How to Get the Most From Your Work-Based Retirement Program

Work-based Defined Benefit Program:

Unless you work for the governement or a non-profit, you are unlikely to have this available to you.  These are traditional pensions where employers contribute on behalf of employees and guarantee to pay a specific benefit for the life of the employee, based on a number of factors, including the number of years employed, the average salary and the final salary.  

The main advantage of these pensions is that the employer takes the risk.  Contributions from employees may be required, and if so, the amount is not optional.  However, at the end of the day, you will know what you will receive and some of these pensions, particularly for school teachers or military personnel, can be very generous compared to the size of the paycheck.

The main disadvantage of these pensions is that they are not portable.  If you swich employers, voluntarily or not,  you may lose benefits.  They may give you some money upon leaving a job, but it it is probably not worth as much as the pension would be.  For example, I taught in Louisiana public schools for two years, and money for teacher's retirement was deducted from my check.  When I left, they refunded my contributions, but not those of the school system, and I received no interest.  

If you participate in such a plan, you need to know  the vesting schedule.  At what point will you be eligible for payments, and how much will you get?  The last thing you want to do is to leave a job a year or two before you would become eligible for a pension.  

Most pensions have some provision for continuing benefits to a spouse after your death in return for smaller payments during your life.  However, once you (and your spouse if that option is chosen) die, the pension is no longer an asset and cannot be left to your heirs.

Some pensions will allow a lump-sum distribution when you retire, which give you the ability to leave left-over money to heirs, but it comes at the cost of a guaranteed check for the rest of your life.

Generally speaking pension income is taxable income in the year it is received.

Some places that offer defined benefit plans also offer defined contribution plans which are a boon to those who do not plan long-term employment with that employer.

To get the most from a defined contribution plan, consider the vesting schedule carefully in making decisions about continued employment, so that you do not leave right before additonal benefits would be due to you.  In picking  your pension payout, consider other assets available and the age of your spouse to pick the type of payout that will likely be worth the most in your situation.

Work-based Defined Contribution Program

These are the 401(k), 403(b) and similar accounts.  Instead of guaranteeing how much money you will receive when you retire, employers who use these plans define how much they will contribute on your behalf (and sometimes that contributioin is $0).  Employers often "encourage" employees to contribute by making employer contributions "matches" rather than outright grants.  

Employee contributions to these plans are made on a tax-deferred basis, which means you pay income taxes on the money when you take it out of the account, rather than when you put it in.  If you are in the 15% tax bracket that means that $100 contributed to the plan reduces your paycheck by $85.  As long as money stays inside the plan, no taxes are assessed on earnings.  

Employers usually contract with an investment company to run the plan.  Usually employees are offered a variety of investment choices--usually mutual funds or similar--and the employee has to decide how to invest his or her account.

If an employer offers to match employee contributions, employees should do their best to contribute enough to get the maximum match--after all a guaranteed doubling of your money the first year is impossible to find in any other investment.  

As far as how much an employee should contribute to an employer plan once a maximum match has been achieved, that depends on the quality of the offered choices and the expenses related to the plan.  My husband's plan has only high-expense funds with mediocre returns.  We get his match and don't add more to that account.  My office plan is pretty good so we make substantial contributions.

Some companies allow you to borrow from your 401(k), others (like mine) do not.  The only way we could access the considerable money in that account (I've been there over twenty years) is for me to quit.  If I quit and wanted to spend that money before I was 59.5 years old, not only would I have to pay taxes on that money at my then-current rate, I would have to pay a penalty.

When employees leave a job with a defined contribution plan, they can always take their contributions with them.  Federal law requires that employees who have been at a job at least three years be allowed to take some of the employer contributions with them (partial vesting) and that those who have been there at least five years be allowed to take all of the employer contributions with them (full vesting).  Often employees who leave are offered to option of maintaining their accounts in the employer program or of moving them to an IRA.  While employer programs are a little more protected from creditors than IRAs, IRAs give you a wider range of investment options, and often lower fees. Having all  your accounts in one place can also simplifiy monitoring and bookkeeping.

Employees who leave a company are also offered the opportunity to "cash out" their retirement accounts.  For employees who are under 59.5, this means paying a penalty on top of taxes, and if your distribution is substantial, it could push you into a higher tax bracket, thereby costing you even more in taxes.  Unless there is an urgent need for the money, this option is not recommended for anyone.   

When you retire and withdraw money from your plan, it is taxed as ordinary income, since no taxes were paid when the money went in.  It makes no difference whether the money you withdraw was money you contributed, money your employer contributed or money that has been earned inside the account.  Generally speaking, once you reach 70.5 you are required to take a minimum required distribution from your 401k, and that amount is based on what actuarial tables say is necessary to deplete the account by the time of your expected death.

If you die with money in a 401(k), it is distributed to the beneficiary (ies) you named, and is generally taxable at that time unless steps are taken to defer the taxes.  The steps aren't difficult, and hopefully the custodian will inform you about them, but they would require another whole blog post, so maybe next week.

To get the most out of your 401(k), contribute enough to get the maximum match.  Pay attention to vesting schedules so you do not leave shortly before you would be entitled to more money.  Keep an eye on the investment options and fees to determine whether the plan is a good place for discretionary contributions.

Work-based programs form the backbone of most people's retirement.  Know how to get the most from yours. 

*Part of Financially Savvy Saturdays on brokeGIRLrich.*