Today, we will analyze how your pension plan interacts with the other retirement savings you have and how to create a strong plan to maximize your cash flow in your golden years.
Why your pension might not be enough
Pension plans, or defined benefit plans, have been an important method of saving for retirement for a long time. These plans stipulate that employers contribute money on their employee’s behalf (depending on age, salary, and tenure with the company) into an investment account and the employee has access to the funds (annuity or lump sum) when they retire.
Sounds like a straightforward system right?
Well, as we have discovered throughout this series, a pension plan is anything but straightforward. It is important that you have a clear idea of exactly how much money you will get from your pension in order to determine if it will be enough to cover all of your expenses in retirement.
But with inflation (which pensions don’t often take into account), lifestyle expectations, and other retirement goals, it is important to ensure you understand all of your savings avenues and streams of income for your retirement planning.
Even if you are comfortable with the balance of your pension, it is still important to fund other retirement savings vehicles like a 401(k) or IRA. How do these accounts differ from your pension and complement your retirement savings strategy? Let’s take a look.
The difference between your pension and a 401(k)
Your pension plan is a defined benefit plan, meaning your employer contributes money to provide you with a definite benefit at certain retirement dates. But with the rise of pension expenses, many employers have moved to offer defined-contribution plans or 401(k) plans for their employees.
With a 401(k), you contribute a percentage of each paycheck into an investment account managed by your employer. You determine your own asset allocation and general risk level but don’t have as much flexibility in investment options as you aren’t in control of the plan, your employer is. One of the most lucrative features of a 401(k) is a match program. Let’s take a closer look at how that works.
Some companies offer a match program where they match a certain percentage of your contributions. While not even close to the same contribution level as a pension, a match program significantly bolsters your retirement balance if you participate.
Most match programs are set at 6% of the employee’s salary, which means that in order to qualify for the match, you would need to contribute at least 6% of each paycheck to your plan. Some employees have a 100% dollar for dollar match, but many employers cap it at around 50%.
Let’s use an example of a person whose salary is $80,000 per year. If they contribute 6% of their salary, in one year they will have $4,800 in their account. Now, if the employer has a 100% match, that would bring the account balance to $9,600, but with a 50% match that would be $7,200.
As you can see, taking advantage of a match program is an incredible way to boost your retirement savings. Another great reason to take advantage of your employer match is that money isn’t counted toward your annual contribution limit. In 2020, the contribution limit is $19,500 and an additional $6,000 per year if you are over 65 for catch-up contributions. But your employer match isn’t counted toward that limit, meaning you could potentially be saving double each year.
You contributed pre-tax money into your 401(k) which means that your distributions in retirement will be taxed at your ordinary-income rate. These tax requirements are similar to that of your pension plan, making it important to implement a strong tax planning strategy alongside your income channels in retirement.
Investing in an IRA
An Individual Retirement Account (IRA) is another excellent vehicle for saving and generating income in retirement.
An IRA can offer more flexibility and customization in terms of investing. With an IRA, you have more control over the type of investments you make because nearly everything is available to you. A 401(k) is limited by your employer’s 401(k) custodian and the options they offer within your plan.
An IRA also gives you the opportunity to better control the fees you pay as you are able to choose the custodian you want to work with. While there are many variations of IRAs, the two we are going to discuss today are Traditional and Roth. The main difference between the two is how the accounts are taxed in retirement.
A Traditional IRA operates in a similar way to your 401(k), as contributions are pre-tax and distributions are taxed at ordinary income rates. Both a traditional and a Roth have the same contribution limits, $6,000 or $7,000 if you are over 50 in 2020. But a Roth IRA also has income limits for contributions, something a Traditional IRA doesn’t have.
The Roth income limits are $139,000 if filing single and $206,000 if filing jointly and married in 2020. Roth IRAs are also different because you contribute to them with after-tax dollars. This means that while you pay taxes upfront, you won’t pay taxes upon distribution in retirement.
This tax benefit differs from any other retirement plan, including your pension making it an important account to consider investing in.
Analyze additional income streams
Diversifying your income channels in retirement is a great way for you to ensure that all of your expenses will be covered. Take some time to evaluate the type of income you can expect in retirement such as
- 401(k), Traditional or Roth
- IRA, Traditional or Roth
- Social Security
- Encore career or part-time work
- Brokerage accounts
- Cash reserve
- Real estate
All of your savings vehicles will come together to help you generate your income in retirement. Knowing what those vehicles are and how they work together can help you create a comprehensive plan that takes into account your income, taxes, financial habits, and needs in retirement.
Our team thrives on helping clients use their money in a way that supports their goals, values, and lifestyle. We would love to talk with you about how to make a plan for your income needs in retirement.