Welcome back. In the next two videos we'll be talking about pension plans. In this video we'll be talking about their tax advantages and the options that are available. So first of all, what is a pension plan? Pension plan supplements an employees retirement income I did that by contributing funds into a special retirement fund. And then these funds had to have tax advantages compared to just simply setting money aside, putting it in a brokerage account and letting it accumulate. So let's start out with taxes. So first of all, let's look at a graph where we have our income on our y axis, and then we're looking at our working years versus our retirement years. So first of all, so we're working and we're earning some income. And then the first few dollars that we make are subject to relatively low taxes. And so this is good for us, that means we get to keep the money that we have make. However, in the United States as in many places there's a progressive tax system that means that each marginal dollar after you've already earned a lot of money is taxed at a higher rate. And so what happens in this higher tax region? Well after you've been taxed at the lower rate, you'll be then taxed at these higher rate tiers and those additional dollars will be partially taxed. And that will true as you work throughout your working life. And indeed these taxes can add up over time. So here's what pension plans do. So pension plans are a way of deferring some of those taxes until your retirement years when you're at lower brackets. And that's important because when you're retired, your income will be relatively low. And so in other words, we have our marginal income in our working years, which is taxed at a relatively high rate. And then what we're doing is through our pension plans we're deferring some of that income until that time when we're taxed at a lower rate. And here's the other big advantage of pension plans and taxes, that additional growth, the capital gains also is not taxed or rather is taxed as ordinary income. And again when you're retired, your earning income is going to be relatively low, which means it will be taxed at a relatively low rate. And so in other words pension plans are a tax advantage because they defer taxes into your retirement years when your marginal rates are relatively low. And also the capital gains grow tax free. And so let's look at the different types of pension plans that are available. Well, first of all there are the traditional plans that is defined benefit plans and defined contribution plans. And then for smaller employers and for the self employed, you have a couple more options that are available to you. So a defined benefit plan is simply a plan that defines the pension's benefit to the employees. A defined contribution plan is a plan that defines how much employees put in or their contributions to the plan. Let's start off with that defined benefit plans. More specifically, defined benefit plans are pension plans in which the employer promises specified monthly benefit or annuity according to formula. And that formula will typically increase with the years of service and earnings. Defined contribution plan like a 401k in contrast is a pension plan which the employer and or the employee makes a contributions into an employee's personal retirement account. So let's look at how the money works for a defined benefit plan. So we have some organization, that organization for its employees is going to contribute funds into a defined benefit pension fund. You can think about this fund as being a large pool of money that's going to fund all of the companies promises to its employees. And then when these employees retire they're going to be able to take a little bit of money out of the defined benefit pension fund consistent with their years of service and their earnings. So let's look at one example here. So first of all, we have Sarah. Sarah is an enrollee in the defined benefit plan. And the defined benefit plan specifies that every year after retirement that fund is going to pay Sarah 1% of her last year's salary for each year that she served. And so supposed that Sarah's last year salary was $100,000, and she served a total of 30 years within the organization. Or in other words this is going to provide 1% for every year of service, or one thousand dollars for every year that she served multiplied by 30 years would translate to a $30,000 annuity this will be taxed as earned income. One thing you can notice about defined benefit plans is that they really reward employees who stick around the organization. Why is that the case? Well because the defined benefit plan in this case would pay 7% of their last year's salary and so if they stick around the organization for a long time, they get last year's salary will be the salary at the end of their career when they're earning a relatively large amount. Let's look at Jake's, just giving another example. So Jake's defined benefit plan works a little bit differently for every year after retirement. The defined benefit will pay $800 per year of service. Jake served 20 years and so you multiply $800 times the 20 years to arrive at a $16,000 annuity. And again, this annuity will be taxed as ordinary earned income. And again, since after that Jake is going to be retired, that marginal tax rate will be relatively low. So that's how defined benefit plans work. Again, there's a kind of a big pool of money that the organization contributes to in order to fund these pension defined benefit obligations. Another alternative is so called defined contribution plans. In defined contribution plan employees and the employer contribute some amount into an employee's fund, and that gives employees a little bit more transparency. They can see how much money is in the fund, and perhaps gives the employees a better sense of how it's growing. Over the years we've seen a very large shift from defined benefit plans into defined contribution plans. And for a variety of reasons, one is that they provide some sense to the employee of how much money they've set aside, they can actually see their contributions. So let's take an example of Amy. So Amy's defined contribution plan. Amy and her employer both contribute 3% of her salary into a 401k. This could be done through a match or Amy might be required to contribute 3%. And then the salary's deducted on a pre-tax basis and it will grow without capital gains. And then when Amy retires, disbursements will be taxed, again, as earned income. Let's look at an example from Blair. so Blair here contributes 2% into her 401k. And then Alex can elect to contribute some additional amount. This salary will be deducted again as a pre-tax basis, and it'll grow without capital gains. And when she retires, those earnings will be taxed as an earned income. So those are defined benefit and defined contribution plans. There's also some options available to smaller employers. Such as a payroll deduction IRA a so called SEP or simplified employee pension and a simple IRA. So a few ways that they're similar so these are all similar that they're very easy to set up and the contributions are immediately vested and available. And also there tend to be tax penalties for early withdrawal. Some of the ways that they vary in terms of maximum number of employees before the employer is eligible to use these options. They also vary in terms of how they're set up, they vary in terms of whether the employee or employer contributes. And they also defer in terms of which employees must be included and which employees must be eligible if you do offer this sort of a plan. And so rather than going through all of the differences, we can note that there's a lot of online resources that make setting up one of these three plans very easy, so you can figure out which one works best for you. And one of the best practices again, is to save early. That is early career contributions to pension funds enjoy exponential growth. And even better, this growth isn't subject to capital gains tax. And so, if you contribute early and contribute often then that sort of a strategy will ultimately yield a lot much larger pension fund than one in which you contribute relatively late in your career. And so next up we'll talk about different options for and different things you can look for when you're shopping for pension plan providers. Thanks and I'll see you next time.
