Most of you will rely heavily on a company retirement plan to fund your retirement years. Today we’ll focus on what types of plans are out there and what you need to know to take maximum advantage of these benefits.
401(k) plans are the most common type of company retirement plan. When the plan is set up it must meet strict government rules that allow it to defer income taxes until an individual takes his or her money out of the plan. This qualified retirement plan allows salary deductions for employees and matching contributions for employers.
Employees can defer up to $19,500 in 2020 with an additional catch-up contribution of $6,500 if they are over age 50 (for a total of $26,000 in 2020). The employer can match a portion of the employee contribution. The match is in addition to the employee contribution, so for example, if you contribute $26,000 in 2020, your employer can add a match on top of that.
Owning company stock can be too much of a good thing. Not only do you have your retirement plan over-concentrated in one stock in a single industry, but your human capital (your ability to earn a salary) is also riding in the same basket. That’s bad news when companies respond to poor economic conditions by making layoffs. Frequently these layoffs have come when the company stock was not performing well. So in those cases, the pink slip meant not only lost income, but also a drop in overall net worth due to retirement plans that had significantly decreased in value.
Generally no more than 10% of your portfolio should be in your employer’s stock, especially if you plan to retire in less than five years. Keep in mind that limiting your exposure to company stock is a defensive measure for your portfolio. There is always the possibility that your employer’s stock will do better than a balanced portfolio of stocks and bonds. But that possibility comes with a much greater risk because of the concentration in one stock.
Most public school, hospital, and not-for-profit employees are offered a 403(b) plan (sometimes called a tax-deferred annuity, or TDA) instead of a 401(k) plan. The two types of investments are the same in theory. The contribution limits are the same: $19,500 a year, $26,000 if you are over age 50. Both 401(k) and 403(b) plans can be rolled over to a traditional IRA at retirement.
This type of plan is a non-qualified deferred compensation plan available to employees of state and local governments and employees of nongovernmental tax-exempt organizations. As with 401(k) and 403(b) plans, you can contribute $19,500 a year, $26,000 if you are over age 50. A 457 plan can be rolled over to a traditional IRA at retirement. There is a special rule that allows participants to double contributions to the plan in the three years prior to retirement. And if you pull money out before age 59 ½, there is no 10% penalty.
Profit Sharing Plans
A Profit Sharing Plan is a qualified retirement plan that allows an employer to make flexible, discretionary contributions on behalf of employees. To set one up, your employer (or you if you are self employed) needs a written plan. Either an outside administrator or most mutual fund companies, banks, or brokerages can provide that document. The SECURE Act allows these plans to be set up even after the end of the calendar year.
The employer can contribute up to 100% of compensation or $57,000 (plus $6,500 in catch-up contributions if over age 50) whichever is less to each participant account. The employee cannot make their own contributions to the plan.
Some of you will have a paired Profit Sharing and 401(k) Plan. Your employer will make the Profit Sharing contribution and you will also have the opportunity to contribute part of your salary.
Simplified Employee Pension (SEP)
A SEP is a retirement plan that uses an IRA as a funding vehicle. Either the employer or the employee can open an account with a fund company, brokerage, bank, or other financial institution. You have until the due date of your tax return (including extensions) to set up the accounts.
The employer can contribute up to 25% of an employee’s salary (up to $285,000 in compensation) or $57,000 whichever is less. (The employer can only contribute 20% of his or her compensation up to $285,000.) The employee can also contribute subject to the regular rules regarding IRAs. The employer is not required to make a contribution every year. When the employer does make a contribution, it can’t discriminate in favor of highly compensated employees.
SEPs are easy and cost-efficient to set up and maintain. Annual employer contributions are discretionary. There is no annual IRS form to file. Contributions can be made after plan year-end (up until tax-filing deadline). Employees have investment responsibility for his or her own account. SEPs must cover all employees, even part-time. No loans are allowed.
Individual Retirement Accounts (IRAs)
Anyone can use an IRA for retirement savings. Not everyone will get a tax deduction for their contributions. Regardless of the type of IRA you choose, you can contribute up to $6,000 in 2020 with an additional $1,000 allowed if you are age 50 or older.
Typically, you can choose between a traditional IRA and a Roth IRA. If you choose a traditional IRA, your contributions may or may not be tax deductible depending on your eligibility. If you contribute at work or your income is considered “too high,” then you can still make the contribution, but you won’t get a deduction for it. You also need to file a Form 8606 with your tax return to report your non-deductible contributions.
If you contribute to a Roth IRA, you don’t get a tax deduction, but after five years, you don’t ever have to pay tax on the earnings. You can always take out your contributions without tax, but you wouldn’t want to do that unless you really had to.
SIMPLE (Savings Incentive Match Plan for Employees) Plan
A SIMPLE plan is a retirement plan available to employers with 100 or fewer employees. Employees contribute using salary deferral. Employers must contribute a match for all eligible employees.
There are two types of SIMPLE plans: SIMPLE IRAs and SIMPLE 401(k)s. Most people set up the SIMPLE IRA because it is less expensive to maintain and has fewer reporting requirements.
Employees can contribute up to 100% of compensation up to a maximum of $13,500. Employees can also make catch-up contributions of $3,000 per year. Employers must match contributions from 1% to 3% of compensation.
Pension Plan (Defined Benefit)
If you have a pension plan, you have a different kind of “animal” from the plans listed above. Those above are called “defined contribution” or “DC” plans. A traditional pension plan is a “defined benefit” or “DB” plan. With a defined benefit plan, the employee doesn’t contribute. The employer is responsible for calculating how much must be put away each year to be able to fund those future pension benefits.
The amount each employee receives is usually tied to years of service and final average salary of the last few years worked. Sometimes the employee only has the option to take a monthly amount (annuity) and sometimes there is a choice of annuity or lump sum. The lump sum amount is calculated using an interest rate. If the interest rate goes down, the lump sum goes up (and vice versa).
Companies can give their employees all sorts of things to keep them happy (and to convince them not to leave): free parking, free day care, and yes, even free money. That last one might sound too good to be true, but free money is exactly what employees get when their company offers to match their DC plan contributions.
Matching is common in 401(k)s and 403(b)s, and it works like this: Your employer agrees to contribute a fixed amount, say 50 cents, for every dollar you invest in your retirement account. That means your DC participation is automatically making you cash, and you don’t have to lift a finger. No other investment even comes close to being as easy and instantly profitable.
Most employers want to make sure you’re going to stick around before they start giving you free cash. So usually they like to wait a year or so before they start matching your contributions. It’s also common for employers to set up a vesting schedule. That means you’re only entitled to the match money bit by bit. For example, if you leave the company after two years, you may only get 40% of the company’s match money. Your own contributions, however, are always 100% yours from the start.
Companies may also place limits on how much of your contribution they’ll match. For instance, your company might not want to give you more than $2,000 a year no matter how much you contribute to your DC plan on your own.
You wouldn’t turn down a $20 bill if someone offered it to you. Likewise, you should try to invest at least as much in your DC plan as your employer matches. It’s the smart thing to do. Otherwise, you’re passing up free money.
There are lots of different types of retirement plans available. Start by better understanding what your employer is offering you. Try this exercise to test your self-knowledge.
It’s time to do a little homework on your company benefits that will affect your retirement decisions.
- Go find your paystub. What are you currently earning on an annual basis?
Gross (before taxes are taken out)
Net (after tax and other subtractions)
- What type of company retirement plan do you have?
Defined Contribution (DC)?
Defined Benefit (DB)?
- Will you receive a pension at retirement? Yes
Are you vested now? Yes No
How much will you receive?
(You may need to have your Human Resource group run projections for you based on different retirement ages.)
- How much are you contributing to your plan now?
Are you “maxing out”? Yes No
Will you increase your contributions? By how much?
- How much company stock do you own?
As a percent of your total portfolio?
Should you reduce your company stock position?
Yes: By how much?
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