This Retirement Party is Coming to a Close

All good parties must come to an end, and this one is no exception. The old geezers of the group, grandma and grandpa Pension, are complaining that the music is too loud and that it’s past their bed time. They have however agreed to do one last meet and greet before this shindig wraps up. So without further ado it is my pleasure to introduce you to Mr. & Mrs. Pension (they are cranky so we will keep this short).

So what is it? Pensions are company sponsored retirement plans that provide retired employees with a fixed payout, usually paid monthly, for the remainder of their life. A common requirement is that the employee work for the sponsoring company for a specific period of time determined by the company (this is referred to as vesting) in order to qualify for the pension benefit.

How does it work? The employee first must sign up for the pension plan then complete a vesting period, usually 5-7 years of active employment, once complete they are entitled to a fixed benefit in retirement (age 65). The amount paid is usually determined by number of years worked for the company and salary level upon retirement or throughout the employee’s career. Traditionally pension plans do not require employee contributions, the employer provides all the funding, however there are some plans that may require employees to contribute.

  • Example[1]: Sam worked for Procter & Gamble for 30 years; his Pension plan states that he will be paid 2% of his average salary multiplied by the number of years worked for the company, each year once he retires. Sam’s average salary during his employment was $70k per year. To calculate his pension payment Sam multiplies 2% by his average salary ($70k) then multiplies the result by years worked (30) to get $42k (2% x $70k x 30). The result, once Sam retires he will receive $42k a year in pension benefits, or if paid monthly $3,500 a month for the rest of his life (pretty sweet deal in my opinion).

Important information to note: Over the past few decades pension plans have become scarcer, especially in the private sector mainly because of the high cost to maintain. With no employee contribution in many cases, and guaranteed befits, the employer must offset any market downturns to maintain the fixed benefits. It should be no surprise that direct contribution plans like the 401(k) have become the retirement vehicle of choice due to lower costs and the ability to pass the responsibility for retirement planning on to the individual employee.

So that about wraps it up for this retirement party, if you have any additional questions about pensions drop a comment below and I’m sure we can convince Mr. or Mrs. Pension to get back to you. If you missed all the action until now you can catch up here with the 401(k) and here with the IRA.

I hear there is an after party in the works for sometime next week, make sure to tell your friends (I hear Facebook, Twitter, and Google+ are good ways to do that ;)) so they can catch up on all the action before it happens!

[1] This is a very simple example; the math behind the real calculations can be much more complex.

What is a Vesting Period?

A vesting period, when mentioned in reference to retirement plans, is the length of time an employee must work for a company before he or she can claim 100% of employer provided benefits. The term vesting period is most commonly used with retirement plans like a 401(k) or pension, but may also be used with stock options.

Example: My current employer requires that I work five years before I am 100% vested in my 401(k). This means if I leave and go to another company before that time I will forfeit my right to the employer contributions made to my 401(k). It doesn’t however mean I forfeit 100%, my company has an incremental vesting period, meaning each year I work for them my vested percentage increases.

  •   2 years: 40%
  •   3 years: 60%
  •   4 years: 80%
  •   5 years: 100%

Each company is different however and for some it may be 0% until the vesting period elapses.

Let’s say I leave my current company after 3 years, and up until that point I have contributed $5,000 to my 401(k) which my employer has matched, giving me total of $10,000 (not counting any gains or losses). When I officially leave my 401(k) will be reduced to $8,000 in total, I would only be entitled to keep 60% of the company match or $3,000 ($5,000 x 60%) in addition to what I have contributed.

Note that vesting only applies to contributions from your employer, everything you contribute you keep. Any gains incurred because of the employer contribution are also forfeited but any gains on your contribution or vested amount is yours to keep


It’s a Retirement Party!

I have received many requests to write a blog post on the various types of retirement plans. This isn’t surprising, since many of my friends are recent college graduates starting their first big boy (or girl) jobs and have never given retirement planning a thought. Instead of doing one long post covering every type of plan I am going to write three separate posts covering the most popular plans, the 401(k), IRA, and Pension. With that little introduction out of the way let’s kick this retirement party off with the big daddy, the traditional 401(k).

So what is it? The traditional 401(k) is a company sponsored retirement plan that allows you save for retirement by making pre-tax contributions to the plan. Not every company offers a 401(k) and you can not open one on your own, it must be through an employer.

How does it work? You elect through your employer to contribute funds to the plan on a pre-tax basis, usually a set percentage of each paycheck (for more information on pre-tax deductions check out the mini series your paycheck). The company sponsoring the plan will provide the employee with multiple options where they can choose what to invest the funds in, common investment options include, index funds, mutual funds, bond funds, and company stock. Once you retire and begin withdrawing funds, those distributions are then taxed at ordinary income taxes rates (see here for example) In many instances your company will match your contribution up to a certain percent (aka: Free Money![1]).

For example, say I make $10,000 a month (I wish!); and the company I work for will match my contribution up to 6% dollar for dollar. This means if I contribute 6% of my paycheck ($600) the company will also contribute an additional 6% ($600) for a total contribution of $1,200.

Matching varies from company to company and the terminology may differ as well. You might find out that your company matches the 1st 3% dollar for dollar then a 2nd 3% at .50 cents on the dollar, up to 6% total. This means the first 3% of your contribution is matched in its entirety and the subsequent 3% is matched at 50%. Using the $10,000 example from above an employee contribution of 6% ($600) would equate to an employer match of 4.5% ($450), the first 3% dollar for dollar equaling $300 and the second 3% .50 cents for each dollar totaling $150.

Important information to note: a 401(k) is not like a normal bank account, it is governed by different laws and regulations. The biggest difference is you can not access your money whenever you want, because it is a retirement account the money can not be accessed until you retire or reach the age of 59 and a half. Now, there are certain instances when funds can be withdrawn before retirement but you could be subject to penalties or additional taxes. Each situation is unique; if you need to withdraw money early from your 401(k) it is best to speak with your HR department or a financial advisor. There are also limits to the amount you can contribute to the plan in a given year, for 2012 the limit is $17,000 and if you are over 50 you can contribute an additional $5,500 for a total of $22,500. These limits do not include employer matching.

What’s all this noise about a Roth 401(k)? A Roth 401(k) is the same as the traditional 401(k) except for one key difference, contributions are made after tax instead of before.  When money is withdrawn in retirement there is no tax withheld since it was already paid. Now many people want to know which plan is better, Roth or Traditional, and the truth is one is not “better” than the other. The choice of which plan to choose largely comes down to your individual tax situation, weather you prefer to pay taxes now or later, and your assessment of future tax rates (something very hard to determine). If you think tax rates could be higher when you retire it may be beneficial to choose a Roth plan, if you think rates will be lower the Traditional plan may suit your needs better.

WTF does the (k) mean? The (k) refers to the sub-section of section 401 of the IRS code. Not nearly as exciting as you thought the answer would be, was it?

Next up is the Individual Retirement Account, or IRA.

[1] It’s for this very reason that if your company offers a 401(k) you should be contributing!!