Retirement Plan – A Three-Legged Stool


3LeggedStool_250A successful retirement plan has been compared to a three-legged stool: The government is one leg. Your employer is another leg. The third leg is you. Let's take a look at how the three legs work together.

1st Leg: Social Security

Social Security provides benefits for old age, survivors, and disability. Social Security benefits are funded by the payroll tax. Out of employee W-2 earnings, 6.25% is credited toward benefits. The employer match provides another 6.25%. The Social Security Act, passed in the 1930s, requires that employee and employer contributions be invested in U.S. Treasury bonds. Also, the fund is legally bound to be actuarially sound for 75 years. Over the years, Congress has deviated from the original statute.

Once contributions go into the U.S. Treasury, they are used to fund ongoing government operations. The Treasury issues a non-negotiable security to the Social Security Administration to keep track of the Treasury's obligation.

Social Security began as a pay-as-you-go plan. Retiree benefits were paid with current worker contributions. There were 15 workers supporting each retiree when Social Security began. Today, three workers support each retiree.

With an aging population, the number of workers supporting each retiree is expected to decline further. The solution to the challenges facing Social Security is beyond the scope of this writing. The important consideration is to evaluate the statement of benefits you receive each year and factor in possible future changes as part of your retirement planning.

There is a great deal of gloom and doom in regard to the future of Social Security. Be aware of the challenges that loom in the future, but don't let them become a cause of paralysis.

2nd Leg: Employer-Provided Retirement Plan

The second leg of successful retirement planning is your employer. The gold standard of retirement was the employer-sponsored pension. The employer paid the retiree a lifetime income, usually based on length of service. The pension benefit was defined to the retiree and carried on the employer’s books as a future obligation. Employers with successful pension plans made regular contributions to ensure the solvency of their pension plans.

The pension plan has been replaced by a plan regulated by IRS code 401k. A 401k plan receives an employee contribution and an employer match. The ultimate retirement benefit is unknown and depends on future investment earnings to increase the plan balance. Most 401k plans offer a variety of mutual funds that hopefully match an employee’s risk tolerance and retirement horizon. Investment returns could be excellent over one time period but then suffer during market downturns. Risk is borne by the employee. A 401k is an important component of a successful retirement but must be continually evaluated to maintain an acceptable balance of risk and reward. One piece of advice that applies universally: The employee should contribute a sufficient amount to his or her 401k to realize the maximum dollar match from the employer.

3rd Leg: Qualified/Unqualified Plans

The third and final leg in the successful retirement plan is you. You have several options: One set of options are known as qualified plans. Qualified plans include Individual Retirement Accounts (IRAs) and Simple Employee Pensions (SEPs). In a qualified plan, pre-tax dollars are put away.

The growth produced within the account grows tax-deferred; that is, gains are recognized but are not realized by you, so they are not taxed until withdrawn. Qualified plans have IRS rules for eligibility, annual limits, and withdrawals. Possibly, the biggest impact on your retirement is that all withdrawals from qualified plans are taxed as ordinary income. Therefore, after you pay any taxes on Social Security and your 401k distribution, you will pay tax on qualified plan withdrawals at your highest marginal rate.

Perhaps a better option is a non-qualified plan. You contribute after-tax dollars. Growth is not taxed until withdrawal.  However, you withdraw money only if you need it. There is no required minimum distribution. This is a powerful option. A non-qualified plan funded with an index annuity can give you some of Standard & Poor’s 500 growth without any downside risk. A non-qualified plan might also be funded with a life insurance contract. If the policy is structured properly, retirement income might be withdrawn as policy loans—which are tax free. There are some extremely important guidelines that must be followed to maintain tax-free status. However, a non-qualified retirement plan funded with an index universal life insurance contract can be a powerful third leg in the successful retirement.

Social Security is going to face challenges. The 401k and other market-dependent plans are subject to market loss. These are beyond your control. You own the third leg. Control what you can.