Money and You: Course Notes

Due to the societal shift away from family homesteads to areas of industry, there grew a demand for financial security after a life in the work force. In order to attract the best workers, employers began offering benefits that help their employees save for retirement.

There are essentially two flavors of employer-sponsored retirement plans.

A defined benefit plan is a plan in which the employer makes a guarantee to pay a well-defined amount to an employee after they retire. The most common form of a defined benefit plan is a pension in which an employer makes a promise to make regular (usually monthly) payments to a retired employee until their death or a certain amount of time after retirement. We’ll discuss these more in the next section.

Because defined benefit plans put the burden of funding retirement completely on the employer, many employers have shifted to a defined contribution plan for their employees. Under these plans, employers put a defined amount of money into an account on your behalf. When you retire, you have access to the funds in this account. The idea is that these funds are invested and will grow long-term into a sizeable amount.

There are benefits and drawbacks to each plan type. Form the worker’s viewpoint, defined benefit plans offer the best security as retirement is up to their employer. However, workers can feel “trapped” in their jobs as they will lose much of the benefits of their plan if they change careers. Defined contribution plans allow for more freedom in employment as retirement accounts are usually transferrable. Form an employer point of view, defined contribution plans are preferred as there are no long-term commitments that they must honor.

These days, most employer-sponsored plans are defined-contribution plans.

Taxation is a little tricky with regards to savings. The philosophy is, if you put money aside to use way into the future, is it really income? Because of this question, most retirement plans come in the form of a 401(k) or 403(b) plan.

In most ways, 401(k)’s and 403(b)’s are the same. The biggest difference is that for-profit companies generally sponsor 401(k) plans, and non-profit institutions generally offer 403(b) plans. These plans must be sponsored by an employer (you can’t just open your own).

Under one of these plans, you have the option of deducting some of your pay to be deposited into your personal plan account. Many employers will also contribute funds as a “matching,” up to a certain percentage of your income. For example, if your employer offers 5%matching, for every dollar you deduct into your account, up to 5%of your annual pay, your employer will also contribute a dollar. If you deduct more than 5%of your total pay, your employer will not contribute any more. For example, suppose you earn $100,000 and your employer matches 7%for your retirement plan. If you deduct 4%of your pay in a year ($4,000), your employer would match that, making your total amount put into your account $8,000. If you deduct 7%($7,000), your employer would match that, making your total amount put into the account $14,000. If you deduct 10%of your pay ($10,000), your employer would still only contribute 7%($7,000). So, the total deduction would be $17,000.

Currently, the most you can contribute each year in a 401(k) or 403(b) is $23,500. If you’re over 50, you can contribute $31,000.

There are two ways to enjoy the tax benefits of a 401(k) or 403(b) plan. It depends on whether your account is a “traditional” or a “Roth” account.

With a traditional retirement account, any contributions you make reduce your taxable income for the year. For example, suppose you make $100,000 (pre-tax) and contribute $10,000 to your 401(k). Then only $90,000 of your pay is taxed. The downside to this is that when you retire and begin withdrawing money from your 401(k), that money is then taxed as regular income. So, if your 401(k)/403(b) is your main source of retirement income, you will need more saved up with a traditional account because of taxes you’ll pay when you withdraw money.

With a Roth retirement account, any contributions you make are made after you pay taxes on your pay. So, if you make $100,000 (pre-tax) and contribute $10,000 to your 401(k), you will still be taxed on your full $100,000. However, when you make withdrawals from your account when you retire, that income is completely untaxed. Generally, you need to save a bit less with Roth accounts because of the lack of taxation with withdrawals.

You often have a choice of a traditional or Roth account. The choice depends on a number of factors. People with higher incomes often select traditional accounts to reduce their tax burden each year. People who start a 401(k)/403(b) later in life also tend toward traditional accounts as they will earn less in investment income. People who start accounts earlier in life often choose Roth accounts as they will earn more in investment income but can avoid taxes on it.