RETIREMENT PLANS

Retirement plans can play a significant role in your compensation package. There are a few different types of plans your employer may have including: pension plans, 403(b) plans, 457(b) plans, or the most common 401(k) plans. There are some basic parts of retirement plans described below that you should review first and then each of these plans have been separated so you can jump to the section that your job offers.

With retirement plans, either employers take on the investment risk and guarantee a specific retirement benefit amount for each employee with a pension plan or employees take on the investment risk and are responsible for choosing how these contributions are invested such as the 403(b) plans, 457(b) plans, and the 401(k) plans. Typically, the contributions are made with pretax dollars, which means that the money you are putting into these retirement investment accounts are taken out of your pay without you getting charged taxes on the money. Taxes are charged when you eventually take the money out of these accounts. For example, for simplicity let’s say you make $50,000 and pay 20% of that in tax. This would mean that the government would take $10,000 in taxes (50,000×0.2) and your take home pay would be $40,000 (50,000 wages -10,000 tax). Making $50,000 if you were to contribute $10,000 to a retirement investment account, you may think that you would now make $30,000 (($50,000 wages – ($10,000 tax) – ($10,000 contribution)) however this is incorrect. You made a $10,000 contribution before paying taxes so you would only pay the 20% tax on the remaining $40,000. This would mean that the government would take $8,000 in taxes (40,000×0.2) and your take home pay would be $42,000 (40,000 – 8,000). You have saved $2,000 in taxes and have instead invested that money. This is a great advantage of investing using pretax contributions because it lowers the amount of taxes you pay now and delays it to a later day when you withdraw the money.

Any money you put into these plans are yours and vested immediately meaning that the money remains yours even if you leave the company. Some employers will contribute money into these plans for you on top of your wages. If your employer contributes to the plan, you should review what their vesting schedule is for their contribution. Their contributions are vested and become yours after you have worked for them for the designated amount of time required for vesting. For example, some companies will require that you work for them for three years before their contribution is vested. If you were to leave before these contributions are vested, any money you put into these plans is yours since it is automatically vested, but you would lose any contributions your employer made. Also, there are employers that require you to work for a certain amount of time before they start contributing to your plan. Next, their contributions would start after the required time and then would become vested after the designated amount of time has passed. For example, a company may start contributing to your retirement plan after you have worked there for a year and then have their contributions become vested after you have worked there for three years. If you leave anytime after three years, you get to keep all the money since all the contributions are vested. Do keep in mind that even if your employer does not make contributions yet, you can and should make contributions as soon as you have access to this plan. Employer contributions are most common with 401(k) plans and are described in detail below in that section.

For the plans where you have to take the investment risk, you will be provided with a lineup of investments that you have to select from. Index funds, such as ones that match the S&P 500, can be a great choice to invest into. 

DIFFERENT RETIREMENT PLANS
(Feel free to jump down to the retirement plan that your employer offers.)

PENSION PLANS

With pensions plans, employers take on the investment risk and guarantee a specific retirement benefit amount for each employee. This benefit payout amount is usually a set defined amount, or a calculated amount based on what your salary was while you were working and how long you were employed. You receive the pension if you work for the company for the designated amount of time required for vesting. Leaving prior to this results in not receiving a pension at all or just a partial one. Once vested, individuals can usually take the entire retirement benefit payout at once or spread out the payments over time. Some pensions are entirely funded by the employer, and some require employees to make contributions as well using pretax dollars.

Pensions today are rare and usually available in a select few jobs such as government related or military jobs. The biggest advantage to a pension plan is that the employees know the exact amount they will be receiving in retirement. The disadvantages of a pension plan include receiving payouts that are usually lower than a properly managed 401(k) plan and unlike the other plans mentioned here pension plans have stricter limitations on benefits amount being transferred to someone else once you pass. 

403(b) PLANS

A 403(b) plan is offered by nonprofit businesses and by the government for employees, including educators. Employers usually do not contribute to these plans as nonprofit businesses look to limit their spending and government employees may have access to a pension plan on top of this. The contributions employees make to this plan are using pretax dollars and you will be provided with a lineup of investments that you have to select from. The government does limit how much you can contribute to these plans each year since you are saving on taxes. For 2023, the annual contribution limit is $22,500. If you are 50 or older, you can invest an additional $7,500 annually. 

You can start withdrawing money from your 403(b) plans once you are 59 and a half. The withdrawal will be considered income and you will now pay the required income tax on that money. If you take distributions before you reach this age, you will have to pay the required income tax and an additional 10% early withdrawal tax penalty. There are special circumstances where you can take it out early without paying the early withdrawal tax penalty. You should check with your employer regarding these exceptions. 

457(b) PLANS

A 457(b) plan is offered to government employees, including educators. These plans are usually entirely funded by employees as government employees may have access to pension plans and 403(b) plans on top of this. The contributions employees make to this plan are using pretax dollars and you will be provided with a lineup of investments that you have to select from. The government does limit how much you can contribute to these plans each year since you are saving on taxes. For 2023, the annual contribution limit is $22,500. If you are 50 or older, you can invest an additional $7,500 annually. 

The biggest advantage of this plan is that you can start withdrawing money from your 457(b) plans at any age after you leave your job. There are special circumstances where you can take it out while still employed without paying a tax penalty. You should check with your employer regarding these exceptions. 

401(k) PLANS

A 401(k) plan is the most common type of retirement plan and is offered by private employers. There are several different methods with which businesses contribute to these plans as outlined below. All these plans encourage employees to fund their retirement plans. The contributions employees make to this plan are using pretax dollars and you will be provided with a lineup of investments that you have to select from.

Method 1 – No Employer Contribution

Employers will not put any additional contributions to the plan, but will set you up with a plan so that you can contribute to it. You should take advantage of being able to invest for retirement using pretax contributions. Your contribution is vested. 

Method 2 – 100% Employer Contribution Match Up to A Limit

Employers will put additional contributions to the plan to completely match what you are contributing up to a limit. For example, with a 3% employer contribution match if you invest 3% of your pay into the retirement plan, your employer will match that and contribute the same amount into your plan. If they have a policy of 3% match and you only put in 2%, they will only put in 2%. Alternatively, you can also put in more than 3%, but the company match will max out at 3%. You should take advantage of the contribution match and contribute at minimum the amount that they will match. This would be similar to giving yourself a raise for the amount they will contribute, but the only way you can receive it is for you to contribute. Your contribution is vested; your employer’s contributions are vested after you have worked for them for the designated amount of time required for vesting.

Method 3 – 50% Employer Contribution Match Up to A Limit (Most Common)

Employers will put additional contributions to the plan to match what you are contributing at a 50% rate up to a limit. This is the most common one employers use and the most common amount is a 3% employer contribution match if you invest 6% of your pay into the retirement plan. Employers like this method as it puts a larger responsibility on employees themselves to save for retirement. If your employer does a 50% match till they hit 3% contributions, if you put in 4% they will only put in 2%. Alternatively, you can also put in more than 6%, but the company match will max out at 3%. You should take advantage of the contribution match and contribute at minimum double the amount required to meet their match. This would be similar to giving yourself a raise for the amount they will contribute, but the only way you can receive it is for you to contribute double since they match at 50%. Your contribution is vested; your employer’s contributions are vested after you have worked for them for the designated amount of time required for vesting.

The government does limit how much you can contribute to these plans each year since you are saving on taxes. For 2023, the annual contribution limit is $22,500. If you are 50 or older, you can invest an additional $7,500 annually. Employer contributions do not count towards your annual contribution limit. 

You can start withdrawing money from your 401(k) plans once you are 59 and a half. The withdrawal will be considered income and you will now pay the required income tax on that money. If you take distributions before you reach this age, you will have to pay the required income tax and an additional 10% early withdrawal tax penalty. There are special circumstances where you can take it out early without paying the early withdrawal tax penalty. You should check with your employer regarding these exceptions. 

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