Planning for retirement

After several decades during which Social Security and pensions provided many people with a large chunk of the money they needed to live comfortably after they retired, some things have changed. While you may be entitled to income provided by your employer during your retirement, you’re increasingly likely to be responsible for contributing toward your own retirement needs.

Employer sponsored plans

Employers can offer different types of qualified retirement plans, though it’s legal to provide none at all. Some plans are funded and controlled by the employer, while others require your active participation. Some plans make promises about what your benefits will be when you retire, and others make no promises at all.

defined benefit plan guarantees you a specific dollar amount, or pension, when you retire. It’s based on your salary or length of service, or a combination of the two. Your employer contributes enough to meet that amount and manages the way the assets are invested.

In a defined contribution plan, you or your employer, or sometimes both of you, contribute money to your retirement account each year. The amount you’ll receive in retirement is not guaranteed because it depends on the amount that’s contributed, the way the money is invested, and how those investments perform. However, because the plans are tax-deferred, no taxes are due on any earnings as they accumulate. This means your account has the potential to grow faster and ultimately provide more retirement income than an account on which you paid income tax on earnings each year.

Profit-sharing retirement plans are funded by your employer, based on annual profits. They make no payment guarantees. The company determines the rate of contributions each year. In lean years, there may be none at all. In some but not all of these plans, you can choose the way the money contributed in your name is invested.

Time on the job

If you’re part of a defined-benefit plan and change jobs frequently, you’ll probably end up with a smaller pension than if you’d stayed put. Four jobs in 40 years rather than 40 years in one place can cut a pension in half.

Plan pointers

Most defined benefit pensions are not adjusted for inflation, which means that each year the fixed amount you receive will cover fewer of your expenses. And some plans, known as paired pensions, reduce the pension to which you would be entitled by the amount of Social Security you receive. Income taxes are due on this retirement income, at the same rate as you pay on other regular income.

When you retire with a defined contribution plan, the money that has accumulated may be paid out as:

  • lump sum, known as a distribution
  • pension annuity, or in regular payments that vary over time based on the investment performance of the products in which your money is invested

You owe income tax on amounts you receive from a traditional tax-deferred account at the same rate that you pay on your ordinary income. However, if your employer has offered a tax-free retirement savings plan, such as a Roth 401(k) or a Roth 403(b), as well as a traditional plan, you may have chosen that way to save. Your contributions are not tax deferred, but you’ll never owe federal income tax on earnings that you withdraw, provided your account has been open at least five years and you are at least 59½.

When it’s yours

If you’re part of a retirement plan, what happens if you leave your job? It depends on the type of plan it is.

With a defined benefit plan, you’re entitled to the value of the amount you qualify to receive based on your salary and years of service provided you’re vested, or have worked there long enough to qualify for a pension.  There are two ways to handle vesting. You are 100% vested in employer sponsored plans after five years, or 20% after three years, increasing by 20% each year to 100% after seven years. Usually, though, if you leave to take another job, you don’t get any payout until you reach retirement age. And since no contributions are added, the account may not provide much income.

With a defined contribution plan, any contributions you’ve made are automatically yours, though you have to be vested to be entitled to employer contributions. The vesting schedule is a bit shorter, as you either qualify for the full amount after three years, or for 20% after two years increasing by 20% each year to 100% after six years. You can always roll the money in your account into an IRA or sometimes into your new employer’s plan and continue to build it. That’s why the plans are described as portable.

The trade off

Because earnings on retirement plan investments have tax advantages, you agree, as a condition of participating, that you’ll leave the money invested until you reach at least age 59½. If you withdraw it before then, you usually have to pay a 10% penalty in addition to the tax that’s due. There are some exceptions. Often if you’re at least 55 and you retire or lose your job, you can collect retirement income without owing the 10% penalty. Some employers, including the federal and state governments, pay pension benefits to people who have been employed for the required number of years, such as 20. No tax penalty is due on that income.

Retirement plan distribution basics

When you retire or take a new job, you can leave the money in your retirement plan, have it rolled over into an individual retirement account (IRA) to preserve its tax-deferred status, or you can take a lump-sum withdrawal of the entire amount.

If the assets in your account are worth at least $5,000, you can leave the money in your old employer’s plan. If the balance is between $1,000 and $5,000, your employer has the right to roll the money into an IRA established in your name if you don’t provide instructions about what you want done with it.

You can have the money rolled directly into another qualified retirement plan if the plan accepts rollovers or to an IRA where it can continue to grow tax deferred. You’ll owe no tax until you begin withdrawing.

You can get the money yourself, keep it for up to 60 days (using it any way you want) and then roll it into an IRA so that it continues to grow tax deferred. However, if you receive the money even briefly, your employer must withhold 20% of the total. If you want to keep the full amount tax deferred, you must make up the missing 20% from another source, such as savings.

You can withdraw the money, pay the taxes that are due, and reinvest the account value any way you like. If you’re younger than 59 ½, you may owe a 10% penalty plus the taxes.

But remember:

If you’re handling a rollover yourself, you must deposit the entire amount (including the 20% that’s withheld) or be vulnerable to taxes and penalties. The 20% that’s withheld will be refunded after you file your income tax return only if you make the full deposit.

The one thing you don’t want to do is use a distribution for everyday expenses instead of keeping it invested.

 

 

 

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