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Retirement Remix – Chapter 13: Financial Vehicles to Help You Save

In this chapter of the Retirement Remix, author Chip Munn discusses how to legally pay lower taxes and save for retirement through a variety of financial products.

The idea of “retirement” is a creation of the modern industrialized society, and therefore so is the concept of saving or planning for retirement.

By all accounts, the concept of the pension probably started with armies whose leaders—kings or princes—felt the need to recognize and care for those who had served and were wounded and unable to work. During the first century BCE, the Roman Empire introduced the concept of an income that continued after work service by offering pensions to retiring soldiers.

Chip Munn

Chip Munn

In the United States, Congress passed legislation in 1862 to provide annuities to Union soldiers who were disabled in the Civil War.

In 1875, American Express, then a railroad freight company, introduced a pensions plan for its employees. The government-sponsored pension first appeared in 1889, in Germany, with The Old Age and Disability Insurance Bill. Financed by a tax on workers, the fund provided a pension annuity for workers who reached the age of seventy years. In 1916, the age was lowered to sixty-five years.

In 1920, the US federal government established a plan for its employees.

For the next several decades, the pension was the dominant form of retirement account.

Defined Benefit Vs. Defined Contribution Plans

By definition, a pension is a defined benefit plan. This means that your employer (company or government agency) has agreed to pay you a defined amount every week or month for the duration of the pension. The amount you receive is calculated on your length of employment, salary history, and the size of the company for which you work. The formula for calculating retirement benefits is known ahead of time, and the company uses it to define and set the benefit paid out to you.

The amount may be fixed or may have a link to the rate of inflation.

Because the company or agency commits to a set amount it must pay you, they shoulder all the risk. Pension funds—the pools of money from which pensioners are paid—can be very large. As of this writing, the world’s largest pension fund is the Federal Old-Age and Survivors Insurance Trust Fund and Federal Disability Insurance Trust Fund (collectively known as the Social Security Trust Fund or Trust Funds). They are the trust funds that provide for payment of Social Security (Old-Age, Survivors, and Disability Insurance; OASDI) benefits administered by the United States Social Security Administration. Funded by taxes, the fund is valued at $2.79 trillion. This pension fund is required by law to be invested in non-marketable securities issued and guaranteed by the “full faith and credit” of the federal government. These securities earn a market rate of interest.

Generally, pension fund managers don’t just keep all the cash in a savings account. They invest it, just like you would invest your money. The largest public employee pension fund in the United States, is the California Public Employees’ Retirement System (CalPERS), an agency in the California executive branch that manages pension and health benefits for more than 1.6 million California public employees, retirees, and their families. With a 2019 valuation of $385 billion in assets, CalPERS derives its income from investments, member contributions, and employer contributions. During the Great Recession, the fund suffered significant investment income losses—a $12 billion dollar investment income loss in 2008 and a $55 billion loss the following year. But since it’s a pension, its obligations don’t change, and in 2019, CalPERS had a reported gap of more than $138.9 billion between its estimated obligations to retirees and the current value of its assets.

As far as taxes are concerned, it should first be noted that while the US Internal Revenue Service (IRS) wants to tax your income, it won’t tax it twice. That is to say, if you receive (X) dollars in income and pay the income tax on it, that same money cannot be taxed again. But if the income hasn’t been taxed, eventually it will be. The IRS warns, “If you receive retirement benefits in the form of pension or annuity payments from a qualified employer retirement plan, all or some portion of the amounts you receive may be taxable.” If you did not contribute funds to the pension, or if your employer did not withhold contributions from your salary, then your pension income is fully taxable at ordinary income rates. Your pension is also fully taxable if you received all of your contributions tax-free in prior years. Most pensions are funded with pre-tax dollars, which means that those dollars are subject to tax when they’re sent to you.

The Federal Government and Retirement Accounts

In a purely libertarian world, the US government would show no interest in how, when, or why you choose to save your money for retirement. You’d be strictly on your own to either save or starve.

But the federal government does take an interest in whether you build up a nest egg for retirement or squander all your cash before the age of seventy and have to go live on the streets or in your kid’s spare bedroom. This could be because the feds know that if you become indigent at an advanced age, you’ll become the government’s headache, and your care and feeding will fall to local welfare agencies. They don’t want this, and so Washington has taken steps to encourage you to save.

How can the government do this? They aren’t going to give you money. That only happens in Alaska, Saudi Arabia, and a few other places. Generally, most Americans think the government handing out money to citizens smacks of either socialism or a welfare state, neither of which sits well with most voters.

In our capitalist system, the government can help you by taking less of your income in the form of taxes. If you’re a tax cheat or you’ve never filed income taxes, and therefore don’t pay income tax, then you should put down this book and go hire a good tax attorney, because you’re going to need one. For everyone else, the idea that you can legally pay lower taxes is always attractive.

Generally, the federal government collects its income tax on money that you earn when you receive it. It wants its money soon after you’ve taken possession of it, which is why most people who work for a paycheck, have the appropriate amount of income tax withheld each payday. If you’re self-employed or have income from investments, you can wait for a few months, but while you wait, the government will be adding interest and late fees to what you owe. Not paying your taxes promptly is an expensive choice.

Because the government taxes your income when you receive it, it can reduce the amount you pay by doing one of three things. It can:

  1. Allow you to defer payment until a later date.
  2. Make some or part of your income tax exempt.
  3. Reduce the tax rate and therefore the tax payments you owe.

Traditional IRA

In 1974, the federal Employee Retirement Income Security Act (ERISA) introduced the individual retirement arrangement (IRA). According to the law, each year, taxpayers could contribute up to fifteen percent of their annual income or $1,500, whichever was less, and deduct the amount from their taxable income. The contributions could be invested in a special United States bond paying six percent interest, annuities that begin paying upon reaching age fifty-nine, or a trust maintained by a bank or an insurance company.

Over the years, various changes have been made to this law. There is no specified employer contribution, and initially, ERISA specified IRAs were only for those workers not already covered by a qualified, employment-based retirement plan. Then in 1981, the Economic Recovery Tax Act (ERTA) broadened this to allow all working taxpayers under the age of seventy to contribute to an IRA. It also raised the maximum annual contribution to $2,000.

As for the tax advantage, traditional IRA accounts are tax-deferred. This means that upon retirement, the withdrawals you make are taxed at your current income tax rate. Capital gains or taxes on dividends are not assessed.

401(k) Plans

In 1978, Congress passed The Revenue Act of 1978, in which Section 401(k) allowed for a qualified employer-sponsored retirement plan under which employees could contribute their own money to an account to supplement any other retirement benefits they have.

In contrast to a traditional IRA, which anyone under the age of 70½ can create, the opportunity to contribute to a 401(k) is generally limited to people employed by companies that offer such plans.

The incentive to save is a tax deferment provided by the federal government. This means you and your employer can contribute pre-tax dollars to your 401(k) retirement account and not pay tax on those dollars until you withdraw them many years later. This also applies to investment income you receive inside the 401(k) account.

For example, if you have a salary of $80,000 and during the year, you contribute $10,000 into a 401(k) account, then only $70,000 of your salary is taxable income that same year. Your employer will report that $70,000 on your W-2. As far as the IRS is concerned, it will be as if your income was $70,000 rather than $80,000.

401(k) plans were designed for private sector employees. Over time, the feds approved three more types of plans to serve other types of employees: 403(b) plans for non-profit and public education employees, 457 plans for state and municipal employees, and the Thrift Savings Plan for federal employees.

In the 21st century, employers have been terminating defined benefit plans—which they can do through a legal process called “plan termination”—and moving toward defined contribution plans. This is because a 401(k) is much less risky for them and insulates the company from steep drops in the stock market or other areas of investment.

There are limits to how much you and your employer can contribute to your 401(k). They are defined by three factors:

1. Salary deferral contributions are the funds you elect to invest out of your paycheck. In 2019, the largest amount you can contribute per year to your 401(k) or similar workplace retirement plan is $19,000.

2. Catch-up contributions are additional money you may pay into the plan if you are age fifty or older by the end of the calendar year. Catch-up contribution limits are $6,000 per-year for workplace plans and $1,000 for IRAs.

3. Employer contributions consist of funds your company contributes to the plan. They are also known as a company match or matching contribution.

In 2019, the total allowable contribution amount by employee and employer from the above three sources was:

$56,000 total annual 401(k) contribution limit if you are age 49 or younger.

$62,000 total annual 401(k) contribution limit if you are age 50 or older.

After the age of 59 and-a-half, you can withdraw money from your 401(k), which will be taxed as ordinary income. But it’s likely that you’ll be in a lower tax bracket, so you’ll pay less.

A 401(k) plan is self-directed, meaning that once you retire and/or reach age 59 and-a-half, your former employer has no further connection to your retirement fund. They no longer fund your account and have no further obligation to pay you. If you retire at age sixty-five, and a month later the market crashes wiping out your 401(k) investments, unlike a pension plan, your former employer is not affected and has no obligation to you.

This is how the federal government incentivizes you to save for retirement.

Roth IRAs

Named for its chief legislative sponsor, Senator William Roth of Delaware, the Roth IRA was established by the federal Taxpayer Relief Act of 1997 (Public Law 105-34).

Unlike traditional IRAs and 401(k) plans, contributions to a Roth IRA are made after you’ve paid taxes on that income. You get the benefit at the other end: Under certain conditions (for example, if the withdrawal is only on the principal portion of the account, or if the owner is at least 59 and-a-half years old), then withdrawals are tax-free.

Like any other retirement account, you can hold various investment assets within your Roth IRA including stocks, bonds, ETFs, bank accounts, CDs, mutual funds, mixed asset funds, and cash alternatives. Transactions inside a Roth IRA, including capital gains, dividends, and interest, do not incur a current tax liability. Earnings, such as stock dividends, may be withdrawn tax and penalty-free after five years, if you’re at age 59 and-a-half or older, and have met certain other qualifications. Distributions from a Roth IRA do not increase the adjusted gross income on your federal income tax.

For example, let’s say you feel good about a fledgling Silicon Valley tech stock, and for $10,000, you buy shares within your Roth IRA. You’ve already paid the income tax on the $10,000. Over five years, the stock doubles in price. You sell it for $20,000, or a capital gain of $10,000. Ordinarily, in your Roth IRA, you won’t be taxed on that extra $10,000. It will be tax free!

Because of the tax implications, there are many pros and cons to 401(k) plans as opposed to Roth IRAs. Not to be morbid, but one thing to consider is that you might not live to retirement or much beyond, in which case the tax structure of a Roth won’t benefit you and will only reduce the amount of assets in your estate that may not be subject to tax. To fully realize the tax benefit, you need to live until you’ve withdrawn and exhausted your Roth IRA contributions. By contrast, with a traditional IRA, if you die before retirement with an estate below the tax threshold, or retire with income below the tax threshold, then the income tax might never be collected at all.

The above article originally appeared as a chapter in The Retirement Remix and is reprinted with permission from the author Chip Munn. No parts of this article may be reproduced without correct attribution to the author of this book.

You can find the full book here.