This edition we will cover the two defined contribution investment retirement plans available to you as a State Employee. Maryland offers two plans to employees of the State Police, the IRC 457(b) Deferred Compensation Plan and the IRC 401(k) plan. They are so named by the section number of the Internal Revenue Code where they are defined. Surprisingly, you can fully participate in both, but we’ll cover that later.
Also surprising is that there are quite of few MSP employees who are not participating in either. I was lucky enough in 1979 to be hired as a Cadet and one of the first things we were told at our orientation was to sign up for Deferred Comp. That, and get a haircut!
The Sergeant who did our orientation at the Truck Weight Enforcement Division headquarters, or TWED as it was called then, didn’t offer much in the way of explanation other than we should sign up and start out with at least $25 per pay. He merely said we would be glad later on that we did and to this day I still consider it the single most important tip I ever got as a cadet.
This really is a no-brainer. If you’re not in Deferred Comp pick up the phone right now and call Flo Johnson at Human Resources (410) 653-4342 and ask her to send you an application. Start out with the 457(b) and put in what you think you can afford to be without from your paycheck—even if it’s just $25 a pay.
Worrying about the stock market or you heard that “Joe lost a lot on money in his Deferred Comp” are not valid reasons to not save for your retirement years. Making money on your investments is not guaranteed (I think we are all painfully aware of that) but what is guaranteed is that at some point in your future, either voluntarily or involuntarily, you will not be earning a regular bi-weekly pay-check. And what you save now while you are working will go a long way toward helping you enjoy the time when you are not.
Now that we have that out of the way, we can move on to the differences between the two plans; the 457(b) and 401(k).
First, I believe the best plan to start with is the 457(b) for the simple reason that you have liquidity from that account the day you leave the Department. With the 457(b) you are allowed to take money out as soon as you leave employment without paying a 10% penalty regardless of how old you are. You will still owe income taxes on any withdrawals, but unlike the 401(k) you can get the money before you’re 59.5 years old without paying an additional 10% penalty for early withdrawal.
That in a nutshell is the only major difference between the two plans. In the 401(k) you cannot get the money before age 59.5 without paying the 10% penalty; in the 457(b) you can.
In both plans all the money is invested pre-tax and any money earned is not taxed until you take it out. So if you’re currently in the 25% income-tax bracket it really only costs you about 75 cents in current pay for every dollar you save. Additionally, if you someday move to State with no State income taxes like Florida or a State that does not tax retirement accounts like Pennsylvania you avoid the opportunity to pay Maryland’s State income taxes which can be as high as 6%.
Let’s say this year you had a great year for income, congratulations. Maybe you worked a bunch of overtime or found some awesome secondary employment, or perhaps you’re lucky enough to have a spouse who made some good money; you could be in the Federal 28%, 33%, or even this year’s highest income tax bracket of 35%. You might want to defer paying income tax on money at say 35% this year and wait until you’re retired and pay it at (hopefully) a lower rate, maybe something like the 15% rate. You just beat the system in that you deferred paying taxes at 35% and instead you’re paying at 15%. On a $10,000 investment that translates to a savings of $2,000 just in taxes alone—not counting anything you might have made on the investment.
Now, for those of you who were really fortunate enough to make outstanding income this year one thing you definitely want to do is stow some away for later, even if it is just so you don’t spend it all now on stupid stuff. A quirky little clause added to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) makes it possible to double-up and put money in both plans—the 457(b) and the 401(k). These are the only defined contribution plans that allow this.
The limit for contributions for folks under 50 years of age for 2011 is $16,500. By joining both plans you can actually save a total of $33,000 tax-deferred in 2011. And if you are over 50 the IRS allows a catch-up of an additional $11,000 for a grand total of $44,000 in tax deferred savings. Of course only the lucky few will be able to afford that kind of income deferrals but if you are one of them you should really consider the opportunity.
Again, no matter how much you save in these plans you will eventually be taxed but by strategically timing withdrawals (when you’re old enough) you have some control of when, where, and at what rate that occurs and that can save you some big money.
As previously mentioned, once you leave the State you can access funds in the 457(b). Depending on your circumstances this is usually not a good idea since many of us leave to take on other jobs and you don’t want to pile-up the income all in one tax-year. But the flexibility of the 457(b) usually means you should keep that money in that account with the current provider. You could roll-it-over to your personal IRA but you then lose that ability and you will then pay a 10% penalty if you take it out too early.
In most cases however, the 401(k) should be rolled over to your personal IRA. The withdrawal rules between the two are about the same, i.e., older than 59.5 years-of-age or pay a penalty. The personal IRA gives you virtually unlimited investment options and more companies to manage your money.
Now stop procrastinating and start to take control of your financial future.
Correction to the last edition: Congratulations to Jimmy Dulay who found a math error in my last article, “Small Change in the Drop.” Turns out the change I wrote about was smaller than I calculated. In the example of a $3,000 per month DROP payment for four years calculated at 4% interest compounded annually compared to 6% compounded monthly—the difference is only $9,421 at 4% compared to 6% not the reported $18,293. Thanks Jimmy. MK
This material is provided for general information only and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness.
Marty Knight, MBA, CFP® is a retired Captain from the Maryland State Police and is currently a Financial Advisor with Chesapeake Investment Advisors Inc. Securities and Advisory services are offered through Geneos Wealth Management, Inc. Member FINRA/SIPC. He can be reached at 800-994-0221