Chapter 20
Investing at Work

In This Chapter
  • Understanding how we save for retirement
  • Looking at some common types of pension plans
  • And then there are 401(k)s
  • Understanding the plan you have
  • Planning for what you’ll need

Most people look forward to retiring. They look forward to having time to do all the things they never got around to while they were working. The problem is, all those trips and activities are going to cost money. And you’ll still have the upkeep on your home to think about. You’ll still need to buy food. You’ll still want to be able to buy presents for people, and go to the movies, and eat at your favorite restaurants.

The obvious question is, where will that money come from?

When we start thinking about retirement—as, no doubt, many of us are—we’re forced to take careful stock of our finances. Will we have enough money to retire? How much longer will we have to work? Have we made the proper investments to assure that we’ll be okay financially when we retire? How much will we get from Social Security?

Go Figure
Social Security is the primary source of income for about 66 percent of elderly Americans. And, experts say the rate of dependency is unlikely to drop in the future because of mediocre savings rates.

Studies show that most people need between 60 and 80 percent as much money to maintain their standard of living during retirement as they required while working. This varies, of course, depending on factors such as health, location, and so forth. Social Security benefits for the average retiree are about 40 percent of their pre-retirement earnings. As you can see, there’s a large gap between what Social Security provides and what it costs to live in retirement. If a retired person doesn’t have enough money saved to make up the difference, there’s a big problem.

In this chapter, we’ll have a look at some work-related investment opportunities, and see how they might relate to your retirement savings plan. Hopefully, you’ve invested through your company’s pension plans, 401(k)s, money purchase plans, profit sharing plans or other work-related opportunities.

Basic Methods of Saving for Retirement

Very basically, there are two ways to save for retirement, regardless of whether you’re saving in a job-related investment opportunity or outside of work:

  • Using pre-tax dollars
  • Using post-tax dollars

In this chapter, we’ll be dealing with work-related investments, nearly all of which use pre-tax dollars. Nonwork-related plans are the topic of Chapter 21, “Investing Outside of Work.”

All of the investment methods discussed in this chapter, then, use pre-tax dollars. That means that the money you invest in these work-related accounts isn’t taxed until you take it back out of the account. This is also known as tax-deferred saving.

Retirement plans, using pre-tax dollars, fall into two types of plans:

  • Qualified investing: 401(k)s, pension, and profit sharing plans
  • Nonqualified investing: deferred compensation and stock options

Qualified investing is the major method, and the one with which we’ll primarily be dealing. Just so you know, what they are, however, here’s a bit of information about nonqualified plans.

Nonqualified plans aren’t subject to the same rules and regulations as qualified plans. Deferred compensation and stock options are two nonqualified plans that are familiar to most people.

All qualified investment plans fall under the rules of the Employee Retirement Income Security Act of 1974, or ERISA. Nonqualified plans are not covered by ERISA guidelines.

Nonqualified plans usually are provided to key employees (the big guys), and used to supplement qualified plans and defer income taxes. Few of us have opportunity to be covered under nonqualified plans. So while it’s good to know that they’re around, they probably will have no bearing on our retirement benefits.

ERISA rules mandate that qualified plans must provide equity throughout an employer’s pension fund. If an employer is going to provide a retirement benefit for his employees, the coverage must extend to all employees, within certain guidelines.

Qualified plans come in different flavors, but they all have the goal of helping you to save money for when you retire. The type of plan you have at work probably is determined by your employer, who, incidentally, is able to deduct the money he contributes to employees’ retirement plans from his federal income tax. Let’s look at some widely used, important qualified investing plans.

Pension Plans

The phrase “pension plan” often is used generically to refer to any sort of retirement plan offered by an employer. It could refer to a 401(k) plan, a money purchase plan, or any of the other plans we’ll discuss in this chapter. If you’re self-employed, and don’t have the benefit of an employer-sponsored plan, you can establish your own retirement savings plan through a SEP-IRA. You can learn more about SEP-IRAs in Chapters 18 and 21.

Traditionally, however, a pension plan is an employer-sponsored retirement plan, in which the employer contributes money to a retirement fund set up on behalf of the worker. When the worker retires, he receives fixed, periodic payments, on which he must pay taxes.

Of the traditional type of pension plan, there are two kinds:

  • Defined benefit plan
  • Defined contribution plan

[image] Money Morsel
Traditional pension plans used to be more common than they are now, but they’re still around, especially at larger companies. Seventy-seven percent of large companies in America still offer pension plans, although most mid-size or smaller companies have 401(k) savings plans.

Both plans provide funding for your retirement. The difference is, with the defined benefit plan, the investment responsibility is on the employer, while the defined contribution plan puts the responsibility on the employee.

The defined benefit plan promises the employee a specified retirement benefit, based on a formula. The investment return risk is on the employer, who is responsible for funding and benefits.

[image] Money Morsel
Defined contribution plans generally are considered more advantageous to younger employees who have many years to invest. Defined benefit plans tend to be better for older workers who don’t have a lot of years to let their investments work for them.

If your company offers a defined benefit pension plan, it, in effect, promises you that if you work there for 30 years, retiring when you’re 65, you’ll get a monthly check for a certain amount of money (determined by the formula), for the rest of your life. The monthly pension payments are based on the number of years the retiree worked for the company and his salary during the years he worked. Different companies have different formulas for figuring out pension payments, but nearly all are based on years of service and salary.

Your employer is responsible for investing the money, and for being able to pay you the amount you’ve been promised when you retire.

A defined contribution plan, on the other hand, promises an employee the value of the employee’s account at retirement—whatever that value may be.

Although the employer is responsible for providing a satisfactory investment vehicle, the investment risk is on the employee.

Let’s say that your employer contributes 10 percent of your salary each year to a defined contribution account in your name. If you make $45,000 this year, he’ll throw $4,500 into your retirement account. Once he’s contributed the money, however, it’s your responsibility. You need to decide where you’ll invest it, and you bear the investment risks. Whatever is in the account at retirement time is what you have.

Under a defined contribution plan, your employer has an individual account in your name. The employer’s contributions are put into the account each year, with all income and capital gains taxes deferred until the money is withdrawn at retirement.

When you become eligible to receive benefits—usually at retirement—the benefit is based on the total amount in your account. The account balance includes the employer’s contributions, whatever contributions you may have added to the account, and the earnings on the account for the years of deferral.

There are three principal types of defined contribution plans. Let’s have a look at what each one entails.

Money Purchase Plan

A money purchase plan is a qualified employer retirement plan in which each employee has an individual account. The employer must make annual contributions to each employee’s account. The amount of contribution is determined by a pre-set formula, based on a fixed percentage, or a flat monetary amount.

The formula requires an employer to contribute a specified percentage (up to 25 percent) of each employee’s compensation. Money purchase plans are expensive for the employer, and are not as common as other plans. If the employer can’t make his required annual contributions, he is penalized.

Some money purchase plans may allow employees to add to the employer’s contribution, but the employee would have to pay taxes up front on the money he contributed.

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An employer’s annual contribution to a money purchase plan is required. He can’t take a year off because business is slow and profits are down.

Profit Sharing Plans

A profit sharing plan is a qualified, defined contribution plan in which an employer contributes money to employees’ accounts, based on the amount of profit the company has realized that year.

The employer gets to decide how much to contribute, and is not obligated to contribute anything if the company has not been profitable. Although an employer can contribute up to 15 percent of each employee’s salary into his or her account, the average contribution usually is between 2 and 5 percent.

A profit sharing plan can be done in conjunction with another retirement savings plan, but sometimes it is the only type of plan available within a company. Employees may add to their employer’s contribution, either with pre-tax or post-tax money.

Target Benefit Plan

A target benefit plan is an age-weighted plan that’s normally used by a company that wishes to have a specified sum available for an older employee (usually an owner) at the time of retirement.

These plans are expensive, and usually employed by companies in which the owners have been unable to contribute to retirement funds while they were building up the company. Once the company starts to be profitable and retirement money is available, the owners try to compensate for their previous lack of retirement saving.

401(k) Plans and the 403(b)

A section 401(k) plan, commonly known simply as a 401(k), is a qualified profit sharing plan that gives an employee the option of putting money in the plan (up to $10,500 per year) or receiving taxable cash compensation.

You either can take the money home as additional pay, or have the funds deposited into a 401(k) plan for you. An employer usually adds a percentage of the employee’s contribution to the employee’s plan.

Both your money and your employer’s contribution are made with pre-tax money. That means that the income you contribute to your 401(k) isn’t considered taxable income at this time. It will, however, be taxable when it’s withdrawn.

Go Figure
Most employees like 401(k) plans because they’re flexible. You’re normally permitted to change the amount of money you contribute at least once a year.

The 401(k) accounts were introduced in 1982, and became extremely popular in the ensuing years. In fact, employees sometimes get frustrated when their employer doesn’t provide a 401(k).

If you have a different type of plan, however, don’t assume that you’re being cheated by not having a 401(k). Another type of plan is likely to do as well, or perhaps even better. They’re certainly preferable to no employment plan, and, 401(k)s do have many advantages. They’re not, however, the only game in town.

While many employers match (or partially match) 401(k) contributions by employees, it’s not required. Some employers contribute nothing. Maybe the employer can’t afford to contribute to the plan, and simply offer the 401(k) as a means for their employees to contribute to a retirement fund, or your employer offers the 401(k) plan as a supplement to an already existing retirement plan.

When an employer doesn’t contribute, all the contributions to the 401(k) come from an employee. The employer would pay only to install and administer the plan.

If your employer does contribute, however, it’s important for you to put enough money in your 401(k) plan to take advantage of the company match. If your company matches dollar for dollar up to 3 percent of your salary, for instance, then you should by all means contribute at least 3 percent. If the company puts in dollar for dollar all of your contribution up to 6 percent, make sure you’re putting away 6 percent in your 401(k).

It’s important that you have a good understanding of your 401(k) plan. You should be aware of when you’re able to change the amount of your contribution and move your money from one investment to another.

Employees get to decide where to invest their 401(k) funds from a list of choices provided by the employer. A greater number of choices increases the cost of the plan, so most employers provide about six choices.

If you have a 401(k), you should try not to touch it until retirement. If you need to, however, if there is a “hardship,” there is a special provision that allows you to get your 401(k) money early.

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A good way to increase your 401(k) contribution is to automatically add any salary increases to the amount you save. You’ll be glad in the long run.

Under the hardship provision, you can withdraw from the plan while you’re still working for the firm that provides the plan. You don’t need to quit to get your money out of the retirement plan. You just ask your employer for the money. Your employer must make sure that the reason you need the money falls within the IRS guidelines. If your need qualifies as a hardship, you’ll get your money.

You don’t need to repay the withdrawn funds, but you’ll need to pay tax on them at the end of the year. Tax is withheld when you withdraw the funds.

Some “hardships,” as specified by the IRS, include the following:

  • First-time homebuyer
  • Medical bills
  • Education costs

Some plans permit employees to borrow money from their 401(k)s. It’s extra paperwork for the employer, so some do not provide this option. And, some employers feel strongly that 401(k) money is retirement money and shouldn’t be borrowed against, so they decline to provide a loan provision.

If permitted under your plan, you can borrow up to 50 percent of the total value of the account, up to $50,000. The loan must be repaid within a five-year period, or it becomes a withdrawal.

Many employees love the loan provision because it allows them to pay themselves the interest on the loan instead of a bank or credit union. When you repay the loan (with interest) the interest is added to your account.

There are, however, some problems with borrowing from your 401(k). If you borrow money and then leave the company, the loan must be repaid within a very short period of time.

If you decide to borrow from your 401(k) to buy a car, for instance, and then you leave the company for a better job, you must either borrow from someplace else to repay the loan, or the loan becomes a distribution, which is a taxable event.

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Never take a loan from a 401(k) in which the interest would be deductible if borrowed elsewhere, such as with mortgage interest. Interest paid to your 401(k) plan is not deductible.

These retirement plans are designed for retirement, and there are penalties if you take the money out ahead of time. Money you withdraw from a 401(k) is taxed at your current income tax bracket. And if you are younger than 59 and a half when you withdraw funds, a 10 percent penalty is due on top of the income tax liability.

So if you borrow $8,000 for a car, leave the company, and can’t pay your loan back within the required period, you’ll pay income tax ($1,200 if you’re in the 15 percent bracket), plus $800 penalty. Ouch!

A good reason to borrow from your 401(k) is to repay credit card debt. If you’ve racked up debt and you’re paying 18 percent interest on your balances, you should consider borrowing from your 401(k) to pay off the cards. You’ll pay a lot less interest every month on the money from your 401(k). Just make sure that you don’t turn around and create new balances on the cards.

Another problem with borrowing from your 401(k) is that the loan is invested at a fixed rate as you repay it. It’s similar to having your money invested in money market funds, and you’ll realize a lower rate of return.

401(k) is an IRS code section that permits this type of retirement plan (a type of profit sharing plan). If you work for a nonprofit organization, such as a hospital, charitable organization, or university, you’ll fall under the IRS code section known as 403(b). Look familiar? 403(b)s mirror 401(k)s, except for until recently, the investment vehicles could only be offered through an insurance company. Now, 403(b)s can be set up through mutual fund companies and you can roll a 403(b) into a 401(k) if you go from a nonprofit to a for profit company.

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There are different methods by which an employer can contribute to a simple plan. If your company has this type of plan, be sure to ask your employer or human resource person for details.

Simple Plans

Simple retirement plans are relatively new. They’re aimed at small employers (fewer than 100 employees), and are easy and inexpensive to administer. An employer must contribute annually to a simple plan.

An employer can set up this type of plan for very little cost. Each employee can contribute to the plan along with the employer, up to a maximum of $6,500 a year. If your company has a simple plan, it may not have an additional type of qualified retirement plan.

Understanding Vesting

An employee must meet certain requirements in order to be eligible to be covered under a qualified retirement plan. These requirements vary from company to company.

Normal requirements are that an employee must be at least 21 years old, and must have worked for the company for at least one year. Some employers begin coverage sooner, but a year is the norm.

An employee always gets back what he’s contributed to a retirement plan. Regardless of how long he stays with a company, he always takes his contributions along with him when he leaves. There are, however, regulations that determine when and how an employee is eligible to get the money his employer contributed.

A tool called a vesting schedule determines when you’ll start to receive your employer’s money if you leave the company before you reach retirement age.

You must be an employee for a minimum amount of time before you become eligible to receive your employer’s contributions if you leave the company. This time period is called vesting. There are two types of vesting, cliff and graduated.

Cliff vesting means that you’ve got to work for your employer for five years before you’re entitled to his contributions to your retirement fund. If you change jobs before you’ve been with the company for five years, you walk away with your own contributions, but none of your employer’s.

If you do stay for five years, and then leave, you take all of your employer’s contributions. It’s an all or nothing deal, and something to think about if you’re considering leaving a company after just a few years.

[image] Adding It Up
Vesting is the amount of time required for an employee to work for a company before he or she is entitled to the employer’s contributions to his retirement plan.

[image] Don’t Go There
Don’t walk away from what could be substantial money for the sake of a few months. If you’ve found another job, but are close to being vested, see if you could delay starting the other position until you’re eligible for the retirement funds.

The other type of vesting is called graduated vesting. You need to stay with a company for seven years in order to get all of your employer’s contributions. If you leave within a shorter time, however, you get some of his money, as long as you’ve been there at least three years. It’s not an all-or-nothing proposition. The graduated vesting schedule is as follows:



Many employees don’t understand vesting, and are unpleasantly surprised when they leave and find out they’re not entitled to the money their employers contributed on their behalf.

Knowing What You Have and What You’ll Need

Many people do a good job deciding how much they’ll contribute and how they’ll invest the money in their retirement funds, only to fall short when it comes to keeping track of the funds.

The first thing you should be paying attention to is your Social Security benefits. Call Social Security at 1-800-772-1213, and request a personal earnings and benefits estimate statement. This will tell you what you’ve earned, and your expected retirement benefit.

You should receive a statement from Social Security every year around your birthday, providing your income history since you began working. Upon retirement, Social Security uses a calculation based on your annual income for most of your working career, with an adjustment for inflation. You should carefully review this annual statement to see that the historical salary levels are accurate. If not, your benefit may be lower than it should be when you retire.

[image] Don’t Go There
It’s tempting to throw information concerning your retirement account into a drawer without even glancing at it, but that’s a dangerous habit. Mistakes happen, and if they do and go unnoticed, it could affect the amount of money you have when you stop working.

Your employer should issue a statement, at least annually, providing information about the company’s retirement plan. If you have a defined benefits plan, the statement should outline the amount of benefits you’ll get when you retire if you continue to work at your current job.

If you have a defined contribution plan, there’s no way to know what your retirement benefit will be because the benefit is based on the value of your account when you retire.

However, an investment advisor should be able to calculate an approximate value of your account at retirement by using your current account value, the number of years until you retire, and an assumed rate of return on the investments. You, then, can use that figure as a base to calculate a monthly retirement benefit for your life expectancy.

Pension laws require your employer to provide you with the following information each year:

  • Summary plan description. This explains the basic rules and features of your retirement plan, and you should get it within 90 days of becoming a participant. Review the information so you understand the plan and can maximize its benefits.
  • Summary annual report. This describes the plan’s aggregate financial status.
  • Survivor benefits explanation. This describes the survivor benefits available to spouses under your retirement plan.
  • Individual benefit statement. This isn’t legally required, but most employers provide it. The statement shows your current account balances or accrued benefits. Always retain a copy for your records.

In addition, if your plan is participant directed, that is, you decide how your money is invested, request a description of each investment option, including its risk and reward characteristics, fees, and expenses.

To figure out how much money you’ll need when you retire, go to one of the retirement calculators on the Internet. Some good sites are:

A more involved calculation is available at

[image] Money Morsel
If you learn from a retirement calculator that you’ll need much, much more than you think you can possibly save by that time, don’t panic. Consult a financial advisor to see if the calculator is accurate, and then plan if necessary.

Calculators at these sites take into account your current income, your age, and the amount of money you contribute to your retirement account. They can provide a rough estimate of what you’ll require when you retire, but remember that no one can pinpoint that amount with accuracy.

These investment or retirement calculators assume an annual rate of return, an inflation factor, and they assume you’ll continue to contribute at the current rate throughout your working career. All of those assumptions leave a lot of room for error, so don’t depend too heavily on the information you get.

Retirement Needs Analysis

Most experts feel you need at least 75 percent of your pre-retirement income to maintain the same lifestyle after you retire. This percentage is called the wage replacement ratio (WRR).

Social Security benefits make up the foundation of one’s retirement needs, but most people find they need much more than their Social Security checks. If you don’t have adequate retirement savings, you might have to think about delaying retirement, or working part-time after you retire.

Plan on paying off as many of your debts and mortgages as possible between now and the time that you retire. An important part of retirement planning is planning for debt reduction or elimination.

Go Figure
People who are 75 or older spend 26.5 percent less, on average, than those between the ages of 65 to 74. A good rule of thumb is to assume that by age 75, you’ll spend 20 percent less than when you first retire.

Older retirees tend not to spend as much money as younger retirees. They normally don’t have a mortgage, and they don’t have expenses associated with travel and the other activities they enjoyed at a younger age. Most older people are less active, and therefore spend less money.

Many older people do, however, spend more on medical care as they age, but usually not enough to offset the steady drop in the rest of their living costs.

Some older folks spend less only because their incomes dropped when they retired. Most retirees, however, cut back spending voluntarily, and almost half of them continue adding to their savings for several years after leaving their jobs.

As an example, let’s assume that you retire when you’re 66, and begin living on 80 percent of what had been your working income. And, let’s assume you’ll live another 25 years.

By age 75, you’re likely to be spending just 64 percent of your former income. If you provide for a retirement income equal to 70 percent of your working salary, you’ll probably be just fine.

The investment decisions you make at this point of your life are crucial in determining your ultimate retirement savings under a participant-directed plan.

If you invested $5,000 a year in a tax-deferred account earning an 8 percent annual return, for example, you would accumulate $247,000 after 20 years. If the same investment earned 10 percent annually (about the average annual return on common stocks over the past 30 years), your account would total $315,000 after 20 years—a full 28 percent more.

Invest wisely, and save as much as you can in your retirement accounts. Take advantage of the tax deferments, and plan for a happy retirement.

The Least You Need to Know
  • There are many different types of retirement savings plans, all of which fall into the basic categories of qualified and nonqualified.
  • Pension plan has become a generic term used to describe different types of retirement plans, but it really is a particular type of agreement between an employer and employee.
  • Many employees love 401(k) plans, but if you’ve got a different type of plan you shouldn’t assume that you’re missing out.
  • It’s important to understand the terms and conditions of your retirement plan so that you can maximize the benefits it offers.
  • Planning ahead for retirement by reducing debt can stretch the money you’ll have after you stop working.
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