Retirement Step 3: Free Money
You've done your Foolish homework, and now you know how much you'll have to accumulate to retire and live comfortably. What now? The next Foolish step is to milk your employer for everything you can.
No, we don't mean that you should confiscate Post-its for home use, or try to create a black market for hole punchers. We're talking about retirement plans. Most midsize and large employers have a retirement plan in place for their employees. Many have two, and some three or more. These plans come in a wide variety of flavors, some good and some, uh, not so good. Still, all of them can help you achieve your retirement desires, as long as you understand them fully and integrate them into your planning.
The secret to no-cost cash
Remember that employee handbook you received on the day you were hired -- the drab document you tucked away under some papers next to the half-eaten Snickers bar? Dig it out, dust it off, and read it. Buried in those pages, you will find a summary plan description of the retirement plan(s) available to you as an employee. Those pages will tell you what kind of plan you have, when you become eligible to participate, and the ultimate benefit you will receive. Is it boring reading? Dreadfully so. But Fool, those pages could be full of free money.
What will that free money look like? It might be called a "defined benefit plan" or a "company pension" -- phrases used to describe one type of plan commonly offered by employers. In this vehicle, employers typically do all the funding, with no contributions by employees. The final benefit is determined by a formula, often based on years of service, an average wage, and a percentage of pay. For instance, the plan could say your final benefit will be a "joint and 50% annuity calculated as 1.5%, times your years of credited service, times the average of your last three years' base annual wage."
What does that mumbo-jumbo mean to you? To a Fool, it means that with 30 years of service, at retirement your pension will replace 45% of your average annual wage for the last three years of work. That means you can save less money each year between now and retirement, because your employer is relieving you of part of that burden. And that means more of your resources can be devoted to other, equally important goals, like maybe putting the kids through college.
Discover your options
The summary plan description will also tell you your options at retirement. You may be able to receive a lump-sum payment instead of a lifetime annuity. That way, if the plan's annuity payment has no automatic cost-of-living adjustment, you can invest the money elsewhere to achieve that growth. Maybe you can take an annuity that will give a surviving spouse more than half your benefit after you die -- something like two-thirds or 100% instead.
The summary plan description will also tell you how long you have to be on the job until the money is 100% yours (the vesting schedule); what happens if you leave your job before retirement; and what happens should you leave this world earlier than you anticipate. This is all valuable information, because it helps to refine the assumptions we must make in the calculation of our retirement needs.
Say your company offers a 401(k) plan. Take out your 401(k) summary plan description and look for:
- When you may participate.
- The types and perhaps the risks of the investment options you have within the plan.
- How often you may switch between those options.
- Whether early withdrawals for hardships or personal loans are permitted.
- What distribution options are available when you separate or retire.
- And finally -- get out a sparkler for this one -- how much your employer will contribute to the plan on your behalf, and when you will vest in those contributions. This is free money.
Absolutely, 100%, completely free
Why is it free? For one, your contributions to a 401(k) plan help reduce your tax bill, because they don't count against your taxable income for the year. (In short, you get to put tax-free money toward your retirement savings.) Of far more importance, though, is an employer's contribution on your behalf. While these contributions will vary from employer to employer, typically employers match your contribution with $0.50 on the dollar, up to 6% of your pay. That means that if you put in 6% of your paycheck, your employer will match that by contributing 3%. (That's 3% of your paycheck in free money.)
Fools jump at this opportunity. We know there is no risk-free, untaxed way to get an immediate 50% return on our money in any alternative investment we can make. Sure, most 401(k) plans use high-cost, mediocre-performing mutual funds as their investment of choice. Yet even there, the immediate return of 50% on our money in every year we contribute would take years to top in any other investment. Spurn this offer by an employer, and you're increasing your risk, hiking your tax bill, and leaving found money on the table. When it comes to 401(k) plans, you should follow our Foolish path by grabbing all the free money your employer offers. What better way to lessen your savings burden?
Again, if you want some guidance with your 401(k) plan, Rule Your Retirement can help. We provide asset allocation strategies you can use with a variety of investment options, including ones you'll find in your 401(k).
Now let's take a look at Step 4: choosing the right account.