4 Essential Facts about 401(k)s, IRAs and Pensions

Your retirement income has to come from someplace, right?

An informal poll of our advisors revealed that a lot of clients aren’t entirely comfortable with the inner workings of common retirement vehicles like IRAs, 401(k)s, or pensions.

It’s my belief that the more you know about how these entities function, the easier it is to know what questions to ask, how to stay on course, and, not only how to meet your savings and investment goals, but how to make your money last.

With that, here are the basics of 3 common retirement accounts.

THE 401K

With 94 million participants, the 401(k) is easily the most popular retirement savings vehicle in America.[1]

But how did the 401(k) evolve?

Conceived in 1980 by benefits consultant Ted Benna (who we recently interviewed on Money Matters), participating in a 401(k) means pre-tax money gets deducted from your paycheck and put away for your retirement.

The money gets invested for you by your employer (though you get to select the risk level of those investments).

Later (usually after you retire), you pay taxes on the distributions as the money is withdrawn.

Quick 401(k) Facts

  • The contribution limit for 2017 is $18,000
  • If you are over 50, you can also use the “catch up” contribution, which is $6,000
  • Most people don’t realize that management fees are being deducted from their balances
  • The key ages for 401(k) plans are:
    • 55: When most plans begin offering retirees penalty-free withdrawals
    • 59½: When some plans offer withdrawals, even if you’re still working
    • 70½: When you typically have to begin taking minimum distributions

An interesting 401(k) fact: It wasn’t invented by the government to benefit taxpayers. Ted Benna literally created it from a tax loophole, and even then it still took years to become law.

That’s right. The IRS didn’t like it. In fact, they twice (in the late 80s) posed legal challenges to invalidate 401(k) plans. The reason? They were concerned that too many Americans were putting money away and that the government was going to be underfunded.

THE Traditional IRA

IRA stands for Individual Retirement Account. There are several types (Roth, SEP, Simple), but let’s discuss the Traditional IRA.

One of the biggest misperceptions about an IRA is that it’s an actual investment. It’s not. It’s a collection (stocks, bonds, mutual funds, etc.) of investments. IRAs are especially popular for people who are self employed, and for those people who work for companies that don’t offer a 401(k).

(Even if you have a 401(k), you can still fund an IRA, but there are income limitations.)

Quick Traditional IRA Facts:

  • 2017 contribution limits are $5,500 (with a $1,000 catch up contribution)
  • You must be under 70½ and still earning income to participate
  • Similar to a 401(k), the money isn’t taxed until it’s withdrawn during retirement
  • If you take money out before you reach 59½, you’ll usually incur a 10% penalty

The two most common IRAs are Traditional and Roth. The most obvious difference between the two is that Roth IRAs are funded with “after tax” income, which means that when you retire and take distributions from your Roth IRA, the money (and even the growth) is exempt from taxes.

Choosing which type of IRA is right for you is a complex process that’s contingent upon your employment status, income, tax bracket, when you’ll need the money, and more. Have your advisor review which options are best for your unique situation.

THE Traditional Pension

A pension is a defined benefit plan where, based on things like your salary level and plan contributions, your employer guarantees you a certain amount of income once you retire.

What’s the status of modern pension offerings?

Private sector companies continue to drop pensions at a fast clip. Once the most common retirement vehicle, now, just under 20% of Fortune 500 companies (down from 60% only 20 years ago), still offer pensions to their new hires.[2]

Somewhat surprisingly, just 4% of non-Fortune 500 private sector companies still offer their new hires pensions.[3]

So, who still offers them? The government. Most public sector jobs, that is, local, state and federal government entities (along with some utility and energy companies), still offer their employees full pensions.

Quick Traditional Pension Facts:

  • Pensions typically give retirees a choice between a lump sum payout or lifetime monthly payments
  • People who earn government pensions often receive no Social Security
  • Pension amounts are usually calculated by a set formula rather than investment returns
  • Pensioners are protected from swings in the stock market (There’s no investment risk.)

Here’s a pension fact I love: The invention of the pension is often credited to German Chancellor Otto von Bismarck, who created the Old Age and Disability Insurance Bill for Prussians back in 1889.

Conclusion

Retirement isn’t free. Whether you participate in a defined contribution plan (401(k)), or you contribute to a defined benefit plan (pension) and elect to receive a lump sum when you retire, your savings have to earn money if they’re going to last. Got questions: Contact us today.


[1] American Benefits Council June 2017
[2] Business Insurance February 22nd, 2016
[3] CNN Money http://money.cnn.com/retirement/guide/pensions_basics.moneymag/index7.htm June 29, 2017