4Q2019 | 50-56 yrs
401(k) to Pensions
You are saving! Congratulations! But, assuming you are on track to save, are you saving in the right places? I find many people are not thinking about long-term tax and demographic trends. They think if they just max out their 401(k)’s then their future will be safe. If you think your 401(k) account is the only answer, it may make sense to reevaluate. There are a lot of different ways to accumulate wealth, which I will describe at a very high level.
Generally, I find that most people are retiring with a handful of account types. For 401(k)’s, we will assume the same basic characteristics applied to a 403(b), Simple, Sep, etc., also known as qualified plans. Pension plans and Social Security are managed by the institutions that hold them, while the rest are managed by the participant. Finally, you have a few tax-advantaged options in Roth and Taxable savings accounts that are still a minority of assets in savings accounts. An important primary difference between these account types is how they are taxed. This is also a critical point to understand when structuring a blend of account types for retirement savings. Identical investments based upon risk tolerance in all account types can help the participant have a better sense of control over his or her portfolio.
Let’s discuss how they work and how they are taxed.
A pension is a defined benefit plan funded by the employer. At a specified age, a pension participant may opt to take a lump sum, a 100% income benefit, or a partial income benefit with a spousal feature. In a 100% payment to the pension participant, the account will be with you for your life only, so the benefit ends with you. When one opts for a spousal option, the monthly pension payment will be smaller, but should the primary pension beneficiary pass away, the surviving spouse will have the continued payment for their life. Pensions are taxed at ordinary income in retirement.
Sometimes a pension participant may look at taking the lump sum. This is sometimes based upon what they think their potential life expectancy is and/or the stability of the sponsoring company. One always wants to look at the potential income stream we could get from moving the lump sum to an IRA vs. a “guaranteed” income stream provided by the sponsor.
A 401(k) is a defined contribution plan where the employee makes contributions and employers may make matching contributions. A 401(k) is always taken as a lump sum or income stream of distributions. Upon retirement, 401(k) participants can move the 401(k) to an IRA and begin taking income from the IRA. More and more, 401(k) plans are equipped to allow some form of income stream from monthly to annual distributions. 401(k) distributions are taxed as ordinary income.
Social Security is kind of like a pension. The individual gets a government guaranteed income stream from the Social Security Administration for their lifetime. If a spouse never worked, and therefore did not accumulate social security benefits, they will get half of their spouse’s Social Security benefit in addition to their spouse receiving their full retirement age while you are both alive. Social Security is taxed as ordinary income in retirement unless it is the only income source. In that case, it is possible to not meet the threshold for taxation. If there are additionally pensions and IRA distributions, it is likely taxes will be payed not only on the Social Security benefits, but also the distributions from the 401(k) and IRA.
An Individual IRA can be accumulated throughout life either through deposits or rolling pension and 401(k) plans into them. IRAs are taxed as ordinary income in retirement.Roth IRA. These can also be accumulated via 401K Roth contributions ($19,000 per year plus catch up with no restrictions) or (individual Roth $5,000 plus catch up with income restrictions). In these cases, the contributions and growth distributions are tax free and make a hedge against rising taxes. Roth IRA distributions are NOT taxed.
With Taxable “savings” Accounts there are no limits on how much one can put into a savings account. These are also somewhat of a hedge against rising taxes. Taxable savings accounts are taxed annually at long-term and short-term gain tax levels.
Many times, I see people have primarily contributed to 401(k) and IRA plans only. This creates a scenario in retirement where every withdrawal is taxable at ordinary income levels. In my experience, this is not an optimum scenario for most. In many cases, savers would be better served with their retirement savings scattered over as many of these types of accounts as possible. A target for all retirement assets might be 15-20% Roth, another 30-40% in Taxable savings accounts, and the rest in 401(k)/IRA type accounts. Years from now, this type of portfolio construction gives the individual the potential to manipulate their tax bracket to a large extent as well as a higher level of liquidity along the way. In retirement it’s not how big the account is, it’s how much you get to spend.
There are some basic demographics at work against us all. The U.S. debt is likely going higher, fewer people are working, and the government doesn’t generate income from a product or service. The government taxes the people who have the money in order to spend it. The government has no way to generate a profit to pay for the rising deficit or promised benefits like Social Security. Roth and Savings accounts will provide some protection against this trend.
So, congratulations on being a great saver, but don’t lose sight of the trends that may wreak havoc with your accounts long-term. If taxes have never been paid, that is a hand-in-hand relationship with the government. You two will figure out the taxes you owe a long way down the road.
For more information, please contact your QPA Financial Advisor.
Advisory services offered through Prime Capital Investment Advisors, LLC. (“PCIA”), a Registered Investment Adviser. PCIA: 6201 College Blvd., 7th Floor, Overland Park, KS 66211. PCIA doing business as Qualified Plan Advisors (“QPA”).
This commentary is provided for information purposes only and does not pertain to any security product or service and is not an offer or solicitation of an offer to buy or sell any product or service.