Pensions and Retirements




Joseph F. Baugher


Last Revised September 22,, 2021

Since I am now semi-retired, I have become interested in issues surrounding pensions and retirements.  Here is what I have uncovered.  Hope that you find it interesting.

A pension is defined as a regular payment made to a person after the fulfillment of certain conditions of service, usually upon retirement.  Pension plans can be state-sponsored, company or employer-sponsored, union-sponsored, occupational, or personal, and they vary widely in terms of contributions and provisions.  Although pensions are often closely associated with retirement, one does not necessarily have to be retired in order to receive a pension.

There are basically two different types of retirement pension plans—defined-contribution and defined-benefit.  They differ from each other primarily in how money is paid into the plans, as well as in how money is drawn out.

Defined-Contribution Pension Plans

A defined-contribution retirement plan is one in which a certain amount of money is set aside each year by an employee, by the employer, or by both for the benefit of the employee when he or she retires.  These contributions are paid into individual accounts that are maintained for each participant.  


The funds in the accounts don’t just sit there, but are invested in various financial vehicles such as stocks or bonds, and the returns are credited to the individuals’ accounts.  In defined-contribution plans, each employee generally has the ability to tailor their investment portfolio to his or her individual needs and financial situation, including the choice of how much to contribute, if anything at all.  The employee often has the option of choosing what types of investments they wish to get involved in—guaranteed interest securities if they are risk-adverse, or stocks if they are willing to tolerate a bit more risk.


The amount of money contributed to a defined-contribution plan is fixed, but the benefit is not--the payout to the retiree will depend on how well the plan investments are doing in the marketplace.  If the plan investments are doing well in the marketplace, the payment to the retiree will be high, but if the plan investments are doing poorly or are losing money, the payment will be lower.  This means that the plan payments to the retiree can fluctuate from month to month, depending on how well the plan investments are doing at the moment.  Since the payout will depend on how well the plan investments perform in the marketplace, there is no way to know ahead of time how much money the plan will ultimately provide to the employee upon retiring.  Defined-contribution plans have become increasingly popular with corporation managements in recent years because they shift the risk associated with investment performance from the company to the employees. 


The 401(k) retirement plan used by many companies and corporations is an example of a defined contribution pension plan.  A certain percentage of an employee’s salary (with often a contribution from the employer as well) is added to their account every month, and this money is invested in various financial vehicles.  When the employee becomes eligible, he or she can begin to take money out of the account.


The TIAA/CREF (which stands for Teachers Insurance and Annuity Association/ College Retirement Equities Fund) pension system that is used to provide retirements for employees in educational, research, cultural, and nonprofit organizations is another example of a defined-contribution retirement plan.  The TIAA part pays the participants a fixed interest rate, but the CREF part invests money in various financial vehicles such as common stock.  Consequently, the payout to a CREF annuitant can vary from year to year, depending on how well the plan investments are doing in the marketplace.  If CREF’s investments do well, the monthly pension check to retirees is high, but if the investments tank, then the amount of the pension check can be sharply reduced.   


Many of these retirement plans are what is known as qualified retirement plans, which is a Internal Revenue Service (IRS) term that it applies to those retirement plans when they are eligible for certain favorable tax treatment.  In qualified retirement plans, a participant contributes a certain fraction of their income to the plan before they have paid any federal income taxes on that money.  In addition, the money grows in value in the plan tax-free, and taxes are only paid when money is withdrawn.  Such plans are also known as tax-deferred, since taxes are paid only when the plan owner takes possession of the assets, usually upon retirement.  The most common types of tax-deferred investments include those in 401(k) plans, in individual retirement accounts (IRAs) and in deferred annuities.   


By deferring taxes on the returns of an investment, the investor benefits in two ways. The first benefit of tax deferral is that contributions to the plan are usually made when a person is earning a higher income and is in a higher tax bracket where they are taxed at a higher rate. Withdrawals are generally made from an investment account after retirement, when a person is earning little or no income, and are taxed at a lower rate, which effectively means that the participant is paying a lower amount of tax on their income. The second benefit is tax-free growth: instead of immediately paying tax on the returns of an investment, income tax is paid only at a later date, when the money is actually withdrawn, leaving the investment to grow unhindered.


Defined-contribution plans are generally fairly portable—they can be moved to your new employer if you change jobs or they can be converted into private accounts if you get fired or laid off.  A rollover is the transfer of the holdings of one defined-contribution retirement plan to another without suffering any tax consequences. 


Defined-Benefit Retirement Plans


A defined-benefit retirement plan is an employer-sponsored retirement plan in which the benefits paid to the retiree are fixed, and are not determined by the returns on any investments.  The employee will get the same (guaranteed) benefits when they retire, no matter how well or how poorly the plan investments are doing on Wall Street.    The benefit may also include a cost-of-living increase each year during retirement, but not all defined-benefit retirement plans have this feature.


One of the primary differences between defined-benefit and defined-contribution plans is that the individual participants in defined-benefit retirement plans do not have separate accounts—any money paid into the plan either by the corporation or by the participants goes directly into a general fund, and the money paid out to the participants comes out of this general fund.  The plan administrator then invests the money from the general fund in various securities such as stocks, bonds, or mutual funds.  The individual participants usually have no say in how the money in their company’s defined-benefit pension plan is handled--investment risk and portfolio management are entirely under the control of the company, and the employer is exclusively responsible for making the decisions of how much money to contribute to the plan and how to invest it. 


There are two subcategories of defined-benefit pension plans—funded and unfunded:


·         In an unfunded defined-benefit pension, no assets are set aside by the plan administrator and the benefits are paid by the employer or other sponsor out of current income and assets.  . 


·         In a funded defined-benefit plan, contributions from the employer and sometimes also from plan participants themselves are added to a general fund that is directed towards meeting the cost of the benefits.  The amount of money that the employer contributes to the plan is based on complex statistical analysis and actuarial calculations that attempt to estimate the costs of future risks—they consider things like employee age and life expectancy, employee income, normal retirement age, investment performance, possible changes in interest rates, employee turnover, etc.  The fund can make investments in stocks, bonds, or other securities at the sole discretion of the employer.  The employee will get the same (guaranteed) benefits when they retire, no matter how well or how poorly the plan investments do in the marketplace.  Unfortunately there is no guarantee that the returns on the money invested by the fund will be adequate to meet future payment obligations, which means that in a defined benefit pension plan, investment risk and investment rewards are assumed by the sponsor/employer and not by the individual employee. 



In the USA most private defined-benefit plans are funded, because the government provides certain tax incentives to the employer for such plans--the money contributed by the employer to the plan entitles them to a substantial tax deduction.


In most defined-benefit plans, an employee must participate for a certain number of years before they have a legal right to receive any benefits.  This is known as vesting.   The number of years of service required before vesting will vary from employer to employer.  The benefits that are paid to the employee when he or she retires are determined by a formula that uses factors such as salary history, age, and duration of employment.   The defined-benefit pension payout usually begins when the employee retires, and will continue as long as they live.  The monthly payout to the retiree will always be the same, no matter how well or how poorly the plan investments are doing.   Generally, the employee cannot start drawing benefits until he or she actually retires, but sometimes the company will offer extra inducements (such as artificially adding extra years of age and/or service to the employee’ record) in order to encourage them to retire early.


Defined-benefit plans usually distribute their benefits through life annuities, under which the retiree receives equal periodic benefits for the rest of his or her life, although some plans may also allow the retiree to receive their entire benefit in one lump sum.    When the retiree starts receiving payouts from their defined benefit pension plan, the money is considered as ordinary income by the IRS, and is thus subject to income tax.  You will have to pay federal income tax on your pension payments, as well as state and local taxes in certain locales.  So even if you originally contributed money to the plan tax-free, you will have to pay tax on that money when you take it out of the plan.


Since defined-benefit retirement plans offer guaranteed lifetime payouts to plan participants, this makes them different from defined-contribution pension funds, under which payouts are somewhat dependent on the return from invested funds. Therefore, employers who have funded defined-benefit pension plans will need to dip into the company’s earnings in the event that the returns from the investments devoted to funding the employee's retirement decline, resulting in a funding shortfall. 


Because the individual participants in defined-benefit pension plans generally do not have separate accounts, these sorts of plans tend to be less portable than defined-contribution plans.  They are supposedly an incentive for an employee to stick with a single employer for many years.  Defined-benefit pension plans tend to be “back-end loaded”, meaning that the greatest gain to the employee occurs near the end of his or her career, at the time when they are earning the highest salary.  If the employee gets laid off or quits before retirement age, they might be worse off than if they had a defined-contribution pension plan such as a 401(k) which they could take with them to a new employer or could be transferred into another pension system.  In addition, if an employee quits or gets laid off before they are vested, they could end up with nothing at all for their retirement.  In addition, defined-benefit pension plans generally cannot be rolled over into other types of pension plans. 


Defined-benefit pension plans are sometimes criticized as being paternalistic, since they enable employers or plan trustees to make decisions about the type of investments that are made and on the benefits that are received.  However, they are typically more valuable than defined contribution plans in most cases and for most employees.  For this reason, employers tend not to like defined-benefit pension plans because they will still have to pay out the same amount of money to their retirees if the economy tanks and the value of the investments drop precipitously.  The open-ended nature of the financial risks to the employer is the reason given by many employers for switching from defined-benefit to defined-contribution plans in recent years. 


Can an employer choose to eliminate or scrap its defined-benefits pension plan in order to save a little money, leaving its employees and retirees out in the cold?  Federal law prohibits a firm from taking away any pension benefits that have already been earned by its employees and retirees, but the firm is free to change its pension policies for future years at any time.   This is most often done by what is known as a pension freeze.  Typically, if a freeze is imposed, some or all of the employees will stop earning some or all of the benefits from the point of the freeze moving forward, but the employees will keep the benefits that they have already earned.  Alternatively, the company may continue operating its defined-benefit plan for its current employees and retirees, but stop new employees from enrolling in the plan, forcing them to enroll in some alternative pension system such as a 401(k) defined-contribution plan.   


Companies most often choose to freeze their defined-benefit pension plans in order to save money—they worry that their defined-benefit pension plan imposes open-ended and unpredictable financial risks in an uncertain economy.   They want to remain competitive with companies that do not offer pensions.  The rising costs of healthcare insurance are another factor.  Current law allows companies to change, freeze, or eliminate altogether their defined-benefit pension plans, so long as the benefits that employees have already earned are protected. For employees—particularly those close to retirement who have spend virtually all their working lives working for the same employer—a frozen pension plan can be a disaster, and the guaranteed income that they had been anticipating could be reduced significantly.  This is because under most defined-benefits plans an employee’s retirement benefit accumulates most rapidly during the last few years before retirement.


Even though the payouts from a defined-benefit pension plan do not depend on how well the plan investments are doing on Wall Street, a defined-benefit pension plan is heavily dependent on the financial health of the employer.  What happens if a company or corporation who sponsors a defined-benefit pension plan for its employees and retirees goes bankrupt or bellies-up?  Are the employees and retirees out of luck?  It turns out that the Pension Benefit Guaranty Corporation (a government agency) insures private defined-benefit pension plans and guarantees the payment of certain pension benefits to the participants (employees, former employees, as well as retirees) in case the company goes bankrupt or if the pension fund itself becomes insolvent.  Federal law requires most defined-benefit pension plans to purchase insurance from the PBGC to protect employees and retirees from the risk of these plans becoming insolvent.  The only exceptions to the insurance requirement are plans provided by professional service employers such as doctors and lawyers that have fewer than 26 employees, plans provided by church group, as well as plans offered by federal, state, or local governments.  More about the PBGC later!



Social Security


Social Security (originally created in 1935 during the New Deal) is the nation’s oldest social insurance system.  It was an attempt to limit the dangers of old age, poverty, unemployment, and the burdens on widows and fatherless children.  It provides a guaranteed income each year for more than 47 million retirees, family members of workers who die, and people with disabilities.  Nearly two-thirds of all retirees count on Social Security for most of their retirement incomes, and about 30 percent of Social Security beneficiaries receive survivor or disability benefits. 


Social Security is a defined-benefit system, since once an individual participant attains eligibility, they receive a guaranteed monthly payment for the rest of their lives, based on a pre-determined formula using factors such as age, the number of years worked, and highest salary earned.  The monthly payouts to recipients are not based on the returns from any sorts of investments, nor are they dependent on how much money the Social Security has on hand at any given point in time. 


Social Security is sometimes compared with private pensions, but Social Security was originally supposed to be a social insurance program, not a retirement plan.  In addition, Social Security makes disability payments, whereas private pensions do not.  However, Social Security has evolved over the years into something more like a defined-benefit retirement pension plan, and many people now rely exclusively on Social Security payments to fund their retirements.


Social Security is considered to be an example of an unfunded defined-benefit pension system, since payments to retirees are financed by a payroll tax on current workers’ wages, half paid directly as a payroll tax withheld from the employee’s paycheck and half paid by the employer.  Social Security payroll taxes are collected under the authority of the Federal Insurance Contribution Act, and such taxes are sometimes even called “FICA taxes”.  The current withholding tax rate is 6.2 % of the gross wage amount up to but not The same 6.2 % tax is imposed on employers.  The tax rate for self-employed persons is 12. 4 %.   Medicare is funded by a separate tax.


Social Security limits the amount of earnings subject to FICA taxation for a given year.  This is known as the Social Security Wage Base.  It generally increases every year.  It was $118,500 for 2015.  This means that higher-income people might stop having FICA taxes withheld from their salaries in later months in the year.  But the same annual limit applies when those earnings are used in a benefit computation, which means there will be a limit on the Social Security benefits that higher-income people will draw when they become eligible.   


Not all jobs in the economy are covered by Social Security. These exceptions generally involve persons who work for state or local governments. Under certain conditions, such employees have been able to voluntarily elect not to have their employment covered by Social Security, and to be covered instead by state or local pension plans. These people don’t have to pay FICA taxes, but they of course are not eligible to collect Social Security benefits. In the 1960s, state and local employees were given the opportunity to elect to participate in the Social Security system. Public sector employees in some states opted to enroll in Social Security in the 1960s and 1970s, but the remaining states (or local governments in some states) chose instead to opt out of Social Security and chose to maintain and enhance their existing retirement systems.


Until 1984, employment by the Federal government was covered under the Civil Service Retirement System (CSRS) and not by Social Security.  Federal employees did not pay Social Security taxes, and their earnings did not appear on the employee’s record.  But in 1984, the Federal Employees Retirement System (FERS) was introduced, and people who began working for the Federal government in 1984 or later were covered under FERS rather than CSRS, and work under FERS was covered by Social Security.  Some workers who had been covered by CSRS chose to switch over to FERS when it became available.   Those Federal employees who stated with CSRS after 1984 were still not covered by Social Security.


Many people have a major misconception about how Social Security works—they imagine that each person contributing FICA taxes to Social Security has their own account, and that the money contributed by them and their employer accumulates in their account, and that this account will sit there until the time of their retirement, after which money can be drawn out of it.  This picture is completely wrong--there is no such thing as your own private Social Security account.  The money you and your employer paid in taxes for Social Security is not sitting somewhere in a bank account with your name on it.  Instead, the taxes you paid while you were working were used to pay benefits to people who were currently drawing Social Security benefits, and when you do retire your benefits will be provided out of the money paid in taxes by people still working.  


Social Security taxes that are collected are paid into the Social Security Trust Fund, maintained by the US Treasury.  This trust fund is actually split into two parts--the Old-Age and Survivors Insurance which is used to pay benefits to retirees and their survivors, with the second part being used to pay benefits to those who are disabled.  Instead of locking up the money somewhere in a safe, any surplus funds in the Social Security Trust Fund that are not needed to pay benefits to current recipients are required by federal law to be invested by the Secretary of the Treasury.  This money can be invested only in special series, non-marketable US Government bonds--federal law forbids the Trust Fund from investing in risky assets such as stocks, bonds, hedge funds, derivatives or other private equities.  The government is required to pay this money back to the Trust Fund, with interest. This means that the Social Security Trust Fund indirectly finances the federal government’s general-purpose deficit spending, and the money owed to the Trust Fund is part of the national debt.   The government is in fact borrowing from itself, and the Trust Fund remains secure so long as the government does not default on the loans.  So far this has never happened.


Retirement and old-age benefits are calculated by a complex formula that takes into account a worker’s earnings history as well as the age at which the worker starts drawing their benefits.  The retirement benefit calculations are based on the employee’s average earnings—Social Security averages the 35 highest years of earnings when it does the calculation.  Years in which an employee had low earnings or no earnings at all are counted to bring the total number of years of earnings up to 35.  Once the monthly benefit payout is determined, it remains fixed for the rest of the recipient’s life, although the benefits are generally increased every December based on a cost of living adjustment.


However, there is a maximum Social Security benefit that anyone can receive, which depends on the age at which a worker decides to retire.  This limit is reflective of the Social Security Wage Base, which limits the amount of FICA taxes collected in a given year.  This means that since the amount of FICA taxes withheld is limited, so is the benefit payout.  This maximum benefit amount changes every year--the maximum amount for 2015 for a person retiring at full retirement age is $2663 per month.  This is based on earnings of a hypothetical worker who started earning at the maximum taxable amount for every year after age 21 and who had always paid the maximum amount in FICA payroll taxes for their entire working life.   This limit means that higher-income people will draw benefits that are a smaller percentage of their lifetime incomes than will lower-income people


Social Security also pays disability benefits.  A worker who has worked long enough and recently enough can receive disability benefits, but the worker must be able to show that they are unable to continue in his or her previous job and unable to adjust to other work.  The disability must be long term, lasting 12 months and expected to last 12 months, resulting in death or expected to result in death.  Disability determination is a major administrative task, and a lot of disability applications get turned down.


In general, to qualify for old age Social Security benefits, a person must have earned at least 40 credits over their working lives. A credit is based on the amount of money earned by working on a job for which you and your employer paid Social Security payroll taxes.  You don’t earn credits for money earned from pension payments, from interest earned on savings, or from dividends earned on investments, since you don’t pay Social Security taxes on these kinds of income.  The amount of earnings it takes to earn a credit changes each year.  In 2015, you had to earn at least $1220 in covered earnings to get one Social Security credit.  However, you can earn only 4 Social Security credits in a single year.  During your lifetime, you will probably earn many more credits than the minimum number required to be eligible for benefits, but these extra credits will not increase your benefits.


Social Security also requires that a person be of a certain age before they are eligible to receive full retirement benefits.  This is often called the full retirement age or the normal retirement age.  The age of eligibility for full retirement benefits depends on a retiree’s date of birth. Those people born before 1938 had a normal retirement age of 65, but the normal retirement age increased by two months for each ensuing year of birth until the 1943 year of birth was reached, after which it stayed at age 66 until the year of birth 1955 is reached.  Thereafter, the normal retirement age increases again by two months for each year, ending in the 1960 year of birth, after which normal retirement age stays fixed at age 67. 


A retiree can opt to start receiving Social Security benefits before they have reached the age of eligibility for the receipt of full benefits.  The earliest age at which Social Security benefits are payable is 62.  However, if you elect to start receiving SS benefits before your normal retirement age, you will have your benefit reduced based on the number of months before reaching your full retirement age that you started drawing Social Security benefits, and this reduction will be permanent.  This formula gives an 80 percent benefit if you started drawing Social Security at age 62 when your normal retirement age was 65. 


Alternatively, you can choose to delay starting receiving retirement benefits past your normal full retirement age –if you do so you will earn delayed retirement credits that increase your benefits once you do opt to start receiving benefits.  This process continues until you reach age 70.   After that, there would be no point to delaying the receipt of Social Security benefits any further. 

If you like, you can continue to work after you start drawing Social Security, but it may turn out that your Social Security payouts will be smaller during the period while you are still working.   Social Security has a rule known as the “earnings test” that can affect the benefits that some retirees receive when they continue to work after signing up for retirement benefits.  However, the earnings test applies only to those people who started drawing Social Security benefits before reaching their full retirement age.  If you start receiving Social Security payments at age 62 but are still working and are earning more than $15,720 per year (the annual limit for 2015), your Social Security benefit is reduced by $1 for every $2 that you earn above that limit.  The earnings limit increases as you get older.  In the last year before reaching your full retirement age, the earnings limit rises to $41,880, and your benefits are reduced $1 for every $3 that you earn above that limit.    

However, when applying the earnings test, Social Security counts only earnings that are made as an employee or as a self-employee.  It does not count income derived from rental properties, lawsuits, inheritance payments, pensions, investment income, IRA distributions, or interest.  But Social Security will count money drawn from a non-qualified pension, one which is one not eligible for favorable IRS tax treatment.  

But once you do reach your full retirement age, Social Security stops penalizing you for working or for drawing income from a non-qualified pension plan.  As of the month you reach full retirement age, your benefits are not affected by any earnings limits, and you can work as long as you like and can earn as much money as you want without it affecting your Social Security check.  Furthermore, the Social Security benefits that you "lost" because you continued to work will eventually be returned to you after you reach full retirement age. At that time, Social Security will review your earnings record, and will increase your benefit to account for all the months in which a full benefit was not paid because of earnings from work.

However, if you do continue to work after starting to receive Social Security benefits, you and your employer will still have to pay Social Security and Medicare taxes on your earnings.  In such a situation, you would be getting a check from Social Security and paying Social Security taxes at the same time.  But the additional money that you make will be used to recalculate your benefits--if your latest work years are among your highest-earning years, the SSA will recalculate your benefit and will pay you any increase due. This is automatic, with new benefits starting in December of the following year.

It is possible for an American to draw a pension from a private employer and to draw Social Security benefits at the same time.  In fact, since Social Security benefits are often quite low, it would be difficult to survive in retirement on Social Security benefits alone unless the beneficiary owns his or her home, or has a secondary source of income from a job, a pension, or a trust fund.

Any current spouse is eligible for Social Security benefits as well, under their spouse’s employment and salary record.  If the spouse hasn’t earned enough credits to qualify for Social Security benefits on their own record, when they reach full retirement age they can receive a benefit equal to one-half of their spouse’s full retirement amount.   

Another tactic that is sometimes used by married couples is the so-called “file and suspend” strategy, which first became available in the year 2000.  Here’s how it works.  Remember that your current spouse is eligible for Social Security benefits based on your work record.  However, your spouse cannot collect this benefit  until you have applied for your own Social Security benefits.  But you may not want to start receiving your benefits yet, opting instead to maximize your benefits by waiting until you reach age 70 by accumulating delayed retirement credits.  Nevertheless, you can arrange for your spouse to start receiving Social Security benefits based on your work record by going ahead and  filing for Social Security as soon as you reach full retirement age, but then immediately suspending your benefits.  This allows your spouse to start collecting a spousal benefit based on your earning record as soon as they reach their full retirement age, even though you are not yet receiving any benefits and are letting your own benefit continue to grow.    While receiving benefits based on your work record, your spouse can choose to let their own benefit amount continue to accumulate delayed retirement credits and switch to a benefit based on their own work record at age 70, perhaps at that time receiving much larger benefits.  So your spouse can still collect spousal benefits while at the same time accumulating delayed retirement credits to maximize their benefits.  This strategy is most attractive to those couples who both plan to continue working past their full retirement ages.  But you are in effect betting that you and your spouse will actually live to reach age 70.

Social Security survivor benefits are available for certain family members, provided that the deceased had accumulated the necessary 40 credits before dying.   Eligibility for surviving spouse Social Security benefits begins at age 60, or 50 if they are disabled.  The amount they will get will be a certain percentage of the deceased spouse’s Social Security benefits.  This percentage will depend on the age of the surviving spouse.  The spouse can receive a reduced benefit (71.5%) of the deceased’s benefits as early as age 60, but if they are at their full retirement age, they will receive 100 percent of the deceased spouse’s basic Social Security benefit.  These benefits will continue indefinitely unless the spouse remarries.  If the surviving spouse had earned enough credits to be eligible for Social Security benefits on their own record, they can switch over to their own benefit as early as age 62.  However, in any event, the surviving spouse can only get one benefit, whichever is higher.  They cannot receive both of them.  Children will be able to qualify for 75% of the deceased’s Social Security benefits until they turn 18. 

The Social Security benefits received by retirees were not originally taxed as income, but beginning in tax year 1984 retirees with incomes above $25,000 for a single person, or $32,000 for married persons filing jointly had a portion of their Social Security benefits subject to Federal income tax.  In addition, some state governments also tax Social Security benefits, but others exempt them.   The portion of Social Security benefits subject to federal income tax has generally increased over the years.  Currently, if you’re a single person with a combined income below $25,000 — or are a married couple with less than $34,000 in combined income — none of your Social Security income is taxed.  But if your combined income reaches $25,000 to $34,000 — or $34,000 to $44,000 for a married couple filing jointly — then half the Social Security benefits you receive will be subject to taxes.  And if your combined income exceeds $34,000 — for a married couple, $44,000 — you’ll wind up paying taxes on 85 percent of your Social Security benefits. 

Taxes on Social Security income can be a hefty bite, particularly if you are drawing additional income from a private pension or are still working and making a good income.   Another problem is that the income limits described above have not been changed since the 1980s, which means that they have not been indexed for inflation.  Consequently, more and more Social Security recipients are now being hit with this tax, as inflation takes its toll in the economy.  In effect, this system of federal tax on Social Security benefits makes Social Security somewhat of a means-tested program, since such taxes mean that higher-income people are having their benefits effectively reduced. 

If you like, you can have Social Security withhold federal taxes from your benefits by filing Form W-4V from the IRS.   When you complete the form, you will need to select the percentage of your monthly benefit amount you want withheld. You can have 7%, 10%, 15% or 25% of your monthly benefit withheld for taxes.   You then submit the form to Social Security.

At one time, if you started collecting Social Security benefits at age 62, you could change your mind upon reaching your full retirement age, pay back the amount of money that you had already collected, and then start getting a higher payment from that time onward.  That used to be true, but the Social Security Administration just published new regulations (effective in December 2010) that curtail this option.  The problem was that too many people were abusing this option and were using it as a way of getting an interest-free loan from the government.  Now, if you want to suspend your benefits, you must do so within 12 months after first receiving them. According to Social Security, 85 to 90 percent of beneficiaries who withdraw their applications do so within this time frame anyway.  The new rules also specify that beneficiaries are limited to one refiling in a lifetime.


An unexpected side effect of the Social Security system has been the near-universal adoption of the Social Security number as the national identification number in the United States.  It has gotten so bad that you need to take special pains to make sure that your Social Security number does not get into the wrong hands, exposing you to identity theft.


Supplemental Security Income (SSI)


Supplemental Security Income (SSI) is a government program that provides stipends to low-income people who are either aged 65 or older, blind, or disabled.  The program is administered by the Social Security Administration, but it is funded from general US Treasury funds, not from the Social Security trust fund.  The program was originally created in 1974 to replace federal-state adult assistance programs that served the same purpose.  It was intended to standardize the eligibility requirements and level of benefits.  About 8 million people are currently drawing SSI benefits.  SSI benefits are not the same as Social Security benefits.

The SSI program is severely means-tested.  A person’s income and resources must be below certain limits, which may vary based on the state, the recipient’s living arrangement, the number of people living in the residence, and the type of income.  The resource limits are very low—only $2000 for an individual and $3000 for a couple.  The monthly federal cash assistance is up to $721 for an individual and $1082 for a couple, but some states make extra payments, increasing the cash assistance available. 

Windfall Elimination Provision (WEP)


If you worked for a time for an employer who did not withhold Social Security taxes from your salary, such as in a state or local government agency, or an employer in another country, any retirement or disability pension you get based on that work may reduce your Social Security benefits that you earned from jobs where FICA taxes were withheld. The Windfall Elimination Provision (enacted by Congress in 1983) affects how the amount of your Social Security retirement or disability benefit is calculated if you receive a pension from work where Social Security taxes were not taken out of your pay.


Before 1983, people who worked mainly in a job not covered by Social Security but who had also worked in a job where FICA taxes were withheld had their Social Security benefits calculated as if they were long-term, low-wage workers. This meant that they had the advantage of receiving a Social Security benefit that represented a higher percentage of their earnings, plus they also received a pension from a job where they did not pay Social Security taxes. Congress passed the Windfall Elimination Provision in an attempt to remove that advantage.


WEP introduces a complex formula[i] for the calculation of Social Security benefits for people who are also getting a pension from a government job that was not subject to FICA taxes. 


Social Security calculates your Social Security benefit based on your average monthly earnings, adjusted for inflation.  They separate your average monthly earnings into three amounts and multiply the amounts by three factors to compute your full Primary Insurance Amount (PIA).  For example, for a worker who turns 62 in 2017, the first $885 of average monthly earnings is multiplied by 90 percent; earnings between $885 and $5,336 by 32 percent; and the balance by 15 percent. The sum of the three amounts equals the PIA which is then decreased or increased depending on whether the worker starts receiving benefits before or after full retirement age.   This formula produces the monthly payment amount.   For example, a person who earned $1500 per month in a job covered by FICA taxes, the monthly PIA would be 0.90($826) + 0.32($674) = $959. 


But for an individual subject to WEP, the 90 percent factor is reduced in stages.  If you received substantial income from a job where FICA taxes were withheld for 30 or more years of your working lifetime, the WEP does not apply to you.  But if you had fewer than 30 years of substantial income and were also drawing a pension from employment where FICA taxes were not withheld, the 90 percent factor is reduced in yearly stages until it drops to 40 percent for someone with less than 20 years of covered employment. 


If you do not have 30 years of “substantial income” in Social Security covered work, the complex formula will significantly reduce your benefit, but the reduction may be no more than one-half of the government pension to which the person is entitled in the initial month of entitlement to the pension. So WEP cannot entirely eliminate your Social Security benefits. In addition, if an individual subject to the WEP dies and has one or more survivors entitled to a benefit, the SSA recomputes the amount of the benefit in a manner that eliminates the WEP and results in a higher benefit


There are some cases where the Windfall Elimination Provision does not apply. If you had 30 or more years of substantial earnings that were covered under Social Security, the WEP does not apply. The WEP does not apply to federal workers hired after Dec 31, 1983.  It also does not apply if one was employed on Dec 31, 1983 by a nonprofit organization that did not initially withhold FICA taxes, but then began withholding FICA taxes. It also does not apply if one’s only pension is based on railroad employment, or if the only work one that one did which did not pay FICA taxes was before 1957. Congress also exempted non-SS –covered military reserve service pensions from the WEP.


Why did Congress enact the WEP? This was basically because of the fact that Social Security benefits are so heavily weighted toward lower-paid workers, under which individuals with low average lifetime wages receive a proportionally higher rate of return on their contributions to Social Security than individuals with relatively high average lifetime wages. If you have spent most of your career in non-SS-covered employment with a state or local government agency and spent only a minimal amount of time in SS-covered employment, you will appear to the Social Security administration as a lower-paid worker.  Congress enacted the WEP in the belief that you should not receive a Social Security benefit as though you are a low-paid worker, and also receive a government pension from non-SS-covered employment.


The WEP causes public employees who have worked for a time outside the Social Security system to lose a significant share of their Social Security benefits. The WEP can also have a severe effect on low-wage employees. The WEP also affects the teaching profession as a whole. Some individuals in SS-covered employment may wish to make a career change and go into teaching. If the teachers in their state are not covered by Social Security, those individuals will be less likely to make the change once they realize that they will lose a portion of their Social Security benefits.


There are bills before Congress that would repeal the WEP. Some of those who oppose repeal of the WEP cite cost as a factor, arguing that allowing people to draw full Social Security benefits while at the same time drawing a government pension costs too much money. Others believe that allowing a person to receive both a full government pension as well as Social Security earned benefits would constitute unfair “double dipping.” But is such a scenario any different from someone who receives both a private pension and a Social Security benefit? “Double dipping” is not an appropriate characterization when an individual has worked two jobs and has earned two benefits. For example, I am receiving full Social Security benefits as well as a pension from my former employer (where I paid FICA taxes), and I don’t see myself as a “double-dipper”, since I paid fully for both benefits.


Government Pension Offset (GPO)


The Government Pension Offset (GPO), enacted by Congress in 1977, is a provision in Social Security law that affects people that are eligible for spousal or survivor Social Security benefits and who also worked in state or local government jobs for which FICA taxes were not paid and who are entitled to a government pension from that employment.  The GPO is similar in intent to Windfall Elimination Provision, but it only affects individuals who apply for spousal or survival Social Security benefits.  The philosophy behind this law was the belief that allowing a person to receive both a full government pension and full Social Security survivor/dependent benefits would constitute unfair “double-dipping”, costing the government too much money.


Once a person receives a retirement or disability benefit from a job from which FICA taxes were not withheld, any Social Security spousal or survivor benefits that they receive will be reduced by two-thirds of the amount of their non-SS-covered pension. This means that under the GPO, the SSA reduces one’s dependent/survivor benefit by $2 for every $3 one receives from their government pension. There are indeed cases in which one’s dependent/survivor benefit could indeed be reduced to zero under GPO.


For example, suppose that a woman worked and earned her own monthly Social Security retirement benefit, but she also was due a dependent or survivor benefit based on her husband’s Social Security record. The Social Security Act does not permit an individual to receive a Social Security benefit from his/her own work and also receive a survivor/dependent Social Security benefit. In that case, Social Security would pay the larger of the two benefits, but not both. This is known as an offset. But before the GPO law was passed, if that same woman was a government employee who did not pay into Social Security, and who had earned a government pension, there was no offset, and Social Security paid her the full spousal/survivor benefit based on her husband’s Social Security record, in addition to her full government pension. So she could be able to collect both benefits, sometimes called “double-dipping.”


In enacting the Government Pension Offset provision, Congress intended to ensure that when determining the amount of a spousal or survival benefit, government employees who do not pay Social Security taxes would be treated in a similar manner to those who worked in the private sector and who did pay FICA taxes. The GPO also applies to dependent/survivor benefits based on a spouse’s disability, but it does not apply to pensions received from non-SS-covered military reserve service.


A lot of people regard the GPO as grossly unfair. Teachers in 15 states and police, firefighters, postal workers, air traffic controllers, federal government employees (hired before 1983), and some state, county, local & special district workers are penalized by the GPO. Even a foreign pension can reduce or eliminate Social Security benefits. When it enacted the GPO, Congress forgot that the original purpose of the dependent/survivor. benefit was to help a husband or wife who depends financially on his/her breadwinner spouse. This dependent/survivor benefit provides additional income to help the financially-dependent husband or wife once the breadwinner retires or is disabled (in which case the dependent benefit applies) or once the breadwinner dies (in which case the survivor benefit applies).


Estimates indicate that nine out of 10 public employees affected by the GPO lose their entire survivor Social Security benefit, even though their deceased spouse paid Social Security taxes for many years. According to the Congressional Budget Office, the GPO reduces benefits for some 300,000 individuals by more than $3,600 a year. The GPO has the harshest impact on those who can least afford the loss: lower-income women.


There are bills currently before Congress to repeal the GPO. Some of those who oppose repeal of the GPO cite cost as a factor. Others believe that allowing a person to receive both a full government pension as well as full Social Security survivor/dependent benefits constitutes an unfair “double-dipping.”  But is such a scenario really any different from someone who receives a private pension as well as Social Security survivor/dependent benefits?   The pejorative term “double-dipping” is not really an appropriate characterization when an individual has worked two jobs and has earned two benefits.


Saving Social Security

Critics argue that the Social Security tax is a regressive tax that discriminates against the poor and the middle class.  The imposition of the Social Security Wage Base limit on FICA withholding means that particularly wealthy individuals will pay no FICA tax on income in excess of this amount.  It could turn out that Bill Gates and I pay exactly the same amount of money in Social Security taxes, and a lot of people think that this is unfair.  In addition, someone who dies before age 62 gets no retirement benefits at all, in spite of having paid money into the system for many years, whereas someone who lives to age 100 gets guaranteed payments that far exceed the amount of money he or she paid into the system.  Typically, however, a retiree will eventually get a lot more money in benefits that they actually paid into the system.  It is generally true that people who have lower incomes will receive a higher ration of benefits to taxes paid than will more wealthy individuals.


Some conservative critics argue that Social Security is nothing more than a pyramid or Ponzi scheme, one which would be illegal if an individual, a private corporation, or a private investment scheme tried it.  This is because benefits are paid out of current operating funds, which were in turn paid by taxes on prior wage earners.  This system works just fine so long as the pyramid keeps on growing, as long as the rate at which money is coming in is greater than the rate at which money is being paid out.  But this may not always be true.


The Social Security Trust Fund is expected to experience financial strain when the baby boomers start to retire.  The baby boom generation, born right after World War II between the late 1940s and the early 1960s, will soon begin to draw from Social Security, resulting in increased numbers of people receiving payouts, and the subsequent decline in birth rates post 1970 will mean that fewer numbers of people will be paying into the system.  Currently, Social Security is projected to remain in surplus until 2017, after which the federal government will owe $3.5 trillion to the Social Security Trust Fund.  After that time, the Trust Fund will have to start collecting the money that it had loaned to the federal government, lest Social Security start running in the red.  Even if this is done, by 2041, this money will all be paid back and the trust fund will be completely exhausted.  Nevertheless, current projections indicate that Social Security will be able to meet 100 percent of its obligations until at least 2042.   However, the recent economic downturn--with larger numbers of people out of work and not paying FICA taxes into the system—may push the onset of Social Security insolvency a couple of years earlier than originally expected.


It is often politically dangerous for elected officials to even consider major changes in how Social Security is funded or in how benefits are paid.  It is often said that Social Security is the “third rail” of American politics—you touch it and you die.  In order to keep Social Security solvent into the future, some radical and unpleasant measures may indeed have to be considered. 


Perhaps the most often-mentioned reform proposal is to raise the age of eligibility for full Social Security benefits, in order to keep the number of people drawing benefits to a manageable level.  The average life expectancy has increased over the years and is expected to increase still further in the years to come.  This will mean that more people will be drawing from Social Security for a longer period of time.  Social Security benefits are automatically indexed for inflation, but the retirement age has not been indexed to account for increased life expectancy.  One proposal to address this problem would be to raise the full retirement age in stages to 68. Starting in 2023, the age would increase by two months each year until it reached 68 in 2028. This is estimated to fill 18 percent of the funding gap.  Another proposal would be to raise the full retirement age to 68 right away. Starting in 2023, the age would increase by two months each year until it reached 70 in 2040. This is estimated to fill 44 percent of the funding gap.  The earliest age for claiming reduced benefits could remain at age 62, but the monthly benefit for those claiming early benefits would be further reduced – about 6 to 8 percent for each year that the full retirement age increases


Payroll taxes may have to rise, or else some older folks might get left out in the cold.  For example, it is estimated that increasing the payroll tax rate gradually over the next 20 years on both employers and employees from 6.2 percent to 7.2 percent would fill over half of the expected funding gap.  Most Americans would probably accept a modest increase in their payroll tax rate to ensure that the Social Security system remains solvent in the future—younger employees might be more willing to accept having to pay higher FICA taxes if they felt more confident that Social Security will really be there for them when they retire.  However, critics argue that increasing taxes in a tight economy is always a bad idea—increasing the tax rate that employers have to pay for their employees might cause them to hire fewer numbers of employees or to move more jobs overseas. 


Some have suggested that the means by which the cost of living adjustment (COLA) is calculated needs to change so that annual Social Security benefit payments do not increase as rapidly as they do now.   Currently, the consumer price index (which measures changes in the prices of consumer goods and services) is used by Social Security to calculate the annual increase in benefits payments.  Many observers feel that the CPI actually overestimates the true increase in the cost of living, and that some other means of estimating the COLA might result in slower increases in the rate of increase, although there seems to be no general agreement on how this might be done. 


One option for lowering the COLA is the so-called “chained CPI”, which measures living costs differently by assuming that if prices for one thing go up, people sometimes settle for cheaper substitutes (for example, if beef prices go up, people might buy more chicken and less beef).  Estimates show that under the chained CPI, your cost-of-living adjustment (COLA) would be about 0.3 percentage point below the plain old CPI. That works out to $3 less on every $1,000, which doesn't sound like much — except that it keeps compounding over time.  The same difference will happen year after year, and pretty soon you will start to notice the cut, and after 25 years or so you could be losing a full month of income every year.  Consequently, it becomes a real benefit cut.


President Barack Obama repeatedly proposed the application of chained CPI to Social Security benefits.  But the proposal has become quite controversial and is opposed by the AFL-CIO, the American Association of Retired Persons (AARP), and by the American Federation of Government Employees.  For one, chained CIP is a real honest-to-goodness benefits cut, and could hurt a lot of people in the long term.  In addition, it probably underestimates the effects of medical care inflation on the elderly.  Because of the controversy, in February of 2014, President Obama dropped the chained CPI idea from his budget proposal.  But it still remains on the table, and could be revised in future budget proposals.


Some have suggested that one of the reasons for the coming Social Security financial crunch is that average life spans have been increasing, with more people drawing Social Security for longer periods of time.  They suggest that Social Security benefits should somehow be indexed to longevity, either by increasing the age for receiving full retirement benefits or by lowering the monthly benefits for everyone as the average lifespan increases.


Another proposal is to bring more people into the Social Security system.  Currently, many state and local government workers have their own pension systems and are exempt from having to pay FICA taxes (Federal workers were brought into the system in 1983).  Perhaps it might be a good idea for all newly-hired state and local government workers to be brought into the Social Security system, with these workers and their employers paying their share of Social Security payroll taxes.  Current state and local government workers would not be affected.  This would bring additional funds into the system.  However, although adding additional workers to the system would provide additional revenue now, benefits would eventually have to be paid to these new-added workers, adding to additional financial problems down the road.  Furthermore, state and local pension systems are currently under a lot of strain, and many are seriously underfunded, and the elimination of contributions from newly-hired government workers would provide additional strain to an already overstressed system.


Some experts have recommended revising or eliminating the Social Security Payroll Tax Cap, so that wealthier individuals would pay more into the system.  Under the current system , I probably pay as much FICA taxes as do multimillionaires, and a lot of people think that this is unfair.  This idea initially sounds attractive, since such a change would initially pump a lot more cash into the system.  However, since these millionaires will be paying FICA taxes on more or even all their income, once they do become eligible for benefits, they would start drawing rather large benefits from the system, creating an even larger drain on the system several years from now.  The Social Security system was not intended to provide such large benefits.


One option to help close the Social Security funding gap would be to increase the number of years of earnings used to calculate Social Security benefits from 35 to 38 or even 40. Because that method would typically include more years of lower earnings, the average earnings would decrease and benefits would be lower. Increasing the number of computation years to 38 is estimated to fill 13 percent of the solvency gap.


Social Security benefits have always been provided to anyone who has paid into the system and who meets the work and age requirements. That’s regardless of other income — investment, pension, savings — the person receives in addition to Social Security benefits (although a portion of Social Security benefits is taxable if the total income exceeds a certain threshold).  Some experts have even maintained that the upcoming financial squeeze on Social Security will require that the system be subjected to means-testing.  Under such a system, higher-income people or those with more financial resources would receive reduced Social Security benefits or perhaps none at all. 


Advocates of means-testing for Social Security argue that the system can save a considerable amount of money by giving benefits only to those retirees who really need them, and should not waste money by awarding benefits to those  more wealthy individuals who could easily get along without them.  These advocates argue that in an era of scarce resources, Social Security can’t continue to pay benefits to all retirees regardless of what other retirement income they have. Instead, the program should provide monthly benefits only to retirees who have less than a certain amount of non-Social Security annual income. Social Security would continue to be insurance against retirement poverty for everyone, but would focus its benefit payments on those who really need them.


Critics of these proposals for means-testing of Social Security benefits argue that such a program would unfairly penalize people who had adequately saved for their retirements during their working years, versus those people who spent profligately during their youth and had not saved enough for their retirements.  The government would have to routinely check your income and assets in order to adjust your benefit, and this would add additional administrative costs and burdens to the entire system, perhaps even eating up any cost savings that could possibly be gained. 


More seriously, the introduction of means-testing might erode public support for the entire Social Security system.  This would turn the whole Social Security program into something more akin to a traditional government-sponsored income maintenance program for the poor such as welfare, food stamps, or Medicaid.  Means-testing of Social Security would run counter to the universality and earned-right principles that have evolved over the years under the present system, under which everyone who is working pays taxes into the system, with the assurance that they will get benefits back when they retire.  It might happen that, under a means-testing environment, the American public would come to perceive Social Security as just another government-mandated income redistribution program rather than as an earned right, leading to political pressures to curtail the Social Security system or even to eliminate it altogether.   In particular, the well-to-do would probably stop supporting the Social Security program if means-testing were applied, since it would become just another government-imposed tax that they would be forced to pay while receiving little or no benefits. 


Others have suggested that the government be forced to stop using money in the Trust Fund for other purposes and make it into a true savings fund.  But this would probably require that the government borrow money from other sources, raise taxes, or significantly cut some current programs. 


There have been some proposals to give the government greater freedom to invest the money in the Social Security Trust Fund in things other than secure government bonds—perhaps in private stocks, bonds, and money markets, things which would offer a higher rate of return than is possible with government bonds but which would also offer greater risk.   


Other proposals would turn Social Security into something more like a defined-contribution pension system, with each participant having their own individual account.  These proposals generally come under the label of “privatization”.   Under privatization, FICA taxes would be paid into a worker’s individual account rather than into a general operating fund.   In addition, the worker would be given some degree of control over their individual account, and would be permitted to invest their own Social Security contributions (or some fraction of them) in the stock market or in other potentially more-risky ventures.  At the basic level, these personal accounts would become very much like IRA or 401(k) private investment plans, but financed from a worker’s Social Security taxes.  Advocates of Social Security privatization argue that money invested in the private marketplace would offer a much better rate of return than the government bonds that the Social Security Trust Fund currently invests in, saving the taxpayer a lot of money and stimulating the economy in the process. 


But what happens if the stock market tanks just as you are about to retire?  Not only would you lose your company-provided 401(k)  investment plan, you would lose your Social Security benefits as well.  Recent bitter experiences with shortfalls in private retirement plans probably make Social Security privatization proposals politically impossible right now.


401(k) Retirement Plans


A 401(k) plan is a qualified defined-contribution retirement plan established by employers in which eligible employees are able to make contributions from their salaries on a pre-tax basis.  The employee elects to have a portion of their wages paid directly into their 401(k) account before any federal income tax is withheld.    The name “401(k)” refers to a section of the Internal Revenue Code, which was added in 1978. 


Employers offering a 401(k) plan may also make contributions to the plan on behalf of their eligible employees, although they are not required to do so.  The employer usually does this by making matching contributions, sometimes 33.3 cents to 50 cents for every dollar the employee donates.  Alternatively, the employer may also add a profit-sharing feature to the plan, under which a certain fraction of the company’s profits are added to each employee’s fund. 


A 401(k) retirement plan is a defined-contribution plan, not a defined-benefit plan.  Each employee contributing to the 401(k) plan has their own account, and the money that they contribute (plus any money that the employer adds as matching contributions) goes directly into this account.   The money that the employee has contributed to the plan is their money, although there may be restrictions or penalties that limit when the employee can take that money out of the account.  However, there may also be a company-imposed vesting schedule, which means that there may be a waiting period before which the company contribution becomes the employee’s money.


This money in these 401(k) accounts does not simply sit there, but is instead invested in various financial securities in the hope that the account will grow in value over time.  The employer generally hires an outside firm to manage the accounts, but most 401(k) plans allow the employee to select from a number of different investment options such as stock or bond mutual funds, money market investments, stable value accounts, even an option to buy company stock.  Which option you pick will depend on the level of risk you are willing to tolerate.  Sometimes the investment choices with a 401(k) can be limited, and your ability to switch your investments to different options may be limited as well (for example, some plans only let you make changes once every three months or so).  However, a few 401(k) plans use professionals hired by the employer to direct and manage their employees' investments, and the employees have little or no choice in what types of things their money is invested in. 


Unlike a defined-benefit pension plan, a 401(k) plan is not dependent on the financial health of the employer.  If the employer becomes financially stressed, declares bankruptcy, or even bellies-up and fires all its workers, the money in the employee’s 401(k) plan is still there.  However, a 401(k) plan is dependent on the health of the economy as a whole.  Employees with 401(k) plans face the risks of market fluctuations, and if the stock market tanks their 401(k) plans could go up in smoke even if their employer is perfectly sound.  In the economic downturn of 2008-2009, a lot of employees discovered to their shock that the amount of money in their 401(k) plans had declined rapidly, with their retirement nest egg having essentially disappeared.  However, some people (like me) who are extremely risk-adverse can opt for more conservative investment strategies such as guaranteed interest funds or money markets.  Their 401(k) will grow much more slowly, but they won’t lose everything if the stock market tanks.


The great utility of a 401(k) plan is the ability of the employee to save considerably on income taxes.  With a 401(k), the money is automatically taken out of your paycheck and put into your retirement plan, thereby reducing the taxable income that is reported on your W-2 form.  Since the employee is paying taxes only on the amount of their salary that is not contributed to the plan, the amount of taxes withheld is reduced.  Any money contributed by the employer in matching funds is also added to the account tax-free. While the money stays in the plan, earnings accrue on a tax-deferred basis.  Taxes on the money contributed by the employee to the plan (as well as taxes on the employer’s contribution and taxes on any income accrued from the investments) will of course eventually have to be paid, but this is usually done only when the employee begins withdrawing money from the account, probably after retirement at a time when their total income is lower.  In any case, it is always better to defer tax payments due to the time value of money.


Some 401(k) plans allow participants also to contribute after-tax money to the plan.  In such a case, the income tax would already been paid on this money before it was contributed.  When this money is taken out of the account upon retirement or at some later time, no additional income tax needs to be paid on it, because the tax has already been paid.  Whether it is financially advantageous to do this or not will depend on what one expects one’s tax bracket to be in the future—if one anticipates that they will be in a higher tax bracket in the future when it comes time to take out the money, it might be wise to pay the tax now rather than later.


There is a limit on the amount of pre-tax money that an employee can contribute to their 401(k).   Caps placed by the plan and/or IRS regulations usually limit the percentage of your salary that you can contribute to your 401(k) account on a tax-deferred basis.   For year 2009, if you are under 50 years old, you can contribute as much money as your employer’s plan allows or $16,500, whichever is smaller.  For example, if your employer’s 401(k) plan allows you to contribute up to 10% of your salary and you earn $50,000, your contribution limit is only $5000, not the $16,500 IRS-imposed contribution limit which would apply only to higher-paid employees.  If you over 50 and your employer allows it, you can make an additional catch-up contribution of as much as $5500 in a year, helping those people who got a late start on saving for their retirement.  This brings the maximum 401(k) contribution limit to $22,000 for those over 50.  The matching contributions made by your employer are not counted toward your 401(k) contribution limits, although an employer usually limits their contribution to a certain percentage of an employee’s pre-tax contribution.   These numbers generally change every year. 


You are allowed to have more than one 401(k) plan, as might be the case if you have more than one employer.  However, the  maximum contribution limits described above apply to all of the 401(k) plans in which you participate—if you have two 401(k) plans, you can’t contribute $16,500 of pre-tax money to one of the plans and then turn around and contribute $16,500 of pre-tax money to the other one.


If your plan allows you to contribute after-tax money to your 401(k),  when after-tax contributions are added to the pre-tax contributions, there is an overall limit on the total amount that can go into your 401(k) account each year—for 2009, it was $49,000 or 100 percent of your salary, whichever is less.   These contribution limits change annually to track inflation.


You do not necessarily have to wait until you actually retire before you start drawing money from your company’s 401(k) plan, but you generally cannot withdraw any money from your 401(k) until you reach age 59 ½.  If you do so, you will have to immediately pay the income tax on it, plus a 10% early withdrawal penalty to the IRS.   This is known as a premature distribution, and is almost always a bad idea.  However, there are some exceptions under which the IRS will waive the 10% penalty for certain “hardship” withdrawals.  These include the purchase of a first home, the occurrence of a sudden disability, medical expenses, higher education expenses, and payments made to prevent eviction or foreclosure.   However, any after-tax contributions made to the 401(k) are considered fully accessible at any time to the employee, since taxes have already been paid on that money, and you would not have to pay any early-withdrawal penalty on that money.


Rather than directly withdrawing money from a 401(k), many 401(k) plans allow employees to take out loans from their 401(k), to be repaid with after-tax funds at pre-defined interest rates.  If you really need the money, it might be a better idea to take out a loan on your 401(k) rather than to take a premature distribution and pay a penalty.  You will need to pay interest on the loan, but you are actually paying the interest to yourself since the interest proceeds then become part of your 401(k) balance.  The loan itself is not considered as being taxable income nor is it subject to an early-withdrawal penalty. However, if you don’t repay the loan on your account within a set period of time, the loan will be treated as a withdrawal, meaning that you will owe income taxes and perhaps a 10% penalty.


When an employee leaves a job (either by retirement, by layoff, by quitting, or by moving to another company), their 401(k) account remains in place and generally stays active for the rest of his or her life.  It may well happen that the original employer’s 401(k) plan is particularly strong, and it may be a good idea for the former employee simply to leave it there, but the old company may discourage you from keeping your 401(k) there because of the administrative costs, plus you will no longer be able to contribute money to it or receive company matching funds. 


Alternatively, if the employee takes a new job at a company that also offers a 401(k), the employee can transfer the account into the new 401(k) hosted by the new employer, but the employee should check with the new company to see if they will allow such a transfer. Alternatively, when the employee leaves the company, the account can be transferred into an Individual Retirement Account (IRA) at an independent financial institution.  Such transfers are known as rollovers.  All of these options will let you avoid having to pay any taxes on the money that is transferred, they will let your money continue to grow tax-deferred, plus you won’t incur any early-withdrawal penalty.  These rollovers must be done very carefully, lest you end up having to pay income tax on all the money in the account plus the 10 percent early-withdrawal penalty.  You should probably have an experienced financial consultant work out the details for you, lest you screw up the paperwork or miss an important step in the process and end up getting burned.


Most employers will not allow you to rollover your 401(k) to somewhere else while you are still employed with them.  Most 401(k) plans don’t allow partial rollovers—you must usually transfer all of your money out of your 401(k) when you do the rollover, although the money can be transferred into different accounts. 


After you turn 70 ½, the government requires that you must take minimum withdrawals from your 401(k), which means that you can’t simply leave the money in there growing.   You have to start taking it out, and start paying the income taxes on it.   The idea behind the required minimum distribution is that the tax code gave you the opportunity to defer income taxes on the money you put in this account over your working career, but now the government wants its tax money.  Your age and your account balance will determine the amount of money that you are required to withdraw.  For example, someone 70 years old with $100,000 in his or her 401(k) would be required to withdraw at least $3650 in 2009.  Generally, if you fail to take the required minimum distribution, the IRS will assess a 50% penalty on the amount not taken out.  However the Worker, Retiree, and Employer Recovery Act of 2008 grants a one-year suspension of the required minimum distribution in 2009.  Alternatively, you could take the distribution and immediately roll it over into an IRA. 

401(k) plans are very popular with employees because they provide automatic savings and earnings that accumulate without the employee having to remember to make deposits.  In addition, they often offer “free” money from the employer in terms of matching contributions.  They also offer the possibility of an employee to have a lower taxable income during their working years, thus saving money on income taxes.

401(k) plans are also very popular with employers.  These plans are generally cheaper for employers to maintain than are defined-benefit pension plans.  Instead of having to make pension contributions, the employer only has to pay plan administration and support costs if they elect not to match employee contributions, or if they choose only to make profit-sharing contributions.  In good years with strong profits, employers can make matching or profit sharing contributions, or they can reduce or eliminate them in poor years.  In addition some or all of the plan administrative costs can be passed along to plan participants.  Consequently, 401(k) plans create easily predictable costs for the employer, whereas defined-benefit plans can impose variable and unpredictable costs on the employer.  Because of these factors, many employers have in recent years eliminated their defined-benefit retirement plans altogether in favor of the adoption of 401(k) defined-contribution plans.

The primary disadvantage in 401(k) plans from the vantage of the employee is that economic risks are transferred from the employer to the individual employee.  This is yet another reason why employers like them so much.  In the economic downturn of 2008-2009, many employees discovered to their horror that the value of their 401(k) plans had sharply dropped, frustrating their dreams of a comfortable retirement.  In the worst event, investments in the 401(k) plan could completely tank and all the money invested in the plan by both the participant and the company could quickly disappear.  Such a danger is especially acute if the investment options are not diversified, or if the company has strongly encouraged its workers to invest the money in their plans exclusively in their company’s stock.   If an employee invests their 401(k) money largely in their company’s stock, not only do they lose their job when the company goes bust, they lose their pension as well.

Roth 401(k)

A Roth 401(k) (named for the late Senator William Roth of Delaware) is an employer-sponsored investment savings account that is funded exclusively by after-tax money, which means that the taxes have already been paid on the money before it is deposited in the account.  Upon withdrawal the employee will not have to pay any further tax on this money.  After the investor reaches age 59 ½, withdrawals of any money from the account (including any investment gains) are tax-free.   This makes the Roth 401(k) different from the traditional 401(k) plan, which is funded with pretax money.   Although you don’t get an upfront tax-deduction when you initially contribute to your Roth 401(k) account, the account grows tax-free and withdrawals taken during retirement are not subject to income tax, provided that you are at least 59 ½ years old and you have held the account for five years or more.  The Roth 401(k) is well-suited to younger workers who are currently in a lower tax bracket but think that they will probably be in a higher tax bracket when they retire, so it is best for them to pay income taxes now rather than later.

There is no adjusted gross income limit on a Roth 401(k), such as that which applies to a Roth IRA (to be described later).  So long as an employer offers this feature, all eligible plan participants can contribute to a Roth 401(k)   The Roth 401(k) has no income limitation on those who want to participate.  Anyone, no matter what his or her income, is allowed to invest up to the contribution limit into the plan.  The Roth 401(k) can offer advantages to high-income individuals who are ineligible to contribute to a Roth IRA because they earn too much.

The contribution limits for a Roth 401(k) are exactly the same as those for a regular 401(k).   An employee’s combined elective contributions—whether to a traditional 401(k), a Roth 401(k), or to both cannot exceed $16,500 for tax year 2009 if the participant is under 50 years of age.  If the employee is over 50, they can contribute an additional $5500 in “catch-up” money.   These limits apply to contributions to both types of 401(k) plans, which means that you can’t stash $16,500 in a regular 401(k) and then turn around and stick an additional $16,500 in a Roth 401(k).  In eligible plans, employees can elect to have their contribution allocated as either a pre-tax contribution or as an after-tax Roth 401(k) contribution, or some combination of the two.  

Employers are permitted to match contributions to a designated Roth account, but the matching funds must be contributed on a pre-tax basis, they must not be made into the designated Roth account, and they cannot receive the Roth tax treatment.  This money has to go into a separate account that is taxed as ordinary income upon withdrawal.  It is a major bookkeeping hassle to keep these two accounts separate from each other.

The early withdrawal rules for the Roth 401(k) are the same as those for the traditional 401(k).  You will have to pay a ten percent premature distribution penalty if you withdraw any money from your Roth 401(k) before age 59 1/2.  And you may get hit with an income tax bill as well, even though all of your contributions were after-tax.   If you take a nonqualified distribution from a Roth 401(k), the part of that distribution that represents earnings on investments will be taxable.   However, unlike the traditional 401(k), the Roth 401(k) is not subject to the minimum distribution requirement at age 70 ½.    You can leave your money in there to grow tax-free for as long as you like.  This makes the Roth 401(k) a handy estate-planning tool for some families.

It is the employer’s option as to whether the company will provide access to a Roth 401(k) in addition to the traditional 401(k).  Many employers may feel that the added administrative burden will outweigh the benefits of the Roth 401(k), and adoption of Roth 401(k) plans has been relatively slow because of additional administrative, record keeping, and payroll processing costs.

Which is better, a regular 401(k) or a Roth 401(k)?  This will depend on your age and on your tax status, either currently or in the future.  If you are currently fairly young and are not earning a high salary, it might be a better idea to put your money in a Roth, since you are currently in a low tax bracket and you can avoid paying taxes when you start drawing the money out at retirement, when you might very well be in a higher tax bracket.  On the other hand, if you are now in a high tax bracket, a regular 401(k) might be a more attractive option, since it offers an immediate tax break and it might help you save money if you expect to be in a lower tax bracket when you start to make withdrawals. 

If you leave your job, or if you retire, you can either leave your Roth 401(k) as it is, or else you can roll it over  into a Roth IRA held by an independent agency without incurring any early withdrawal penalty or suffering any tax consequences.

403(b) Retirement Plan

A 403(b) plan, sometimes known as a tax-sheltered annuity (TSA), is a retirement plan for certain employees of public schools, tax-exempt nonprofit organizations, and certain religious institutions.  Individual accounts can be an annuity contract provided through an insurance company, a custodial account that is invested in mutual funds, or a retirement income account set up for church employees.  The features of the 403(b) plan are quite similar to those of the 401(k) plan. The contributions are deducted from the employee’s income on a pre-tax basis and all dividends, interest, and capital gains accumulate in the fund on a tax-deferred basis.  This means that the contributions and related benefits are not taxed until the employee withdraws them from the plan.  Generally, the annuity can be carried with the participant when they change employers or they retire.

The annual employee contribution limits are the same as those for the traditional 401(k).   Some 403(b) plans may also include designated Roth contributions—after-tax contributions that permit tax-free withdrawals.   The money in the 403(b) accounts can be invested in fixed annuities which guarantee that a minimum amount of interest will be earned, in an equity-index annuity that has a payout that varies based on an equity index such as the S&P 500 Composite Stock Price Index, or in a variable annuity which invests in mutual funds and has a variable payout based on how well the investments perform.

Individual Retirement Account (IRA)

An individual retirement account (IRA) is a retirement plan that works much the same way as a 401(k) works, but the difference between an IRA and a 401(k) is that an IRA is a private investment plan funded solely by your own money, while a 401(k) is offered through your place of work and involves your contributions and often contributions from your employer.  Your employer has nothing to do with your IRA account.   The IRA was first introduced by Congress in 1978. 

An IRA can only be funded by cash or cash equivalents.  An attempt to transfer any other type of asset into an IRA is prohibited and will disqualify the fund from any of its beneficial tax treatments. 

There are several different types of IRAs—the Traditional IRA, the Roth IRA, the SEP IRA, the SIMPLE IRA, and the Self-Directed IRA.    There are two other subtypes, named Rollover IRA and Conduit IRA, but these are considered as being obsolete under current tax laws.

Traditional IRA

First, the Traditional IRA.  Almost anyone is eligible to open a Traditional IRA.  Since the IRA is not connected with your job in any way, you can open a traditional IRA if you are still working full-time, if you are already retired, if you are working only part-time, or even if you are out of work.  If you are younger than age 70 ½ for the entire tax year, and you have taxable compensation, you are eligible to establish and make an annual tax-year contribution to a traditional IRA, even if you already participated in certain government plans, a tax-sheltered annuity, or a qualified pension or profit-sharing plan established by an employer.  You are even allowed to contribute to an IRA even if you already have a 401(k) at your place of work, and you can have both types of accounts at the same time.

Traditional IRAs are held by custodians such as commercial banks and retail brokers. Once money is inside an IRA, the IRA owner can direct the custodian to use the cash to purchase most types of assets, although most IRA custodians limit available investments to traditional brokerage accounts such as stocks, bonds, or mutual funds.  Assets, such as real estate come with heavy restrictions from the IRS, and may be taxed differently.   Real estate cannot be held in an IRA if the owner benefits from the property in any way—they cannot use it or live in it.  The only way that real estate could be held in an IRA is if it were held indirectly via a security.  In addition, things like collectibles (such as coins or stamps) or life insurance cannot be held in an IRA. 

In a Traditional IRA, individual taxpayers are allowed to contribute as much as 100% of their compensation, up to a specified maximum dollar amount to their account. For years 2008 and 2009 the maximum dollar amount for someone under the age of 50 was $5000.   For people over the age of 50, the limit is $6000, but higher annual contribution limits may apply to them if their IRA has been only recently created or if it has been under-funded in previous tax years.  These are known as catch-up contributions.  You can have as many IRA accounts as you please, but the contribution limits apply to the sum of the amount of money that you can put in all your accounts—you can’t put $5000 in each of them. 

Contributions to the Traditional IRA may be tax-deductible, but this will depend on the taxpayer's income, tax-filing status and other factors such as whether the taxpayer is already a participant in an employer-sponsored retirement plan. In most cases, when you contribute money to an IRA, you simply declare the amount of the contribution on your Form 1040 and the corresponding amount is subtracted from your taxable income.  However, if you have a 401(k) or other retirement plan at work, your IRA contribution is fully deductible only if your adjusted gross income is less than $85,000 for married filing jointly or $53,000 for an individual or $10,000 for a married person filing separately.  Consequently, the amount of your IRA contribution that is tax-deductible can be a rather complicated matter--you may be eligible for the maximum deduction, a partial deduction, or no deduction at all, depending on your income and your tax status.  Even if you are not eligible for a deductible IRA contribution, you still may make nondeductible contributions to your IRA.

At one time, there were restrictions on what types of funds could be rolled into an IRA and what type of plans IRA funds could be rolled into.  However, most of these restrictions have now been relaxed, and most retirement plans can be rolled into an IRA after meeting certain criteria, and most retirement plans can accept funds from an IRA. 

All transactions within the IRA have no tax impact, since you don’t start paying income taxes until you start drawing money out of the IRA.  At any time after you reach age 59 ½, you can begin to withdraw money from your IRA, even if you are still working full-time in your job.  These withdrawals are known as receiving distributions.  When you start receiving distributions from your traditional IRA, the money withdrawn is treated as ordinary income and may be subject to federal income tax as well as state taxes

The rules for a premature distribution from an IRA are much the same as those from a 401(k).  If you are younger than age 59 ½ and do not meet any of the exceptions, you must pay the income tax on the money taken out and must also pay a 10 percent penalty tax for a premature distribution.  So making an early withdrawal from your IRA is almost always a bad idea.  However, the portion of a distribution attributable to nondeductible contributions or rollovers of after-tax assets is not taxable when withdrawn nor is it subject to the 10 percent penalty.  In addition, there are several exceptions to the 10 percent early withdrawal penalty rule.  These include money withdrawn from the IRA to pay for unreimbursed medical expenses in excess of 7.5 percent of your adjusted gross income, the payment of health insurance premiums if you have been receiving unemployment compensation for at least 12 weeks, disability, money distributed to beneficiaries of a deceased IRA owner, the buying of a new home, and higher education expenses 

As in the case of a 401(k), distributions are required to come out of the Traditional IRA account by the time the owner reaches age 70 ½, or severe tax penalties will apply.  If you do not take the minimum distribution as required, there will be a 50% excise tax on the amount not distributed as required.  The amount of the required minimum distribution that you need to withdraw from your IRA depends on how much money you have saved in the account and your life expectancy, according to a complex set of tables published by the IRS.  In addition, you can no longer make contributions to your Traditional IRA after you turn 70 ½.

A major difference between an employer-sponsored 401(k) and a private IRA is in how loans from it are handled.  You can borrow money from a 401(k) without penalty (so long as you pay it back), but IRS rules say that you can’t borrow money from your IRA.   Such a transaction disqualifies the IRA from special tax treatment.  An IRA can borrow money, but any such loan must be secured solely by assets in the IRA itself and cannot be personally guaranteed by the owner of the IRA.   Also, the owner of an IRA may not pledge the IRA as security against a debt.   Income from debt-financed property in an IRA may generate unrelated business taxable income in the IRA.

When you die, your named beneficiaries will receive the entire proceeds of your IRA.  The beneficiaries will not be subject to the 10 percent premature-distribution penalty tax.  Distributions to the beneficiaries are made in accordance with the required minimum distribution rules and the IRA agreement.

A debtor in a bankruptcy can exempt his or her IRA from the bankruptcy state.  Many states have laws that prohibit judgments from lawsuits being satisfied by the seizure of IRA assets.  However, this protection does not apply in the case of divorce, failure to pay taxes, deeds of trust, or fraud.

Roth IRA

A Roth IRA (named for the late Senator William Roth of Delaware) is an individual retirement plan that bears many similarities to the traditional IRA, but with a different tax treatment. It bears much the same relationship to a traditional IRA as a Roth 401(k) does to a traditional 401(k).  It was first established in 1997.   

Like the traditional IRA, the Roth IRA is an individual retirement plan and is not related in any way to your employer.  In a Roth IRA, contributions are made with after-tax assets, and qualified distributions are tax-free.  You have already paid taxes on the money you put into the Roth IRA, and in return for receiving no up-front tax break, your money grows tax free, and when you withdraw it upon retirement, you pay no taxes.

Unlike Roth 401(k) plans, Roth IRA contributions are limited by income level.  In general, high-income people are not allowed to contribute to Roth IRAs.  For year 2009, for unmarried filers, the amount of money you are allowed to contribute begins to phase out at $105,000 and is completely eliminated when an income of $120,000 is reached.  For joint filers, the contribution limit is eliminated as joint income moves from $166,000 to $176,000.  You can contribute to a Roth IRA if your income falls below these limits, although you are allowed a prorated contribution if your income falls within the “phase-out” range.  If your income exceeds the range, you will not be allowed to contribute any money to a Roth IRA.   These limits change every year based on cost-of-living adjustments.

In addition, the amounts of income that can be invested in a Roth IRA are significantly more limited than those that can be invested in either a traditional 401(k) or a Roth 401(k).   For 2009, individuals are limited to contributing no more than $5000 to a Roth IRA, if under age 50, or $6000 if age 50 or older.  In addition, an individual 50 years of age or older is allowed to make catch-up contributions of $1000 each year.  You can have both a Traditional IRA and a Roth IRA, but the contribution limits described above apply to both types, including a combination of the two.

You can usually take money out of your Roth IRA any time you want, but you have to be careful how you do it, lest you get stuck with a 10% penalty.  Only “qualified distributions” can be taken out without penalty.  A qualified distribution is one that is taken at least five years after the taxpayer establishes his or her first Roth IRA and when he or she is at least age 59 ½.   There are some exception to the penalty such as if the Roth IRA holder becomes disabled, is using the withdrawal to purchase a first home (limit $10,000), or dies (in which case the beneficiary collects).  However, the basis in a Roth IRA can be withdrawn before age 59 ½ without any penalty (since the tax has already been paid on it), and there would be a penalty only on any growth.   For example, suppose your Roth IRA has $100,000 in it, $50,000 of which are contributions and $50,000 of which are investment earnings.  If you withdraw $60,000, the IRS will consider $50,000 of that to be contributions and $10,000 to be earnings.  So any early withdrawal penalty would apply only to the $10,000.

Are there any taxes on the earnings made by the investments in your Roth IRA?  The answer is no, provided you take the earnings as part of a qualified distribution.  You pay no taxes on any earnings that your contributions have generated.  However, distributions of earnings taken for any reason other than a qualified reason are subject to both taxes and perhaps a 10 % premature-distribution penalty tax.

Unlike a conventional IRA, the Roth IRA has no mandatory withdrawal requirements.  The owner of a Roth IRA is not required to take minimum distributions when they reach age 70 ½, and they can leave your money in there as long as they please.  While you can no longer make contributions to a traditional IRA after you have turned 70 ½, you can keep contributing to a Roth IRA regardless of your age.  Since qualified distributions from a Roth IRA are always tax-free, some argue that a Roth IRA may be more advantageous than a Traditional IRA.

Single or joint income tax filers may convert assets from a traditional IRA into a Roth IRA, but the distribution is subject to income tax when the transfer occurs.  However, there is no 10% premature distribution penalty if the holder of the traditional IRA is under age 59 ½.   In addition, eligible assets from an employer pension plan may be directly rolled over to a Roth IRA.  The taxable portion of the direct rollover amount is subject to federal income tax.  Up until 2009, in order to do these conversions, single or joint income tax filers had to have a modified adjusted gross income of less than $100,000, and married individuals who filed separate returns were not eligible to convert.  However, these limitations no longer apply for tax years beginning in 2010.

If you converted money from a traditional IRA into a Roth IRA, you cannot take it out penalty-free until at least 5 years after the conversion.

Which should you choose—a traditional IRA or a Roth IRA?  This will depend on your tax status.  A traditional deductible IRA is appropriate if you expect to be in a lower income tax bracket when you retire.  By deducting your contributions now, you lower your current tax bill.  When you retire and start withdrawing money, you will be in a lower tax bracket and will pay less tax.  However, if you expect to be in the same or higher tax bracket when you retire, you may instead want to consider contributing to a Roth IRA, which allows you to pay your taxes now.


A SEP (Simplified Employee Pension) IRA is a plan that allows an employer (typically a small business) or a self-employed individual to make retirement plan contributions into a Traditional IRA established in the employee’s name, instead of into a pension fund account in the company’s name.  In addition, a self-employed individual could set up a SEP IRA to fund their own retirement.  Employees of the business cannot contribute—the employer does.  Like a traditional IRA, the money in a SEP IRA is not taxable until withdrawal. 

One of the key advantages of a SEP IRA over a traditional or Roth IRA is the elevated contribution limit—for 2010 business owners can contribute up to 25% of  their employee’s income (up to a maximum considered compensation of $245,000) or $49,000, whichever is less.  For an employee, the income is established by the Form W-2 wages from the employer, but for a self-employed person, the compensation is his or her earned income.    These limits adjust each year for cost-of-living changes.

Under IRS rules, the employer must contribute a uniform percentage of compensation for each eligible employee, but not all employees must necessarily be eligible.  A SEP plan can exclude employees who are younger than 21 years of age, and they can exclude employees who have not worked in at least 3 of the immediately preceding five years.  In addition the SEP plan can exclude employees who have learned less than $550 during 2009 (subject to annual COLA adjustments, and they exclude nonresident aliens receiving no US-source income from an employer, as well as employees covered under a collective bargaining agreement if retirement benefits were a subject of the negotiation.

The employer’s contributions to the SEP IRAs of their employees are deductible as a business expense.  A self-employed person would claim his or her personal SEP plan contribution as an adjustment to gross income on his or her personal income tax return.

Once the SEP contribution has been made, each employee’s account is subject to all the traditional IRA rules, including limits on premature withdrawals before age 59 ½ and required minimum distributions after age 70 ½.

SEP IRAs are appealing to small business owners because they are easy and inexpensive to set up and contributions are tax deductible.  In addition, the employer is not required to contribute to the plan every year.  If the business has a bad year, it could choose not to contribute to the plan, but if the business has a good year, it could fund the plan with a larger contribution than would be ordinarily expected.


A SIMPLE (standing for Savings Incentive Match Plan for Employees of Small Employers) IRA is a simplified employee pension plan that allows both employer and employee contributions similar to a 401(k) plan but with lower contribution limits and simpler (and thus less costly) administration.  Unlike SEP IRAs, SIMPLE IRAs permit employees to make contributions to the plan on a tax-deferred basis. 

In order to offer a SIMPLE IRA plan, the business must have 100 or fewer employees, and must not have any other type of retirement plan.  An employee can contribute to a SIMPLE IRA up to an annual limit of $10,500 for 2008, but if the employee is 50 or over, they can also make an additional $2500 catch-up contribution.  The employer is required to make a contribution on the employee’s behalf—either a dollar-for-dollar match of up to 3% of salary or a flat 2% of pay—regardless of whether the employee contributes to the account.  However, the company could lower the matching contribution to 1% or 2% of total compensation in any two out of 5 years that the plan is effect.  In the other three years, the company must make either a 3% match or the 2% flat contribution.  The contribution limits for a SIMPLE IRA are much lower than those for a SEP IRA ($11,500 for the SIMPLE in 2010 versus a maximum of $49,000 for the SEP).  The catch-up limit (age 50 and older) is $14,000.  Employers are generally required to match each employee’s salary reduction contributions, on a dollar-for-dollar basis, up to three percent of the employee’s compensation.

Self-Directed IRA

A Self-Directed IRA is an IRA that permits the account holder to make investments on behalf of the retirement plan.  IRS regulations require that either a qualified trustee, or custodian hold the IRA assets on behalf of the IRA owner.  Such accounts are typically not limited to a select group of asset types, and most self-directed IRA custodians will permit their clients to engage in investments in most if not all of the IRS permitted investment types.  You can even add real estate to your Self-Directed IRA.

Keogh Retirement Plan

A Keogh plan (named for the late Congressman Eugene Keogh from New York) is a tax-deferred pension plan originally established in 1962 that is available to self-employed individuals or unincorporated businesses.  A self-employed person can establish and make tax-deductible contributions to a Keogh plan, even if they also work as an employee for a company and are covered by their employer’s tax-qualified retirement plan.  A Keogh plan enables its participants to attain benefits roughly equal to those under corporate pension plans.

The annual contribution limit to a Keogh is much higher than that for an IRA--you can contribute as much as 25 percent of your income to a Keogh plan, up to an annual limit of $49,000 (as of 2009).  Keogh plans can invest in the same sorts of securities as 401(k) plans and IRAs.   Keogh plan types include money-purchase plans (used by high-income earners), defined-benefit plans (which have high annual minimums) and profit-sharing plans (which offer annual flexibility based on profits). 

Keogh plans serve as tax shelters, since you receive a tax deduction on the money you contribute to the plan.  In addition, you don’t pay any tax on the plan’s earnings until you start drawing money from the account.  At that point, the payments are treated as ordinary income and are subject to tax. 

A Keogh retirement plan can be set up as either a defined-benefit or a defined-contribution plan, although most Keogh plans are defined-contribution.  Retirement benefits received from a defined-contribution Keogh plan are based on the contributions made to the plan and the accumulated interest and gains.  Under a defined-benefit Keogh plan, the benefits received are based on a formula, and the tax-deductible contributions are adjusted to provide the required benefit.

As with other qualified retirement accounts, Keogh plans let your investment earnings grow tax-deferred until you withdraw them.  Like other qualified plans, the money in a Keogh plan can be accessed as early as age 59 ½ and withdrawals must begin by age 70 ½.   There are tax penalties for early withdrawal. 

Keogh plans have more administrative burdens and higher upkeep costs than Simplified Employee Pension plans, but the contribution limits are higher.  Many other tax rules apply, the paperwork involved in setting up the plan is complex, and you should probably seek the help of a qualified professional investment counselor before you try to establish a tax-deductible Keogh plan.

Recently, the IRS has become suspicious of Keogh plans and is auditing them more frequently.  As many as 1/3 of them are found to be noncompliant.  If your Keogh plan is noncompliant, none of your contributions are tax-deductible, you will owe back taxes, and may have to pay interest and penalties.

Cash Balance Pension Plans


There are also hybrid plans, that have aspects of both defined-contribution and defined-benefit plans.  An example is a cash-balance plan, which is technically a defined-benefit plan but with individual accounts maintained for each employee that grow at a specified rate, usually based on pay levels and interest credits. There is no money actually in these individual accounts—they are simply accounting devices used to figure out how much money the employee is entitled to when they retire.  These accounts are often referred to as hypothetical or virtual accounts because they do not reflect actual contributions to an account or actual gains and losses allocatable to the account.  In a typical cash-balance plan, a participant’s account is credited each year with a pay credit (such as 5 percent of compensation) and an interest credit (either a fixed rate or a variable rate that is linked to an index such as the one-year T-bill rate).  These credits may vary according to the employee’s age, service, or earnings


In actuality, the cash balance benefit plan is funded by the employer on the basis of an annual actuarial valuation, just like all other defined-benefit plans, and the money in the plan is invested in various financial assets.  However, increases and decreases in the value of the plan’s investments do not directly affect the benefit amount promised to participants.  Thus, the investment risks and rewards on plan assets are borne solely by the employer.   The employee plays no role in the management of the pension money. 


The promised benefit for each employee is defined in terms of a stated balance in his or her individual virtual account, and when the participant become eligible to receive benefits, the benefits received are defined in terms of the account balance.  Benefits are defined as a lump sum (the cash balance) of a covered employee’s account rather than as a periodic payment to be received during retirement.  The employee knows the cash value of the plan at any time, and when the employee starts receiving benefits, the amount of the payout is based on the value of their account at the time of retirement.  Upon payout, the money is subject to income tax, just as any other sort of defined-benefit pension plan


Many cash balance plans offer the vested participants the option to receive the accrued benefits in lump sums--traditional defined-benefit pension plans usually do not offer this feature.  The benefits in most cash balance plans are fully protected by the Pension Benefit Guaranty Corporation.


Cash balance plans are the most attractive for young people who are doing a lot of job-hopping, because unlike most other company defined-benefit pensions they are portable--if you leave the company before retirement you could take the contents of your cash balance plan as a lump sum and roll it into an IRA.  However, if you work for a single company for a long time, the total amount you will get from a traditional defined-benefit pension plan is typically larger than what would get from a cash-balance plan.  This is because the formula for a traditional pension gives heavier weight to your average salary over the last few years of employment, whereas a cash balance plan gives equal weight to every year’s salary.


An employer is allowed to convert their traditional defined-benefit pension plan to a cash-balance plan, and many have done exactly that.  Alarmed at the prospect of rapidly-growing pension obligations, many employers have converted their existing defined-benefit pensions into cash-balance plans.  The reason was to save money, since cash-balance plans typically result in smaller payouts to long-term employees.  This spurred a flood of age-bias lawsuits by employees nearing retirement who were suddenly faced with lower pension payouts.  The 2006 Pension Protection Act added some protection when it prevented employers doing the switchover from reducing an employee’s benefits below what they were entitled to before the conversion.


Pension Benefit Guaranty Corporation


The Pension Benefit Guaranty Corporation (PBGC) is a nonprofit corporation, functioning under the jurisdiction of the Department of Labor, which guarantees the payment of certain benefits to the participants (employees, former employees, as well as retirees) in private-sector defined-benefit pension plans that have been terminated because of a company’s bankruptcy or because of insufficient money being on hand to pay benefits.  This federal corporation was established by Title IV of the Employee Retirement Income Security Act (ERISA) of 1974. 


Almost all defined-benefits pension plans are required under federal law to purchase pension insurance from the PBGC.  The only exceptions are defined-benefits pension plans offered by professional service employers such as groups of doctors, lawyers, engineers, or architects with fewer than 26 employees, plans offered by church groups that have elected not to be covered by federal pension regulations, or plans offered by federal, state or local governments.  Certain plans covering only top executives or those plans in which all the participants are substantial owners of the business are also not insured.  So, most traditional private defined-benefits pension plans are protected by the PBGC, but not all of them.  You should check with your local benefits experts to determine whether or not your particular employer’s defined-benefits pension program is insured by the PBGC.


The PBGC guarantees the pension benefits only of defined-benefit plans, not the benefits provided by defined-contribution plans such as profit-sharing or 401(k) plans.   So if your company’s 401(k) plan tanks, you are out of luck.  The PBGC does not guarantee company-provided retiree health insurance payments, nor does it guarantee welfare payments.  It does not guarantee vacation pay or severance benefits.  It will not guarantee any lump-sum death benefits for a death that occurs after the date the plan ended, nor will it guarantee disability benefits for a disability that occurs after the plan’s termination date.


The PBGC covers both single-employer and multiple-employer plans.  A multiple-employer pension plan is one that is collectively bargained between employers and one or more unions and which covers two or more unrelated employers, usually in a single industry such as trucking or construction.  ERISA specifies that the PBGC must run separate programs for single- and multi-employer plans, with no cross-subsidy or borrowing between the two types.  However, the single-employer program is much larger than the multiple-employer one.


The PBGC is not funded by tax dollars—it is much like a private insurance company in that it is funded by premiums collected from defined-benefit plan sponsors, by assets from defined-benefit plans for which it serves as trustee after having taken them over due to insolvency, by recoveries in bankruptcy from former plan sponsors, as well as by earnings from invested assets.   The insurance premium is usually a fixed, flat rate per plan participant, although pension plans deemed to be “at-risk” may have to pay higher premiums. 


If a single-employer defined-benefit pension plan terminates without enough money to pay all benefits, the PBGC will take over the plan and will pay the pension benefits through its insurance program.  In such an event, most participants and beneficiaries will receive all the pension benefits that they would have ordinarily received under their previous plan.  The PBGC guarantees “basic benefits” that were earned before a plan is terminated, including pension benefits at normal retirement age, most early retirement benefits, annuity benefits for survivors of plan participants, and disability payments for a disability that occurred before the date the plan terminated.


However, the PBGC guarantees pension benefits only up to certain maximum limits. The maximum guaranteed benefit is currently $4500 per month, or $54,000 per year, payable in the form of a straight life annuity, for a 65-year old person in a plan that terminates in 2009.  The cap is lower for someone who retires before age 65.  For people whose plans end in 2009 but who start receiving benefits at ages earlier than 65, the cap on benefits is reduced for each year they begin receiving benefits before age 65—7 percent per year for the first five years and 4 percent for the next five years.  For example, if you are 55 when you retire, your benefit could be reduced to $2025 a month or $24,300 a year.  This is true even if you retired with a special “subsidized” early retirement benefit.  The maximum benefit may also be reduced if the pension also includes benefits provided to a survivor of a plan participant.  For a beneficiary who is already retired, the age used to determine the maximum amount guaranteed is the age of the participant as of the date of the plan’s termination.  However, if the PBGC is able to recover enough assets during a plan termination, annuitants whose plan entitled them to benefits above the cap might be able to collect more than the maximum guarantee.  The retirees most likely to be hurt by the existence of the cap are those who are older and who have served the longest.  These workers would also be less able to recover from a job loss.  Despite these limitations, over 90 percent of participants receive the full benefits that they entitled to prior to plan termination.


However, the PBGC does not guarantee benefits for which you did not have a vested right when the plan terminated—for example in situations when you have not worked long enough for the company to be entitled to the benefits.  It does not guarantee benefits for which you have not met all age, service, or other requirements at the time the plan terminates.   Early retirement payments that are greater than payments at normal retirement age may not be guaranteed.  For example, a supplemental benefit that stops when you become Social Security eligible may not be guaranteed.  In addition, health insurance, life insurance, or death benefits are not guaranteed. 


Company changes to a pension plan that increased the benefits but that were made within 5 years of the plan’s termination are not fully guaranteed by the PBGC.  Generally, the largest of 20 percent or $20 per month of the increased benefits is guaranteed for each full year that the increased benefits were in effect.  In addition, benefits paid by PBGC are not adjusted for inflation, even if the original plan called for such increases (few defined-benefit plans provide for such increases in any case)


There are some fears that a whole bunch of companies trying to save a little money will simply abandon their defined-benefit pension plans and dump them all onto the PBGC, resulting in a massive government-sponsored bailout of the private pension system.  However, it isn’t quite that simple for a company to ditch its defined-benefit pension plan, and there are some protections against abuses. 


If an employer decides that they want to eliminate their defined-benefit pension plan, this will be allowed only if they can show the PBGC that their plan currently has enough money to pay all benefits owed to the participants.  This is known as a standard termination.  In the event of a standard termination, the plan sponsor will either purchase an annuity from an insurance company that will pay lifetime benefits when the company’s employees retire and that will also continue to cover those employees who have already retired.  Alternatively, they could issue one lump-sum payments that cover the entire set of benefits, both for the current employees and for the retirees.  Plan participants must be provided with a written “notice of intent to terminate” at least 60 days prior to the pension termination date.  The PBGC will make sure that the plan really does have enough money to meet its obligations, and then will approve the termination.  Once the pension plan has been converted into an annuity, the PBGC will not guarantee the fund any further—if the insurance company that handles your pension annuity goes belly-up, you might be out of luck. 


If the company finds that it does not have enough money to meet its pension obligations to its retirees, the employer may apply for a “distress termination”.  A distress termination will be approved by the PBGC only if the employer is in imminent financial danger--the employer must be able to prove to a bankruptcy court or to the PBGC itself that the employer cannot remain in business unless the plan is terminated.  If the application is approved, the PBGC will take over the plan as trustee, will assume all the assets and liabilities of the plan, and will pay benefits, up to the legal limits, using plan assets and PBGC guarantee funds.


Under certain circumstances, the PBGC can take action on its own to end a pension plan.  This is known as an “involuntary termination”.  Most such terminations occur when the PBGC determines that plan termination is needed to protect the interests of plan participants or of the PBGC insurance program.


There is the possibility that a plan sponsor could choose to “freeze” their plan by ceasing to credit new pension benefits to its employees for additional service.  A freeze is not a termination—the plan continues under the normal funding and other rules but employees earn fewer or no additional pension benefits.


With defined-benefit pension plans going belly-up at increasing frequency, there is a danger that the PBGC itself could become insolvent.  Many company pension plans are deeply underfunded, and companies obligated to remedy the underfunding can, and in a number of cases do, declare bankruptcy instead, turning their plans over to the PBGC.  A sudden increase in such bankruptcies could place severe stress on the PBGC.  The PBGC is currently running a deficit of about 23 billion dollars, and this deficit could get much worse if the level of bankruptcies gets even more severe.  PBGC liabilities are not explicitly backed by the full faith and credit of the federal government, and such a disaster would probably require a massive federal bailout of the PBGC, lest a lot of pensioners find themselves out on the street.;


Here is a link to a guide for senior citizens moving. available at


Here is a link to an article on the importance of home inspections for seniors looking to age in place

                        importance of home inspections for seniors looking to age in place


Here is a link to a guide highlighting everything you need to know about the different types of beneficiaries, frequently asked questions about the process, and tips for choosing one


                        Guide to beneficiaries


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