but inevitably they lose, and lose big. Make a plan and stick with the plan; don’t jump in and out.
Emotion and Reason
Balance your emotions and reason. We all have intelligence and emotions. We can all be pushed to our breaking point. None of us likes market volatility, and our emotions can get the best of us at either end. It’s easy to get greedy when the market is hitting new highs, and very easy to get fearful when the market is falling. You shouldn’t buy out of greed, and you shouldn’t sell just out of fear. That’s how to lose money over the long-term. You have to develop a reasonable investment plan and stick with it during the emotional highs and lows.
Withdrawals, Taxes and Penalties
All retirement accounts have withdrawal rules. They can be simple enough, but if you don’t pay attention and break the rules, it can get expensive quickly.
Pension plans set their own specific rules but generally revolve around the traditional retirement age of 65. At the retirement age, you have been promised a certain monthly payment which can be paid over your life, or over your life and your spouses lives, or over some other time span. Your pension administrator will tell you what the monthly payment options are. Many pensions also let you take a lump-sum one-time payment equal to the calculated value of your monthly payment promise. Again, the administrator will tell you what this amount is, if a lump-sum payment is allowed.
If you take one of the monthly options, then the payment you receive is taxable, just like regular income.
If you take the lump-sum option, the payment will be 100% taxable if you don’t roll it over into an IRA. If you do roll it over into an IRA, then the rollover is not taxable. Later, as you take withdrawals from the IRA, each withdrawal is taxable.
It is impossible to determine for all cases whether the monthly payment or the lump-sum rollover to an IRA is the best option. You need to have a financial advisor analyze this so you can make the best decision for your circumstances.
If you leave your employer before retirement, you’ll have some variation of the options above. The amount of your monthly payment and of the lump-sum payment will be lower than if you remain until retirement age, but you should have options on how to take the money.
401Ks and IRAs
401Ks and IRAs are very similar to one another. If you withdraw money from an IRA or a 401K and roll it over into another 401K or IRA, there is no tax on the rollover. However, if you withdraw and fail to make a rollover, then there are tax consequences.
If the withdrawal is made when you’re 59 ½ or older, you only have to pay income taxes on the withdrawal amount.
If the withdrawal is made before you’re 59 ½, then you have to pay income taxes AND you will have to pay a penalty tax for an early withdrawal. There are some exceptions:
Penalty Tax Exceptions:
- Hardships – if you meet certain stipulated hardship circumstances, you can avoid the penalty taxes
- SEPP Withdrawals – if you agree to take Substantially Equal Periodic Payments (SEPP) for the longer of 5 years or until you turn 59 ½ you can avoid the penalty taxes.
Roths allow you to withdraw your money at any time, but there may be penalties. In order to make a “qualified” withdrawal and avoid penalties, you must be 59 ½ or older, and at least 5 years must have passed since you first contributed. Having said that, you may withdraw your contributions at any time without penalty. It is your earnings which are subject to the penalties above. If you withdraw earnings, you must meet the test above.
The Good, Bad and Ugly
In summary, it’s mostly all good. All these retirement vehicles allow you to prepare for retirement, and if you manage them correctly, it can be a very nice retirement. All of them provide a tax benefit somewhere in the process from contribution through withdrawal. Many of them are fully or partially funded by your employer. The “bad” part is that you cannot escape taxes entirely, and if you’re not careful bad investment decisions will undo the rest of the benefits. The only ugly part occurs when you run afoul of withdrawal rules and start to incur penalty taxes.
Making the most of your retirement opportunities may require some professional advice. Ask a trusted, objective financial advisor to help you determine which options are best for you, and you’ll be well on your way to a successful retirement.