Employee Retirement Options, Part 1

The following article is courtesy of Marotta Asset Management.

Putting all of your retirement eggs in one basket is easy to carry, but risky. Most workers are putting all their retirement assets in the basket of their employer's retirement plan. They are depending on one employer and two dozen eggs (funds) to hatch and maintain their lifestyle, independence and dignity in their later years. Don't trip.

Just one generation ago employers provided their employees with defined benefit plans for retirement. The employee could plan on a benefit that the employer had contractually promised. The employer was responsible to insure that a defined amount would be payable to each employee when they retired. Such security today is obsolete.

The new model moves the outcome responsibility from the employer to the employee through what are called defined contribution plans. The employer is helping with the input (the contribution), but no longer guaranteeing the output (the benefit).

An employee's retirement income is now contingent on four variables: how much the employee puts in, how much the employer matches, the performance of the underlying funds and of course, time.

In a typical defined contribution plan the employer will match dollar for dollar the first 3% of your salary, and fifty cents per dollar on the next 2% of your salary. That means if you contribute 5% of your salary, your employer will give you an additional 4% of your salary in retirement contributions.

Getting the maximum amount possible of this free money should be your first priority in saving for retirement. Even if your 401k or 403b defined contribution choices are not stellar, you still get an automatic 80% return on your money the very day you contribute. Strangely, many employees neglect to pick up this free money. The 80% automatic return is an offer you should not refuse.

After saving enough to get the full match from your employer, don't necessarily continue to use your employer's plan as your only retirement basket. After getting the full match, we recommend funding your Roth IRA, your spouse's Roth IRA and your taxable account. Only after adequately funding these individual account choices should you consider putting more money into your employer's plan than is necessary to get the full match.

Retirement plans through work are laden with fees and expenses that are not on individual investment accounts. The difference in fees is often 1% or more. The longer you leave your money in a defined contribution plan, the more the excessive fees will erode its value. There are plans so laden with fees that they are not even worth the match. Where the fee differential is 2%, after 30 years the fees will have eaten up the entire 80% match.

In other words, if you had the same amount of money in a traditional IRA account earning 2% more because of lower fees after 30 years you would have 81% more money in your account. For this reason alone, make sure that you don't leave money in an employer's retirement plan any longer than you have to. After terminating employment with one employer you should always roll that money into an individual IRA Rollover account where you can invest with lower fees and better choices.

It is a mistake to move money from a pervious employer's plan into your current employer's plan. This mistake, however, can often be undone. Money that has its source from another employer is usually allowed to be rolled out of an employer's plan and into an IRA Rollover account. If you are in this situation you should see if you can rescue some of your investments from the higher fees and limited choices of your current employer's plan.

There's another important tax reason not to put all of your retirement assets in your employer's plan. If you take a deduction while you are in a low tax bracket and in retirement when you are taking withdrawals you are in a higher tax bracket then your contributions work against you. You would have done better to have put your extra non-match retirement savings into a Roth or taxable account. Your tax rates are likely to be higher during your retirement. Currently, top marginal tax rates are only 35%. Before the Bush tax cuts the top marginal rate was 39.6%. Before the Regan tax cuts the top marginal rate was 70%. Before the Kennedy tax cuts the top marginal rate was 90%. Tax rates are at historic lows.

When you take the money out of an employer's plan or a traditional IRA account you will have to pay taxes at whatever tax rate is currently in effect. And after age 70 ½ you will have to start taking required minimum distributions in order for the government to ensure that they will get their tax. Historically speaking, the odds are your withdrawals during your retirement will be charged at a higher income tax rate than the deduction you received when you put the money in.

If may be better for you to pay your current tax rate and get your money into a Roth IRA where it won't be taxed again or a taxable investment account where the growth is only taxed at capital gains rates.

If you are just starting out in your career you are probably in the lowest tax bracket you will ever be in. Therefore it is more important to carry your retirement savings in more than one basket. Fund your employer's plan with no more than is necessary to get the match and then fund your Roth IRA and build your taxable savings.

Comments

[Brandon Barkley]

Pretty good article, but there is one mistake. The tax rates really are not at historic lows. The analysis only covers tax cuts in the 1960s and early 1980s.

If you follow the analysis further, you will see that tax rates fell to 28% in 1988-1990 and were 31% in 1991-1992.

So basically, there were lower taxes during Papa Bush's administration than currently.

[Brandon Barkley]

Source: http://www.truthandpolitics.org/top-rates.php

[plonkee]

My company offers an even better 200% return in the form of a company match, and in 2008 its going to be on the first 2% rather than the first 1.5%. I think its a good job I've been enrolled since I started with them 5 years ago.

[Saving Freak]

I believe the correct terminology is, "historically speaking" income tax rates are very low. Yes they were at their lowest after Regan cut them in the 80's but before that they were very high and had been for some time.

[Kevin]

Good article, too bad the people that really need to read it probably won't. The 401(k) match is the best return on investment out there, but sadly too few people take advantage. Or they take advantage, but then withdraw the money (and pay tax and penalties) when they job hop.

[beastlike]

Shoot, so I should take the money I rolled over from my last employer to the new employer out and in a traditional IRA? What's the main purpose of this, just to have more options and possibly lower fees?

[Swim Upstream to Wealth]

I agree that after getting the full match that you should look to the Roth. Tax rates are going to be going up in the future. If you look at the projected government outlays in the coming years, the government will have to raise rates. We are experiencing a similar cycle to the 60s. In the 60s, we had low tax rates, low inflation, and a booming stock market. This led the government to spend, spend, spend. Eventually, spending got so bad with Johnson's guns and butter programs that taxes were raised in addition to massive borrowing. By the time the 70s rolled in, there was widespread inflation (beyond the rise in oil due to the embargo), the stock market moved sideways for several years, and higher tax rates. Look for a repeat.

[Kevin]

beastlike - generally an IRA will give you more investment options (& potentially lower fees), plus the distribution rules are a little more lenient than a 401(k) or similar plan. But if you like the investments your current employer has, there's probably no reason to get out now.

I'm surprised the author of the article didn't go into the Roth 401(k) option since it is available now.

[Sarah]

"They are depending on one employer and two dozen eggs (funds) to hatch and maintain their lifestyle, independence and dignity in their later years. Don't trip."

This doesn't make a whole lot of sense. Sure, it *sounds* scary, but really all you're relying on that "one employer" to do is not to outright embezzle your retirement funds.

"Retirement plans through work are laden with fees and expenses that are not on individual investment accounts. The difference in fees is often 1% or more."

This is an outright marketing-driven lie.

I pay no more expenses on my retirement funds than I would if I held them individually. Now, it is true that if your company only offers expensive managed funds, you might be better off getting at least some of your money into indexes outside the 401(k) plan, but selection has gotten much better in recent years. (And somehow I don't see Marotta pitching indexes as the alternative to tax-sheltered investments.)

"It is a mistake to move money from a pervious employer's plan into your current employer's plan."

Again, untrue. Most people who don't roll over their 401(k) investments end up spending it (I've read), which is the worst possible thing you could do with it, given the penalties. So most people should be rolling over their 401(k)s, unless they have a fixed plan which they can stick to of moving the funds to a more tax-advantageous investment.

"Your tax rates are likely to be higher during your retirement."

Er...most people earn less money during retirement than before. Therefore, their tax rates are likely to be *lower* during retirement. There's nothing wrong with some hedging against the possibility that overall tax rates will increase, mind you (depending on individual situations, a Roth can be better than a 401(k)), but as a flat statement, this is just misleading. It especially makes very little sense to say that your money would be better off in a taxable account--where you contribute after-tax dollars (unlike the 401(k)) *and* will be taxed on the gains (unlike a Roth)--unless your company only offers the most terrible choice of 401(k) options.

FMF, I'm disappointed in you. This article--or, should I say, pitch?--really isn't up to your usual standards.

[Lord]

Nice rebuttal.

This is a higher match than I ever received. Some even offered no match. When offered, it usually came with five year vesting so it didn't even amount to that much and in a turbulent industry five years is forever. If you really want that money set aside, you may be better off rejecting the match than planning on it only to lose it in a downturn and layoff.

Overall I prefer an IRA Rollover to a 401k rollover but there is one significant difference. You can draw on a 401k when retired at 55 without penalty while you have to wait until 59.5 on an IRA or go through the complicated 72t withdrawal process for early withdrawals.

[justin]

No, the match mentioned in the article is not the typical match, the typical match is 50% of the first 6%, so a 3% salary match.

[Teri]

Actually I have to disagree with Sarah.

The fees in employer plans our often rather transparent to the employees. As a CPA who accounts for plans it amazed me how much employer plans get eaten up by fees. There is a lot of red tape when it comes to 401k plans. Administrators, tax returns, accounting, etc. & that cost lots of money... A lot of this is coming to light in the media lately.

Also, 401k plans usually have pretty limited investment choices. You are much better off investing in an IRA most of the time. If you had the choice to roll your money into an IRA where you could invest ANYWHERE or to be limited to an expensive and limited new employer plan, I would take the IRA any day.

[Sarah]

Sure, if your employer offerings are bad (and they can be), go into IRAs after the match. But this is absolutely not the case for everyone, or even, I think, most people. Not to mention that most people don't need a huge range of options for their 401(k). They need index funds in the major categories. You can't tell me that this little blurb wasn't written up for the purpose of discouraging people from going into their employer 401(k)s and into something Marotta (or companies like it) can get a piece of.

(I have read all the materials for my company's 401(k) plan. No separate fees. Whatever the costs, my company must pick them up. I doubt my company is unique in this. And IRA custodians often charge fees, too--to the extent that there are expenses to be met, moving to an IRA doesn't get rid of them.)

[Livingalmostlarge]

Sure it's nice to get the match, but why aren't people maxing out an IRA and 401k? I'd rather invest in retirement funds than taxable accounts or else the gains are taxed annually.

Also I agree it's nice to roll the money into an IRA after leaving a company, but the truth is MANY/MOST people spend the money. So I don't like that option.