CHAPTER
5

Company Pensions

In This Chapter

• Types of pension plans
• Other ways to save for retirement
• Deferring distribution—and taxes, too
• Borrowing from your pension

Most employers provide qualified retirement plans for their employees, usually through contributions by the employer and employee. The government encourages contribution by providing tax incentives.

No one wants to rely solely on Social Security after retirement, but many people have trouble saving on their own. Pension and retirement accounts are an essential part of your estate plan. Fortunately, a variety of pension plans have been developed, with attractive tax incentives as well. This is a complex area, but after you’ve read this chapter, you’ll better understand your own choices and have more confidence in building savings for your golden years.

Note government employees and some others might have pensions not discussed in this chapter. If that applies to you, check with your plans benefit office for information about your retirement program.

Qualified Pension Plans

A pension plan is an employee compensation program through which a worker receives his or her benefits upon retirement.

What does qualified mean in the context of pensions? It’s a pension plan in which the employer’s contribution are not taxed to the employee in the year it is contributed. The accumulated income and contribution are taxed only upon distribution, which is usually a monthly payout to the employee after he or she retires. Those payments are tax deferred, a term you’ll read often in this chapter. In the context of pensions, it means taxes on that money are not due and payable until the employee has retired, when he or she is presumably in a lower tax bracket and pays less than when he or she was employed.

I talk about three types of qualified retirement plans in this chapter: defined benefit pensions, profit sharing, and stock bonus plans.

Joann is enrolled in a defined benefit pension plan because it clearly states her retirement income. It might have some variables, such as a cost-of-living adjustment (COLA), or a reduction equal to her Social Security benefit when that kicks in. But essentially, Joann can count on that $2,000 coming to her each month during her retirement.

Joann’s husband will receive her pension benefits if she dies before him because she has a joint-with-survivor pension. If her husband had waived his right to that money, her pension would be larger, but only for her life rather than paid over two persons’ lives.

Generally, a husband or wife has a right to at least a 50 percent survivor benefit in the other spouse’s qualified pension, unless that right is waived in writing in a prescribed form. (A prenuptial agreement won’t ensure that a spouse has waived his or her pension rights.) If a spouse agrees to waive to those rights, the employee can ask to fill out an employer waiver form, which the employer can provide.

Defined pension benefits are determined by years of employee service and average compensation during that work time, based on a formula set into the plan. The employer is supposed to set aside enough money to fund your benefits, using actuarial calculations of how long you and your spouse are expected to live. There are limits to annual benefits—$210,000 in 2015, with subsequent years adjusted for inflation—but you probably won’t have to worry about that unless you are a retiring senior executive with a Fortune 500 company or a pro athlete.

Defined Contribution Pension Plan

In a defined contribution plan, what’s fixed is not the amount of money you get at retirement, but how much money—usually determined as a fixed percentage of your income—you put in before retirement. In a defined contribution pension, benefits are based solely on the amount the employee and employer contributed plus the account’s accumulated income. Each plan participant has his own account, which is much like a savings account, and usually the employer makes a contribution as determined by the plan. Upon retirement, it’s easy to determine the amount available to the employee, and that amount is usually reported on a quarterly basis.

For example, Ken works for Medium Company. He is enrolled in a defined contribution plan and contributes 4 percent of his salary, which is matched by his employer. Adjusted annually, the contribution limit for 2015 is $53,000. The quarterly statement on Ken’s retirement account shows his contribution, his employer’s contribution, and the accumulated income. Neither his nor his employer’s contributions are taxed when he earns the money, nor is the accumulated income. Ken only starts paying taxes on the money when he begins receiving retirement payments.

Profit Sharing Plan

A profit sharing plan is a program in which employees share in any profits the company makes. It’s set up by the employer, who contributes part of the company profits to separate employee accounts, as determined by the plan and those profits.

The law generally treats a profit sharing plan like a defined contribution pension, although it could also be used to fund accident, health, or disability programs. When the profit sharing plan makes a distribution to the employee, the employee is taxed on the money he or she receives.

Stock Bonus Plan

With a stock bonus plan, the employer establishes and maintains a program of contributing shares of its company stock to employees. The plan is subject to most of the same requirements as a profit sharing plan. When the employee receives the stock, he or she is taxed on its worth.

Because the retirement account in a stock bonus plan consists of the employer’s company stock, there is no diversification of portfolio. With this plan, market fluctuation in that stock has an impact on your retirement benefits. In other words, your eggs are all in one basket, and that basket is your company.

Quite similar to stock bonus is an employee stock ownership plan (also known by its initials, ESOP). In such a plan, the employer contributes its company stock to a qualified trust, which manages it for both employer and employee. The employee is taxed upon distribution.

Vesting Requirements

In pension language, vesting means having met the particular plan requirements for the legal right to receive pension benefits, based on your years of service. Your benefits start at retirement age, which is usually 65. In most plans, an employee is vested after contributing to the plan for a certain number of months. Once the employee is vested, the employer also begins to contribute to the plan.

To use the jargon, you are 100 percent vested in, or you own, what you contribute to that plan.

Your right to your employer’s contribution is another matter. If, according to your plan, you are entitled to all the employer’s contribution upon completion of 5 years’ service with that company, that’s called cliff vesting. Or your plan might have graded vesting, which is a staggered ownership style. The following table shows what you are allowed to keep of your employer’s contribution with graded vesting.

Years of Service	Nonforfeitable Percentage
0	0
2	20
3	40
4	60
5	80
6 or more	100

Amy has worked for her employer for 6 years. Her retirement plan has 5-year cliff vesting, so 100 percent of her accrued benefits are hers. Tommy has been employed by his company for 5 years, but his employer has graded vesting, structured as in the preceding table. So Tommy is 80 percent vested in employer contributions.

If you leave the company, the employer’s contribution that is not vested remains in the pension plan. You take with you whatever you put into the plan.

Check your own retirement plan, and consult with the appropriate office at your place of employment if you have any questions.

Distribution Requirements

Distribution, or payment, from any qualified retirement plan must begin no later than April 1 of the calendar year following the year you reach age 70½. So if your birthday is January 1, your half-birthday is July 1. If your 70½ birthday is July 1, 2016, you must receive a distribution no later than April 1, 2017.

Not only must you receive a distribution by a certain date, but that distribution also must meet the pension law’s minimum requirement guidelines. If you fail to follow this rule, you’ll have to pay a penalty.

The Internal Revenue Service (IRS) provides various actuarial tables you can find at its website, irs.gov. The following partial table illustrates how to determine your minimum distribution requirement based on your age.

Uniform Actuarial Table

Age	Factor
70	27.4
71	26.5
72	25.6
73	24.7
74	23.8
75	22.9

Here’s how to use the table:

1. Find your age at distribution date on the table.

2. Find out what your retirement account balance will be in the year prior to the current distribution. (Your benefit plan report tells this.)

3. Divide the amount in step 2 by the factor in the chart.

Let’s use Bart as an example. Bart must receive his first distribution in 2008, when he’s 70 years old. According to the IRS table, his required distribution factor is 27.4. The amount in his retirement account is $500,000. Therefore, Bart must receive $18,248 ($500,000 ÷ 27.4). Each year thereafter, he recalculates his distribution requirement by the next age factor.

The IRS has other tables for joint-life IRAs (usually based on the lives of both husband and wife) and qualified plans, as well as for beneficiaries of such plans. Please contact your financial planner for advice. You may want to consult IRS Publication 590-A, “Contributions to Individual Retirement Arrangements,” and 590-B, “Distributions from Individual Retirement Arrangements.” Or view the information on the IRS website, irs.gov.

Generally, you can’t take any distribution prior to age 59½, but there are exceptions to this rule that I discuss later in the chapter.

40l(k)s, IRAs, and Other Ways to Save

40l(k)s, Roth 401(k)s, 403(b)s, individual retirement accounts (IRAs), Roth IRAs, and more—you’ve got several choices if you don’t have a pension plan or you want to put more away for retirement than what your company is providing.

• Contributions can be made by deducting money automatically from your pay (through a salary reduction plan). You’re less likely to miss money you never see; even better, you don’t pay taxes on the money deducted from your salary.
• Your employer might make a matching tax-deferred contribution.
• You’re taxed upon distribution of the employee and employer tax-deferred contributions, plus the accumulated earnings, but that tax is applied when the retiree’s income bracket is (probably) lower than it was when he or she was working.
• Plan distributions can be delayed until age 70½.

You can take your 401(k) plan with you if you leave your present employer. However, the employer contributions may have vesting requirements similar to a defined contribution plan.

Employers with 100 or fewer employees can establish a Savings Incentive Matching Plan (SIMPLE) as a 401(k) or an individual retirement account (IRA).

Employers can also establish a Roth 401(k) plan for employees. The contributions have been taxed; therefore, subsequent distributions are tax free.

403(b)s

A 403(b) plan is similar to a 401(k), except it applies to not-for-profit companies. There are some slight differences in income limitations and investment opportunities with 403(b)s. Your financial adviser can explain these differences to you.

Roth IRAs permit the same contribution amount as the IRA, but the income earned in the account is exempt from income tax if the Roth IRA is held for at least 5 years. Contrast this with the IRA, which simply defers the income until it’s withdrawn. Consult with your financial planner to determine which is more advantageous for you.

Expect to pay heavy financial penalties for early withdrawal from regular and Roth IRAs—both have age-specific distribution limits. In addition, whether your contribution is tax deductible depends on your income and defined benefit or defined contribution plan limits, as previously discussed. Some limitations exist on your choice of investment vehicles, but you still have plenty to choose from, including mutual funds.

Deductible contributions and the accumulated earnings of an IRA are taxable when distributed. That distribution may begin as early as age 59½ but no later than age 70½.

Keogh Plans

Self-employed individuals are eligible to receive qualified retirement benefits under a Keogh plan (pronounced KEY-oh). Keoghs cover partners and sole proprietors and can include employees. The coverage requirements, contribution limitations, and taxability upon distribution are similar to defined benefit or defined contribution plans, depending upon which form is used in the Keogh plan.

If you are self-employed, consult with your financial planner for the Keogh plan that can be tailored to fit your needs.

Is There an Annuity in Your Future?

Whether through your place of employment or on your own, you can put as much money as you like each year into an annuity. An annuity is an investment vehicle that brings a fixed, periodic return for a specified number of years, or for a lifetime (or, if desired, for the lifetime of a spouse). The annuity grows without taxation. But the amount you deposit is not deducted from your reported earnings.

Joe purchased an annuity from an insurance company for $20,000 in 2014. The company promised him he would receive $3,000 a year for 10 years (a fixed term), beginning in the year 2024, when he is retired and in a lower tax bracket.

Each one of Joe’s annual payments, starting in 2024, will include income earned from his premium. His investment was $20,000, with an expected return of $30,000. His annual payment will be $3,000, but because $2,000 of that will be considered ¹/₁₀ of an investment and not earnings on that investment, only $1,000 will be taxable each year.

The advantage of the annuity is, as you’ve read so often here, that the payment of income earned is deferred until the future, when your tax rate is likely to be less.

Contrast that with Joe putting his $20,000 into a certificate of deposit (CD). Each year the interest earned from the CD will be taxed, while the income from an annuity will be tax deferred until payout begins.

Annuities are considered safe for future needs, but with limited returns. They appeal to people who don’t like high-risk investment strategies.

You want something a bit more daring? Then you might want to consider what is known as a variable annuity, which puts your principal into the stock market. Now your annuity becomes as responsive to the current economy as the performance of any stock or mutual fund. And any earnings are tax deferred.

Building Wealth at the IRS’s Expense

You have been very patient in reading through this complex subject. For that, you are to be commended. But the bottom line, as you are probably thinking right about now, is Just tell me how much all this will save me.

That will depend on many factors. For one thing, it depends on how much you can afford to put into your retirement plan. Of course, there are limits. With an IRA, for example, you can contribute only $5,500 a year. A person age 50 and over can contribute an additional $1,000 annually.

Here are the tax-deductible limits for each year for some plans:

• A defined contribution plan permits a contribution of up to $53,000 per year, with increases indexed to inflation after 2016.
• A 401(k) plan permits you to contribute up to $18,000 for 2016. Thereafter, any increase is indexed for inflation. If a taxpayer is at least age 50, a contribution may be increased by $6,000 in 2016.

All this is income that is tax deferred.

Let’s look at an example of how one employee is working her pension to her advantage. Hope has a 401(k) plan at work. She earns $50,000 annually and has agreed to contribute 5 percent of her salary to her plan through a salary reduction plan. Her employer agrees to match her contribution. Hope’s taxable salary for a year is then $47,500 ($50,000 salary minus her $2,500 salary contribution, which is 5 percent of her income). Into her 401(k) goes her $2,500 contribution, which is tax deferred, and her employer’s $2,500, which is also tax deferred. Thus, Hope has $5,000 put away for retirement and has reduced her taxable income by the $2,500 she herself contributed. If she wanted to, she could make an additional contribution from her salary, which could also be tax deferred.

When Hope retires and starts receiving distributions from her 401(k), they will be taxable, but by then, she will be making less money, so her tax rate will be lower.

Compare the results in Hope’s 401(k) account with her putting her contribution into a savings account. If she is taxed at a 20 percent rate, she will have to earn $3,125 to save $2,500 (because the savings account is funded with after-tax dollars), and any interest earned each year would be taxed. She is, therefore, saving at the IRS’s expense. And you would, too, if you had a 401(k). And as a bonus, her employer kicked in another $2,500! What you save in your retirement account is tax deferred, and the income earned by the account is tax deferred. I don’t know about you, but I personally prefer paying taxes sometime in the future—when I retire, but certainly not now!

I like to get paid up front. The IRS prefers that I make money that way, too, and pay tax on it right away. However, most of us have some form of retirement plan that pays us later—after that magic 65 or 70 years of age mark, or whenever specified in the retirement plan. Our money is tax deferred until those payouts begin.

A few folks have other deferred compensation plans I haven’t talked about yet that deserve mention. (If you are not in the highest tax bracket, you can skip this section.)

Tony “Tiger” Templeton is a running back for the Indianapolis Horses and recently signed a 4-year contract with the team for $500,000 per year. Actually, he is only going to receive $250,000 each of the 4 years. The other $1 million will be paid beginning in the year 2020 in 10 annual installments of $100,000 each—quite a few years after Tony’s knees will have started giving way. Tony’s taxable compensation this year and for the next 3 years is $250,000. The rest will be taxed when he receives it, beginning in 2020 and each year after that, when he is in semiretirement signing autographs and, thus, in a lower tax bracket.

If you are an employee in a high tax bracket, you may be able to contract with your employer for a deferred compensation arrangement, with part of your salary to be paid when you begin retirement. It would likely be taxed at a lower rate than it would be now because your income then will have dropped.

Besides deferred compensation plans, you also may want to investigate stock options with your employer. They receive favorable tax treatment, too, with taxes often hitting when you’re retired and in a lower tax bracket.

Early Withdrawals from Your Pension Plan

Maybe you look at your assets and see a big chunk of money sitting right there in your retirement plan, doing absolutely nothing. What a crime! If you are short of cash, you might feel tempted to withdraw some money from that account to pay off debts.

You might be able to borrow from your retirement plan. There are a number of restrictions in this area, and you need to consult your benefits administrator to do it correctly. Keep in mind, though, that the amount you borrow, if not paid back, may seriously deplete your retirement fund.

Early withdrawals (that usually means before age 59½) from qualified pension plans are subject to a 10 percent penalty tax. In addition, you must report the tax-deferred amount you withdrew to the IRS as income in the year withdrawn.

There are several exceptions to this withdrawal penalty:

• Employee separation from employment after age 55
• Distribution to a beneficiary after the employee’s death
• Distribution to the employee due to a disability
• Distribution to pay medical expenses
• Distribution to a divorcing spouse
• Distribution for higher education expenses
• Distribution for first-time homebuyers

Will Your Pension Be There When You Need It?

I certainly hope so. During the coming few decades, the baby boomers (those born between 1946 and 1964) will earn larger and larger incomes, rack up more years with their company, and, as all of us must, approach retirement. And employers will have to make larger and larger contributions to their pension funds. Some experts fear many companies will cancel that benefit when faced with the increased amount they must spend.

Can they do that? Yes, I’m afraid they can. A company does not have to file for bankruptcy, or even be in financial trouble, to justify terminating its pension plan. Actually, more than 30,000 American companies have done just that since 1980. However, most have replaced it with some form of employee contribution plan.

Whatever the future holds for you—and your company—your pension is probably safe, although its benefits might be frozen at the date the plan was terminated. You can thank an act of Congress, which in 1974 set up the Employee Retirement Income Security Act (ERISA) that now governs pension plans. It, in turn, established the Pension Benefit Guaranty Corporation (PBGC), which acts sort of like the Federal Deposit Insurance Corporation (FDIC) does for banking.

For example, if Acme General Company wants to terminate its pension program, the PBGC requires it to prove it has enough money to pay all the scheduled benefits for retired and vested employees. If the PBGC is satisfied, the company in question usually purchases an annuity from an insurance company to pay pensions.

If a company declares bankruptcy and has an underfunded pension plan, the PBGC takes on the responsibility for paying its pensions. Broadly speaking—and there are a lot of “whereas”s in this operation—as a retired Acme employee, you likely would be paid some, if not all, of your money.

Note that what I’m talking about here is private company pensions. The PBGC’s role does not include government employees, not-for-profit groups, and professional associations, such as doctors or lawyers.

So yes, it’s very likely that your pension will be there for you when you’re ready. But not knowing absolutely for certain, coupled with nail biting about Social Security and whether that system will be around for you when you retire, should get all of us busy putting away as much as we can in savings and investments—just in case.

The Least You Need to Know

• A company retirement plan can sometimes be tailored to fit your particular needs.
• If your company does not provide a pension, you can set up your own.
• Money you put into your pension doesn’t get taxed until it’s distributed to you at retirement, when you’re probably in a lower tax bracket.
• Your company pension will probably be alive and well when you hit retirement age, but it still makes lots of sense to save as much as you can.