Retirement Plans: DB, DC, 401(k), deferrals, investments, vesting….We’ll talk about everything you need to know to understand and to get the most benefit from your retirement plan.
We all worry about retirement. At some point, we’ll leave our jobs and transition into retirement. This brings up a ton of questions: “When can I retire?” “How much money will I need?”, all of which create anxiety, because there is no easy answer.
Types of Retirement Plans: DB v DC
Defined Benefit (DB) Retirement Plans
Let’s start by getting a better understanding of retirement plans. For those who are working, your employer will likely offer some form of retirement plan. If you’re lucky, your employer offers a DB (defined benefit) retirement plan. Defined benefit retirement plans are rare. In this type of plan, the employee does not contribute to the plan. The employee receives a benefit (thus the name) when he or she retires. This is likely expressed as x% of salary. There is typically a vesting schedule that specifies how the percentage you receive increases as your tenure with the company grows.
My mom and dad were both teachers. They have defined benefit retirement plans. Defined benefit plans are more common these days in the public sector (i.e. government). My dad has passed but his defined benefit pension had a feature that allowed him to take a smaller % of pay while alive, and allowed him to designate his spouse as a beneficiary to be paid after he died. So my mom now gets 2 defined benefit pension checks each month. Yay!
Defined benefit plans are a wonderful benefit. While you are actively working, you have no decisions to make. You are typically signed up for the plan at employment and you have nothing to do until you retire at which point, you may have some decisions about how to take your benefit (for example, my dad’s decision on spousal death benefit) but you essentially get a portion of your pay for life.
Defined benefit plans were popular years ago. When my mom and dad began their employment, life expectancy was 691. When an employee retired at 65, on average, the company would need to pay their salary for 4 years. Today, life expectancy is 79. Employers need to put a significantly larger chunk of money aside in order to be able to pay a retired employee’s salary for 14 years.
Defined Contribution (DC) Retirement Plans
Today, defined contribution (DC) retirement plans are much more common. Some common defined contribution plans are 401(k) and 403(b) plans. In this type of plan, an employee contributes a portion of each paycheck into an account that the employee owns. Over a long working career, this account grows in value so that the employee can fund his or her retirement.
While the employee needs to contribute, there are some additional benefits.
- Tax advantages – we’ll talk details later
- Employer contributions. Many (but not all) employers will either match a portion of employee contributions, make an annual profit sharing contribution, or sometimes, both.
After my career in finance and technology, I briefly took a part-time job as a car salesman. I’ve always loved cars and thought this would be fun. It was, but more about this in future posts…
On my first day, a woman from the business office helped 4 or 5 new associates and myself fill out our onboarding paperwork. Part of this effort was a form to enroll in the company 401k. I asked a few questions, and was told, “don’t worry about that, you really don’t need to fill it out.” I hope you are all gasping in horror, as I was. Nothing against the woman in the business office – she was a delight, she’d just never been trained. Once I was hired, I made it my mission to talk to some of the new employees about their 401k and try to encourage them to sign-up. Defined Contribution retirement plans are a fantastic benefit and it is important to understand them so that you can make good decisions about how to use them to your advantage.
Key Features of Defined Contribution Retirement Plans
Contribution or Deferral Percentage
This is the percent of each paycheck that you would like to defer into your retirement account. This retirement account is yours so don’t be afraid to contribute. Even if you leave your employer, you can take this money with you.
Investment Options
Your employer is responsible for choosing a menu of investments – typically mutual funds – that are appropriate for their plan. Please see the post on mutual funds for more info. It is important to know that just because these investments are appropriate for the plan they may not be suitable for your personal needs. You need to select an investment fund, or funds that meet your needs. Many plans today have target retirement funds that may be appropriate for you.
Target Retirement Funds
Not really a plan feature but I want to expand on this. Let’s say you are 20 years old in 2024. Your expected retirement age is 65, so you expect to retire in 45 years. Your retirement year is 2069. If your plan has target date funds, you will typically see investment options like: Target Retirement 2050, Target Retirement 2055, Target Retirement 2060, and so on. You’ll see a fund for every year at 5 or 10 year intervals. As a 20 year old, you would choose the Target Retirement 2070 fund, which is the one closest to your 2069 retirement date.
Here’s why. The funds automatically rebalance their asset class (cash, equity, fixed income) weightings on a regular basis to ensure the portfolio of investments in the fund are properly aligned to your age. I’m sorry…I know that probably wasn’t helpful but it does describe what they do. In more simple terms, equity (stock) prices tend to be more volatile than fixed income (bond) prices. Cash is the most stable. As you start out in these portfolios, they are heavily weighted towards equities. While equities tend to be more volatile, with large swings up and down, history shows that over long periods of time they gain more than fixed income or cash. As years go by and you get closer to retirement, these portfolios sell equities and move to fixed income and cash to be prepared for when you need to start taking your money out.
I’ll give you a story to demonstrate why this is important. I have a delightful daughter named Jess. Jess was born in 1991 and started to college in 2008. What other big event happened in 2008? Anyone? There was a huge financial crisis. The market tanked. Most of Jess’ college savings were in an S&P 500 fund. As her first college payment was due, her account balance was half of what it was at the start of 2008. This is why you want to have the majority of your investments in cash and fixed income as you get closer to the time when you will be needing them.
Click here for more about asset allocation. For now the important thing to note is that target retirement funds do a pretty good job of handling this for you.
Company Match
As an incentive for you to save for retirement, many companies offer a company match. Essentially, the company will contribute money to your retirement account each time you make a contribution (typically with every pay check). This is free money. Take advantage. You need to make a contribution for them to match.
Lets take a company match example to see how this works. You make $50,000 per year. Your company says that it will match your contributions dollar for dollar up to 3% of pay. Don’t be afraid. This means that for every dollar you put into the plan, the company will put in an additional dollar of their money. The maximum amount the company will put in is $1500 (3% of your $50,000 salary). You will see the company’s money going into your account each pay period until they have paid $1500, and then they will stop contributing until next year.
Profit Sharing
Similar to a company match, your employer may have rules in the plan that specify that a company matching contribution will be made for each employee if the company meets certain profit targets. This is usually a 1 time annual contribution by your employer that is calculated based on your salary.
Vesting Schedule
Good for you. You are contributing to your defined contribution plan. Your company is matching dollar for dollar up to 3%. When you go to your defined contribution plan website, you see your total balance split by money source. Money source is simply where the money came from. The plan keeps track of the money you put in v. money your employer put in.
Regardless of source, all the money in your account belongs to you, however, there is likely a stipulation on that employer contribution. Your plan may have a vesting schedule. This defines when that money becomes yours, no strings attached.
Because this is an employee benefit, your employer wants to retain you. The vesting schedule is a way to do this. Let’s look at an example. The vesting schedule may say that you are 25% vested right away, 50% after 2 years, and 100% after 5 years. Once you’ve been with the company more than 5 years, the money in that employer bucket is all yours. If you stay with the company less than 5 years, you will only be entitled to a portion of that employer money, based on the vesting schedule. However, remember, you are always entitled to 100% of the money you put in (and whatever gain/loss is associated with those contributions).
Annual Increase %
Often folks starting out at their job are at the lower end of the salary range and can’t afford to defer a large % of their salary into the defined contribution plan. They may make the minimum required contribution to get the full employee match, with plans to increase their deferrals in the future. Many plans now offer participants the ability to specify this up front so that they don’t need to go back and change this each year.
Contribution Limits
Your plan will allow you to choose the amount of each paycheck that you want to defer. However, because of the tax benefits that the plan provides, the IRS publishes annual limits to the amount you can contribute. This limit is $23,000 for 2024. If you are making $50,000 and deferring 3%, you will put $1500 in your plan. This is below the limit so you don’t need to worry. If you are making $100,000 and you defer 25%, you will put $25,000 in your plan and go over the limit. Most plans won’t actually let you go over. Most likely they will take 25% out each paycheck until you hit the $23,000 limit. After this, you’ll notice your take-home pay is larger because you will not be contributing to the plan. Contributions will start up again next year, and if limits change, your record-keeper will handle this.
Loans
Many, but not all, plans offer loans. As I mentioned above, the money in your account is yours. You could choose to take it all out at age 30 (or any age below 59 1/2). But, you will pay a steep penalty (10%), you will have to pay taxes on any money that was contributed pre-tax, and you will pay taxes on any gains. An alternative is taking a loan from your plan. Basically, you’re borrowing your own money so you pay back the principal and interest to your account. Just remember, this is your retirement money. It needs to grow over time. When you take a loan against it, that money is out of the market and is not growing.
Hardship withdrawals
There may be certain conditions under which your plan will allow you to withdraw money without a penalty, though you still need to pay taxes. Conditions are restrictive. See your plan document or contact your plan sponsor for details.
Now for some fun…let’s talk about taxes. (Groan)…We’ll make it simple.
Traditional v. Roth
Many defined contribution retirement plans allow you to choose whether you will make traditional or Roth contributions. Some will allow you to switch back and forth or even split your contributions between traditional and Roth. Let’s talk about what they are and this will become clearer.
Traditional retirement plan contributions are made pre-tax
Let’s look at an example. I make $50,000 a year and I defer 3%, so $1500 goes into my defined contribution plan. At the end of the year, my W-2 shows my taxable income as $48,500 (my $50,000 salary – the $1500 I put into my defined contribution plan). I have the tax advantage of lowering my taxable income and deferring the tax on that $1500.
At age 59 1/2 I can start taking this money out. At age 72 1/2, I must start taking this money out. At 72 1/2 I must take a Required Minimum Distribution (RMD) each and every year. This is because the government wants to collect those taxes you deferred. The money you take out after age 59 1/2 is taxed as ordinary income. Presumably, when you retire, your income will be lower so you may be at a lower tax rate. I say “may” because who knows where tax rates are going?
Roth contributions are made after-tax
Using the example above, with Roth contributions, my taxable income is $50,000. I do not get a tax credit in the current year for the $1500 in contributions. While this is a huge bummer, you will never ever ever pay taxes on this $1500, or any gain on these dollars. So let’s assume this $1500 grows at a 6% rate over my 30 working years. At the end of 30 years, assuming a 6% return, this $1500 would grow to over $8000, which you could take out without paying any taxes. Before you say “big deal”, think about what would happen if you deferred 1500 a year, every year for 30 years. Now you end up with over $125,000 completely tax free.
Let me pause here for a sec. I’ve included a link below to an investment return calculator.2 You can find these all over the internet. That’s what I used to come up with these returns. I used 6% as an annual growth assumption as it is fairly standard assumption for conservative growth expectations over many years. See the post on the magic of compounding for more info.
I need to apologize for not making an unbiased comparison of traditional v. Roth. I have both traditional and Roth accounts and love them both dearly. I do however get really excited about the idea of having some money on which I will never have to pay taxes. We don’t know where tax rates will be when we get around to taking our retirement money out. Roth contributions are a bet that tax rates will be higher because we pay the taxes now instead of later. Traditional is a bet that they will be lower because we are deferring tax payments into the future and because we expect our taxable income to be lower after we stop working. The important take-away is that they both have tax advantages so either way you win.
Is Traditional Better than Roth?
I also want to share an argument I’ve heard frequently about why traditional is better than Roth. The premise is that I can take the money that I saved on taxes and invest that in a traditional brokerage account. Going back to our traditional example above, I’ve decreased my current year tax liability by $1500. If I’m in a 22% tax bracket, that’s an extra $330 in my pocket each year. If I invest that at 6% for 30 years, I end up with over $25,000 in my brokerage account. Now I will need to pay taxes on that $25,000, but that’s a solid chunk of change.
So to close out the traditional v. Roth debate, I’ve laid out the key facts as best I could. They both have tax advantages so you are a winner either way. Don’t overthink it. Get started. Starting today always beats starting tomorrow. And look at your plan; if it offers Roth, it may support both traditional and Roth contributions.
Wrap-up
That brings us to the end of a really long post. I hope you hung in there, because we are all responsible for our own retirement. People are living longer. If you are 20 years old and reading this, awesome, you can let the magic of compounding work for you, but you will likely live longer so you will have more retirement years to save for than I will. Get to know what type of plan or plans your employer offers. If you are self employed, there are options as well (look up a SEP IRA).
I hope this helps. I’m sure there is stuff I’ve missed so please post questions or suggestions. If I can give you one piece of advice, it’s get started now. It’s not as difficult as it seems, and very few decisions can’t be undone, so start deferring some of your income and choose some investments and learn along the way.
1 https://www.statista.com/statistics/1040079/life-expectancy-united-states-all-time/
2 https://smartasset.com/investing/investment-calculator#GDpaQRM4q1