Pensions (Part Two)

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The last post describe the two basic sorts of pension plans, defined benefit (DB) and defined contribution (DC).  This second part digs down a bit into the DC area and the many different structures available there.  We start with the most widely used –– the 401(k) plan.

401(k) Plans

 Named for the 1980s law that established them, these plans take, for the purposes of investment, contributions from both employer and employee.  The law determines how  much can be put aside in this way.  Within limits, these plans also allow employees to add to them.  Some employers, in addition to their basic contribution, will match a portion of the additional savings that an employee elects to add.

One big appeal of these plans is their significant tax advantages.  The monies going into the plan on behalf of each employee do not count as taxable income.  What is more, the invested funds collect dividends, earn interest, and enjoy capital gains also free of tax.  When participants draw on the funds they will have to pay income tax on the withdrawals, but if they are already retired, the chances are they’ll have a lower tax rate then than when they were working.  These plans have a further tax advantage.  Normally, when a person sells a long-term holding, it has gained in price, creating a capital gains tax liability on the amount of that gain.  (For more on this subject, see this post.) But the monies in 401(k) plans are excused this tax when their contributors begin to liquidate their investments.

When employers set up such plans, they almost always do so with established investment firms where plan participants can choose from an array of investment products.  It is up to each participant to direct the investment of the funds, though many employers offer assistance in making these choices, as does this site. All plans give participants periodic opportunities to change their investment choices.

For all their advantages, 401(k) plans face a number of constraints. Participants must begin to draw down on the funds and pay taxes on those withdrawals no later than age 70½. Because they are meant for retirement, they impose a 10 percent tax penalty if the participant draws on the funds before age 59½.  There are, however, hardship exceptions to this rule.  The government will waive the 10 percent penalty if:

  • You have suffered a disability that makes it impossible for you to work;
  • You have significant medical expenses;
  • You face a court order to give the money to an ex-spouse or a dependent;
  • You take early retirement, but only after age 55;
  • You die and your beneficiaries collect the money.

Some plans will let you borrow against the value of what you have invested, but there are restrictions.  You can get help with specific questions from the 401(k) Help Center at

Individual Retirement Accounts (IRAs)

 If you are not in an employer-based retirement plan, you have the option of setting up a tax-advantaged individual retirement account for yourself.  (Actually, the law makes allowances for IRA contributions — though on a sliding scale –– even if you or your spouse participates in another pension plan.)  If you are married, you and your spouse can contribute to the same pool of investable money.  The law sets the maximum amount you and your spouse can put into the account.  These have the same benefits and restrictions as a 401(k) plan:

  • Every dollar put into the IRA reduces your taxable income.
  • You pay the taxes only when you begin to draw down on the funds in retirement, when, presumably, you will face a lower tax rate.
  • You pay no capital gains tax on your investments when you sell them.
  • You will pay a 10 percent tax penalty if you withdraw funds before age 59½ except under hardship conditions, as described earlier.
  • You must begin to draw down on the funds and pay taxes after age 70½.

Check with your accountant before setting up an IRA to find out exactly what restrictions apply to your particular circumstances.  The Internal Revenue Service offers help on its website,

You can open an IRA with any bank, broker, mutual fund company and many insurance firms.  The paperwork is simple and you have until April 15 (let’s say of 2020) to make the contribution for the previous year (that is, for 2019) –– although the IRA itself must be set up by Dec. 31 (of 2019).  Your investment choices are as wide as those offered to anyone doing business with the financial firm you choose.  If you were in a 401(k) plan at work and you lose your job or change employers, you can convert those 401(k) investments into an IRA, called an IRA rollover.  You set these up in the same way as a new IRA.

There is an alternative to these conventional IRA arrangements.  In 1997, Senator William Roth sponsored legislation establishing the Roth IRA.  Unlike a conventional IRA, a Roth offers no tax deduction for the funds you contribute.  To compensate, the Roth excuses tax on any monies you withdraw, including all investment income, interest, dividends, and capital gains.  As with a conventional IRA, there are limits on the amount you can set aside, but there is no 10 percent penalty if you withdraw funds early nor do you have to withdraw money after age 70½.  On the contrary, the law allows you to contribute to a Roth IRA forever and leave it there for your beneficiaries.

You can convert your conventional IRA to a Roth.  The firm handling your IRA can provide you with the necessary materials.  When you convert, you must pay tax on all the tax-deductible contributions you had previously made to the conventional IRA.  The same applies to IRA rollovers.  This tax liability can grow to significant size, especially if you have contributed to your conventional IRA for a long time.  See your accountant for how heavy this tax burden might be.

Simplified Employees Pension (SEP) Plans, Simple IRAs, and Keogh Plans

 There are three other options for tax-advantaged pension plans.  All are similar to 401(k)s and IRAs, but they are meant for the self-employed, for small firms, and for partnerships that otherwise might be unable to use a 401(k).  They are also much simpler to administer.

SEP arrangements are available to any self-employed person with a business that employs 25 people or less.  Unlike other plans, you can set up a SEP without setting up a corporation or LLC or any other corporate structure. If you qualify, you can contribute up to one-quarter of your salary, up to a stipulated amount, though the IRS might change these requirements from time to time.  These plans are similar to 401(k)s but have much lighter administration and reporting requirements.

The Simple IRA aims at firms with 100 employees or less.  Participants must earn a certain minimum salary, a figure that the IRS changes occasionally.  They can set aside a certain portion of their pay, which the IRS also reassesses these amounts from time to time.  This money is excused from taxable income.  Employers have two choices when setting up a simple IRA: (1) They can match the contributions made by participating employees up to 3 percent of their compensation, or (2) they can contribute for each employee, whether they agree to participate or not, up 2 percent of their compensation.  Otherwise, the rules are much like conventional 401(k) arrangements, except the penalty for early withdrawal is more onerous and presently stands at 25 percent.

Keogh arrangements aim at the self-employed and their business partners, whether part time or full time.  Even if you have a 401(k) for a salaried position elsewhere, you can establish a Keogh for that portion of your income that comes from self-employment.  A Keogh allows you to put aside up to a quarter of your income each year, up to a maximum that the IRS adjusts from time to time.  Generally, a Keogh allows larger contributions than either a conventional 401(k), an IRA, a simple IRA, or a SEP.  Otherwise, the rules are much like those of a conventional 401(k).

Financial institutions that work with conventional 401(k)s can make arrangements for any of these other plans.  The employer and the participants benefit if the employer sponsoring the Keogh pays the fees involved separately from the plan.  That way the plan avoids the burden and the cost counts as a tax-deductible business expense to the employer.

The 529 Funds for Education

 Though not strictly a pension, the 529 shares similar characteristics with other plans discussed here.  Named for the section of the tax code that covers the matter, the 529 allows for a tax-advantaged saving/investment plan for educational expenses.

529s are governed by each state, so rules and benefits may vary quite a bit. In general, you can set up a 529 with any financial firm, probably a mutual fund.  It will have custody of the funds and administer them together with the investments when the money is put to work.  Unlike most retirement schemes, the money put into 529s is not tax deductible when it comes to federal taxes, because the IRS treats the proceeds from a 529 as a gift.  Some states, however, allow a deduction of contributions on their (state) income taxes. However, investment earnings and capital gains are excused from all federal and state taxes.

To secure these advantages, the funds must be used for what the IRS calls “qualified” educational expenses.  These include tuition, room and board, books, fees, supplies, computer software and hardware.  Though established under state auspices, few states, if any, have strictures against using the funds for out-of-state schools.  Nor do they make distinctions between public and private institutions.  You should compare all plans available to you because their differences may suit one person more than another.  Make sure that the school chosen qualifies as a recipient of these funds.

If you start a 529 for your child at birth, invest mostly, or entirely, in stocks. The 18 or so years until the child will draw on the money is ample time for the assets to recover from the inevitable, though temporary, setbacks that stocks suffer.  As your child approaches within five years of college age, your investment focus should change.  Because short time spans constrain the period for stock values to recover from a setback, shift the fund’s investments to bonds and more stable stocks.  (See this post for more detail.)


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