We are facing a precarious economic environment, with the inflation rate running hot at an annual rate of 9.1%, and the U.S. economy is officially in a recession with two negative GPD readings back-to-back. These onerous situations make it more important for you to choose the right retirement plan.
With the traditional pension plan becoming less popular for various reasons, employees are looking for a way to transfer their nest eggs to other retirement savings accounts, such as 401(k) plan and individual retirement account, or IRA. Before diving into the transfer steps, you must understand the types of pension accounts and their benefits. Then use the information to determine the pros and cons of rolling over a pension plan into other retirement accounts – for those who don’t have money tugged away for retirement yet, check out this comprehensive guide on saving money. At the end of the article, you should be able to decide whether changing your pension scheme is beneficial for your personal circumstances, and know how to execute the process if you choose to do so.
What is a pension plan?
A pension account provides benefits to employees and help them achieve financial stability at retirement age. There are two types of pension schemes: defined-benefit and defined-contribution plans.
Defined-benefit plan (traditional pension account)
A defined-benefit pension account is also known as the traditional pension. This pension scheme automatically enrolls you in the plan after one year of employment. Employers are the pension sponsor responsible for making contributions – the money sent to the savings account. It is at the employer’s discretion to determine how to invest the contributions, and the employees have no influenceon the decisions. Also, when you reach the predeterminedretirement age, typically at the age of 55, you are eligible to collect the pension payment order, but leaving the company before retirement might lead to losing some or all of the benefits. The distributions – the pension paid to you – can be disbursed in an annuity or lump sum. Annuity means the pension administrator authorizes a monthly pension payment order sent to you till the end of your life. Whereas lump sum allows you to receive the whole available pension account amount in one payment. The process of cashing in the pension account happens regardless of the underlying investment pool’s performance. The pensioner’s benefits are calculated based on the average salary of the working period and the longevityof the employment with the company.
Because the employer has complete control over the defined-benefit plan, they also assume the liability that comes with it. Sponsoring employers of the pension accounts can either oversee the retirement fund themselves or hire third-party professionals to manage the savings pool. Running their own investment ventures requires employers to pick investment options carefully. This is because relatively safe investments – such as index funds and ETFs – can yield handsome returns to the pension account, whereas risky assets – like private equity and derivatives – can cause the pension scheme to run dry. While partnering with professionals to operate the fund helps navigate the difficulties embedded in different investment vehicles, employers have to pay fees to and share profits with the third party, making the whole partnership costly with no guaranteed returns. Additionally, suppose the pension account is insufficient to pay out distributions due to poor investment choices. The pension account sponsor is responsible for covering the pension payment order deficit, further emphasizing the significance of investing the fund prudently. However, in case of the pension disbursing authority goes bankrupt or becomes insolvent, the pensioner’s account can still receive payments as the amount iscoveredbythe Protected by Pension Protection Fund (PPF).
As opposed to the defined-benefit, the defined-contribution plan requires employees to make the contributions themselves. The pension payment scheme collects pretax money that comes off the top of the paychecks, providing a deferred tax benefit. For example, if your annual gross income is $30,000 and you contribute $5,000 that year into a defined contribution account, then only $25,000 ($30,000 – $5,000) is subject to taxes. In addition, because employees are responsible for sending money to the pension account, they also get to elect the investment options, catering to their investment preferences.
However, the value of the retirement savings account depends on the investment performance. Although pensioners reap the benefits of outsized gains in a bull market, they face the depreciating value of the pension amount during market downturns – here is a valuable article that helps you grasp some of the important concepts of the stock market. Additionally, there are no guaranteed monthly distributions like the annuity offered by the traditional pension plan. And the employers are no longer liable for the pension payment order deficit as employees are the ones choosing the investment options.
The most common types of the defined-contribution plan are 401(k) and 401(b). 401(k) is a common savings account that requires less time and resources to manage compared to the traditional pension. As a result, just 26% of workers have access to a traditional pension plan, while the figure is 60% for the defined-contribution pension payment plan. Meanwhile, the 401(b) is only available for non-profit and government positions; therefore, the content will focus solely on the 401(k) when discussing the defined-contribution plan from this time forward.
After introducing all the benefits and basic properties of the pension accounts, it’s now time to delve into the details of rolling over your pension to more prevalent retirement savings accounts – 401(k) and IRA.
Transferring from a pension account to an IRA
Before moving your pension account to an IRA account, you need to know all the advantages and disadvantages of the IRA.
- Receiving the payment of pension
When an employee decides to leave a job or reach retirement age, they can ask the pension administrator to cash in the pension amount in a lump sum. There are two approaches to collecting this pension payment order. You can request that the pension account be transferred directly to the IRA account. Or in the form of a check, and you deposit the amount yourself. However, the latter route can be subject to taxes and penalties if not performed properly (more on this later).
- Tax implications based on different types of IRA accounts
There are various types of IRA, with the most popular ones being Roth IRA and Traditional IRA. Based on the IRAs, the tax implications when transferring a pension account can vary. For example, traditional pensions typically receive contributions from before-tax money, while the Roth IRA takes after-tax dollars. As a result, rolling over the pension amount can trigger a hefty tax bill. Suppose you want to transfer a $50,000 pension account into a Roth IRA. Since the money has not been taxed, you must pay taxes upon withdrawingthe balance. So the whole $50,00 won’t be deposited into your new retirement savings account. Nevertheless, the earnings in the Roth IRA can grow tax-free, making qualified withdrawals a reliable financial tool for retirees who don’t want to worry too much about taxes. On the other hand, if you prefer receiving a tax break now and paying your obligations later, Traditional IRA is an appropriate choice. Like the traditional pension scheme, this type of IRA directs pretax dollars to investments, and the resultingearnings can grow tax-deferred – that is, you can delay taxes until you receive the pension payment.
- Age restrictions with the IRA accounts
Another thing to keep in mind is that the age restriction for cashing in the savings is also different in IRA accounts. Pensions disburse the retirement money when employees are 55 years old and up. Whereas withdraws from IRA are only available when you are at least 59 1/2. Pulling out money before that will be subject to a 10% penalty. However, the case also differs depending on the type of IRA. For Roth IRA, the 10% fee only applies to the earnings growth from the investments, not the initial principals. Even though you need to work, minimally, 5 to 7 years at a company before being able to vest any amount in the pension account, you own and are permitted to take out the contributions at any time, as you already paid taxes on the money. On the other hand, the traditional IRA case is a bit more burdensome. You are liable for both taxes and penalty when performing early withdrawals – with some exceptions, such as money for qualified higher education expenses, home purchase, birth or adoption of a child, medical expenses and health insurance premiums, substantially equal payments, qualified reservist distributions, and death or total and permanent disability.
- Investment options offered by IRA accounts
Finally, you elect your own investment options in IRA. As mentioned above, sponsoring employers use the pension fund to invest in an array of businesses and ventures, but pensioners typically don’t influence the investment decisions. However, with the IRA, you havethe authority to make your own investments, culling from the available financial assets. All in all, IRA accounts have investment vehicles catered to risk-averse investors – like savings accounts and CDs, treasury bills and U.S savings bonds, and money market funds – and aggressive investors – such as mutual funds, ETFs, stocks, and bonds.
Transferring from a pension account to a 401(k)
- Employer matching policy
401(k) is among the best employer-sponsored retirement plans in America. One of the most enticingaspects of 401(k) is something called matching offered by employers. For instance, assume your employer offers to match 100% of your contributions, up to 3% of your annual salary. That is, if your income is $70,000 a year, and you contribute 3% of $70,000, which is $2,100, to your 401(K), the employer will also deposit another $2,100 to the account. In another example, the employer agrees to match 50% of your contributions, equal to 6% of your salary, which is a more common policy. If you earn the same $70,000 and contribute $4,200 (6%*$70,000) to the retirement account, the matching benefit provided by the employer is capped at $2,100 (50%*$4,200). However, no matter the matching percentage, you should always take advantage of the matching policy, as this is essentially free money offered by your employer.
- Pension payment is more predictable, but 401(k) yields higher returns.
Pension plans allow for a monthly income regardless of the investment pool’s performance, whereas the value of your 401(k) relies on earnings growth. Here is what Tim Quillin – a chartered financial analyst and partner with Aptus Financial – has to say, “A good old-fashioned pension gives you a source of stable and predictable income in retirement, so you don’t have to worry about depleting assets in defined-contribution plans like 401(k)s.” He also advises, “Pensions take some of the guesswork out of retirement planning.”
However, even though the prospects of receiving monthly payments at the retirement age might sound intriguing, according to Forbes, “the median benefit of private pensions and annuities was just $9,827 per year in 2018.” If you think that amount is underwhelming, then you are not alone. The low benefits offered by annuity are why employees utilize 401(k) more. The maximum contributions allowed for a 401(k) plan is $20,500 per year, or $27,000 if you’re 50 years of age and up. Most importantly, employers let your start saving right away. According to Vanguard, “in 2019, 70% of employers allowed employees to open a 401(k) as soon as their first day of employment. And 96% of plans offered matching contributions, helping to boost your retirement savings.” To see how this is important, you need to understand the power of compound earnings.
For example, suppose you invest at the age of 30, and you manage to contribute the maximum amount of $20,500 to your 401(k). With a conservative return of 6% in the stock market, after 35 years, you will accumulate $2.3 million in retirement savings. You can mess with the numbers yourself by using this link, but all the figures should already be entered. However, if you start saving later, let’s say at the age of 40 with the same interest rate of 6% and the same monthly contribution of $20,500, It will take you till the age of 75 to accumulate the same amount of $2.3 million. But here is where it becomes mind-blowing. With the same interest rate and monthly contribution, and thanks to the exponential growth of compound earnings, if you invested at the age of 30, you would have a whopping $4.3 million in the account when you reach 75 years old even though it’s only ten years apart between 65 to 75. Hence, the sooner you invest, the better.
Steps to transfer your pension to IRA or 401(K)
Finally, theprocess to roll over the pensions to other retirement accounts is as follows:
First, you need to open a 401(k) account with your employer, or an IRA account with a brokerage or other financial institutes. Then ask your pension administrator to directly transfer the balance to the 401(k) or IRA account, or issue a check that must be deposited within 60 days. If the rollover is not completed within 60 days, the IRS might consider this an early withdrawal and issue a 10% penalty if you’re under 55. Also, the employer will withhold 20% of the amount if you choose to receive it in a check. By and large, to avoid this inconvenient occurrence, you need to check that everything goes smoothly in the rollover process that goes directly to the 401(k) or IRA account, and do not transfer through issuing a check. Finally, ensure that all the transferred amount is invested per your selections in the IRA or 401(k).
In conclusion, transferring a pension is very possible, but the devil is in the detail. There are many factors that are likely to impact how easy, and how beneficial, it will be for you to transfer existing pensions into a new pension account.