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What the heck is a Keogh?

When I was a young whippersnapper doing my taxes back when I spent more money than I saved, the idea of planning for taxes was as absurd as planning for retirement. Like my vague notion of ‘net worth,’ the various letters and numbers for tax-advantaged retirement plans and programs were like reading Cyrillic — Keogh, 401(k), Roth, Xлеб, SEP. 

I miss the simpler days of filling out the 1040EZ form with my #2 pencil. Every April, I had a small glimmer of my fleeting income as I transferred information from my slim W2. Again and again, I thought to myself — where did it all go?

Single. Marginally employed. Living with my parents. My cash flow was pretty simple. Easy come. EZ go. 

Later, when I was married and navigating Turbo Tax on my Macintosh clone computer (Google it), I blithely skipped past the question, “Did you make any retirement contributions this year?” But those same arcane letters and numbers were still there.

What did it all mean? If you are confused too, don’t be embarrassed. Retirement investing is WAY TOO COMPLICATED. If it wasn’t, there would be no need for FIRE Me!

Let me try to clear a few things up. I realize that financial and economic stuff is complicated and BORING. But in order to plan for your financial independence, you have to understand what tax-advantaged investments and defined benefit plans are, why they are part of our modern retirement landscape, and how they are essential to your four-legged educator retirement plan.

What does ABBA have to do with tax-advantaged investments?

Friday night and the lights are low
Looking out for a place to go
Where they play the right music, getting in the swing
You come to look for a king

I will happily acknowledge that in addition to selling women’s shoes in my early years, I went to junior high school in the late 70’s when disco ruled the radio airwaves.

To this day, I thank my foxy classmate (initials DL) who dragged me from the sidelines onto the dance floor. On that sweaty autumn Friday night in the Shumway Junior High School cafeteria, clad in San Francisco Riding Gear jeans, she took me by the hand to dance, dance, dance. I never stopped dancing. I will forever be grateful to you DL. You were my first dancing queen.

So let’s return to the question posed by my header — what does ABBA have to do with tax-advantaged investments? To use a favorite phrase of the late 70s, I’ve got a far out idea

Since a lot of the changes to tax-advantaged investments and retirement planning went down around the same time that Evelyn ‘Champagne’ King, and The Bee Gees ruled the airwaves, let’s cue up some disco and go back in time. 

I give you the FIRE Me Tax-Advantaged Disco Playlist. I’m pretty sure that I’m the ONLY financial blogger to EVER mash up disco and defined contribution plans. And, yes, the titles of the songs are carefully curated for each topic below. And of course, I’ve pulled out some semi-relevant lyrics from each song.

The Hustle – Van McCoy

Do it!
Do it!
Do it!

(The Hustle didn’t really have many lyrics.)

In the mid-1970’s, retirement savings were defined by two pillars — pensions and Social Security. While some Americans additionally invested in stocks or other savings accounts, there was no widely-available means for investing for retirement outside of these two systems. Workers (including teachers and other educators) would put in their time building years of service and when they qualified for retirement (usually at age 65), they would begin collecting benefits. According to the U.S. Department of Labor, 27.2 million adults had a pension in 1975. 

Pensions and Social Security are defined benefit plans which means that you and/or your employer contribute to these programs and when you qualify for and begin retirement, you receive a defined benefit in the form of a monthly check for the rest of your life. This post is not really about these plans. For that, see my posts about pensions.

But to understand how we got to where we are today, it’s helpful to know how retirement planning changed almost overnight from one based on pensions to defined contribution plans which is what this post will introduce you to.

As an educator, defined contribution plans should be part of your planning for financial independence and retirement. So let’s keep the disco hits rolling and learn a little more about these retirement investments, how they came to be, and what you need to know to get started.

Shame – Evelyn ‘Champagne’ King

You got me so confused, it’s a shame
Sometimes I think I’m going insane

In the late 1970’s, the Federal government began implementing changes to the IRS tax code that created a new set of retirement program guidelines. In 1978, the 401(k) was born. As Wikipedia clearly explains, 

“In the United States, a 401(k) plan is an employer-sponsored, defined-contribution, personal pension (savings) account, as defined in subsection 401(k) of the U.S. Internal Revenue Code.[1] Periodic employee contributions come directly out of their paychecks, and may be matched by the employer. This legal option is what makes 401(k) plans attractive to employees, and many employers offer this option to their (full-time) workers. 401(k) payable is a general ledger account that contains the amount of 401(k) plan pension payments that an employer has an obligation to remit to a pension plan administrator. This account is classified as a payroll liability, since the amount owed should be paid within one year.”

In what has been described as an ‘accident,’ the 401(k) was never intended to replace pensions, but they were quickly embraced. Not by workers, but by companies who wanted out of the pension business.

Tragedy – The Bee Gees

When you lose control and you got no soul
It’s tragedy
When the morning cries and you don’t know why
It’s hard to bear
With no one beside you, you’re goin’ nowhere

Concurrent with the emergence of the 401(k), corporations and organizations which previously offered pensions began shifting the responsibility and risk for retirement saving onto working adults. Unlike defined benefit plans (pensions and Social Security) which offered defined lifetime benefits for retirees, the 401(k) and its brethren were defined contribution plans.

According to Monique Morrissey of the Economic Policy Institute,

“…we went from a system where the employer in the private sector paid for the entire pension and took on all the risk to a system where the worker in the private sector took on most of the cost and all of the risk,” said Morrissey.”

As corporations and other organizations dismantled or stopped funding traditional pensions, like an invasive weed, the 401(k) and defined contribution plans took their place, suddenly dominating the retirement landscape. 

“401(k) and other defined-contribution plans like it quickly replaced traditional pension plans. From 1980 through 2008, participants in pension plans fell from 38% to 20% of the U.S. workforce, while employees covered by defined-contribution plans jumped from 8% to 31%, according to the Bureau of Labor Statistics….Within a decade, the majority of workers overall were in a 401(k) rather than a traditional pension,” said Morrissey.”

She Works Hard for the Money – Donna Summer

Already knows
She’s seen her bad times
Already knows
These are the good times

401(k) and similar programs were/are promoted as a means to save taxes because contributions to these plans allowed taxpayers to deduct qualified contributions when filing their annual 1040s. But this retirement hustle overlooks some important caveats:

• Before the 401(k), workers with a pension received tax-free contributions toward their retirement, often paid all or in-part by their employer, and
• Risk and responsibility for making and managing contributions fell on the employer or the pension program, and
• Taxes on 401(k) accounts were only deferred until retirement when both contributions and earnings are taxed as regular income. 

For the vast majority of American adults, this tragedy is now the norm for their retirement planning. But for (most) teachers and educators there is some good news.

First, you probably have a pension which many non-educators don’t have. This old school (both literally and figuratively) retirement benefit may be a throwback to the disco era, but it’s still solid gold. Dig it.

Second, while most educators do not have access to a 401(k) through their educational employer, there are other programs such as the 403(b) and 457(b) which are unique to education and non-profit organizations. We’ll cover both of these later in this post.

Before we get there, I’m going to add one more wrinkle. 

That’s the Way (I Like It) – K.C. and the Sunshine Band

That’s the way, aha, aha
I like it, aha, aha
That’s the way, aha, aha
I like it, aha, aha

Tax-advantaged retirement accounts do provide savers with choice — some type of tax relief either now or in the future. While most teachers and educators are familiar with tax-deferred accounts like the 403(b), they may not be aware of the 457(b) or understand or appreciate why a tax-exempt Roth account can support financial independence and retirement. Read on!

Don’t Stop Til You Get Enough – Michael Jackson 

Lovely is the feelin’ now
Fever, temperatures risin’ now
Power (oh power) is the force, the vow
That makes it happen, it asks no questions why (ooh)

The 401(k) and its half-cousin, the 403(b) offer retirement savers tax-deferral. In other words, you enjoy tax savings now and the IRS will tax you later. If you choose to contribute to these kinds of accounts, your payroll department usually deducts your elected contribution from your paycheck and sends it off to an approved brokerage or retirement account.

At the end of the year when you do your taxes, your W-2 will show a larger ‘Social Security wages’ in Box 3 than your taxable income in Box 1. The IRS gives you a pass today, but will collect its due when you take money out of the account in the future. For educators, this is the most familiar type of defined contribution retirement investment and still dominates the PK-12 retirement landscape.

I’m So Excited – The Pointer Sisters

I’m so excited, and I just can’t hide it
I’m about to lose control and I think I like it

In 1998, Congress authorized the Roth IRA which allows adults to contribute to their retirement investments with after-tax dollars. So instead of getting a tax break in the year when you file your taxes, you invest money that has already been taxed into a Roth IRA. Money in Roth investments grows tax free over time AND when you take the money out in the future, both your contributions and any earnings are tax free. 

While the Roth is often called tax-exempt, you have, in fact, actually already paid taxes on the money you contribute to the account. It would be more accurate to say that money in a Roth account is future tax-exempt. Of course, there are some strings attached, but the Roth provides savers with a choice in their retirement planning and saving. 

For educators, the Roth has, up until recently, been hiding in the shadows. While you have been able to contribute to a Roth IRA on your own as an individual, it is not commonly part of educator retirement programs offered by employers or state retirement agencies. However, in my home state of Washington, some changes are underway which will make investing in Roth accounts easier for educators.

Personally, I love the Roth. Had I caught a clue earlier in my career, I would have started piling money into Roth investments long ago. Look for more information about Roths in future posts.

Take That to the Bank – Shalamar

Open your account to me
‘Cause I’ll give you security, my love
Take that to the bank
My interest is strong

When I began investing in my retirement, there were far fewer options for teachers than today. As a newbie investor, I was thick as a brick. And because I had few deductions (still renting) and wanted to get the tax savings NOW, I paid little attention to this newfangled thing called the Roth. Why would anyone pass up on saving on their taxes now in exchange for saving taxes when they’re old(er)? Show me the refund, baby!

Fast forward to today when I am old(er). Thanks to the quantity, frequency, and efficiency of saving over the last 30-some years, my investments are far larger than they were when I put my first dollars into the overly expensive 403(b) variable annuity account. When I turn 59 1/2, I can begin taking money out of these accounts if I want to or need to. 

And when I do, I will pay income tax not only on what I contributed, but all the earnings that these investments have made over time. When I calculate the potential future value of these tax-deferred investments when I’m in my 70s, I see balances larger than I ever thought possible when I was young. On one hand, I’ll be rich(er). On the other hand, I will pay a LOT of taxes. Especially since I will also be receiving monthly pension and Social Security checks too.

As you think about investing for your own financial independence and retirement, there is no ‘right’ answer as to whether tax-deferred or future tax-exempt is the best choice. This is why reading and learning more about both kinds of investments are essential to your financial intelligence. 

Ain’t No Stopping Us Now – McFadden and Whitehead

Ain’t no stoppin’ us now
We’re on the move
Ain’t no stoppin’ us now
We’ve got the groove

But there is a wrong answer. 

If you don’t take advantage of saving in tax-advantaged investments to complement your pension and Social Security, you will only have two legs on your retirement stool. That’s not financial independence, that’s just Bad Luck (Harold Melvin and the Blue Notes.)

Tax-advantaged investments are an essential third leg for your financial independence and for educators there are several options.

403(b) – a half-cousin of the 401(k), 403(b) plans offer tax-deferral for educators, often taking the form of elective deductions from your paycheck. In most cases, your district or educational agency will have a list of approved ‘vendors’ which offer 403(b) plans.

On your own, you research and select one or more of these investment plans, decide how much and how often you want to contribute to them, and then provide some paperwork to your payroll department. There are a range of 403(b) investment options from variable annuities to mutual funds. And as a tax-deferred retirement investment, you enjoy a tax benefit in the year in which you make the contribution, but will have to pay taxes in the future when you begin taking distributions from your investment. 

457(b) – deferred compensation programs are generally only available to employees of non-profit organizations (including public educators). Deferred compensation programs are usually operated by your state. While they are publicly-managed like pension systems, they are different in that they are defined contribution plans, not defined benefit plans. In Washington State, they are part of the same state retirement agency and offer investment options similar to those in the retirement portfolio.

Here’s what’s awesome about 457(b) programs. In most cases educators can triple dip retirement savings by contributing to a 457(b) plan, a 403(b) and/or their pension.

Defined contributions to pension – teachers and educators hired over the last few decades are likely part of pension plans which are hybrids that combine both defined benefit and defined contributions by the employee. Older plans for old(er) workers only had a pension (defined benefit) part. But to keep pensions operational, new plans or tiers have been created and most current educators are likely part of a hybrid plan.

If this applies to you, the defined contribution part of your pension is much like a 457(b). You can usually designate a certain percentage of your salary or amount to be deducted from your paycheck. Your state pension program should offer a small set of investment choices and you determine where you want your money to go. In Washington State, the investment choices for both the retirement program and 457(b) deferred compensation are the same. For more information about pensions, see my posts about pensions and defined benefit plans.

More, More, More – Andrea True Connection

More, more, more
How do you like it? How do you like it?
More, more, more

One of the reasons I created FIRE Me | Financial Intelligence for Educators is because the vast majority of retirement and investment sites, articles, and books are not written for educators and those who work in the public sector. One of the significant perks of being an public educator is the ability to invest in multiple defined contribution plans if desired.

For working adults, there are IRS annual limits to contributions to tax-advantaged defined contribution programs. But for most educators, there is an ability to supersize retirement contributions by investing in multiple tax-advantaged programs. In the section above, I describe 403(b), 457(b), and defined contribution pension options. As an educator, you are not limited to just one type of program. If you want, you can contribute to all of these. While you still have to pay attention to IRS limitations for each type, you can ‘stack’ these investments to sock away more than most non-educators. That’s what my wife and I did (once I realized what a 457(b) was!)

Finally, while most 403(b) and 457(b) programs are tax-deferred, Roth (tax-exempt) options are beginning to emerge. In other posts, I’ll explore all of these options in more detail. But for now, let’s spin one last song from the Queen of Disco herself….

Last Dance – Donna Summer

I need you by me
Beside me to guide me
To hold me, to scold me
‘Cause when I’m bad, I’m so, so bad

Tax-advantaged defined contribution plans and investments are an essential part of your educator retirement stool. Now that you know a little more, here are some next steps to build your financial intelligence and independence. 

You. Can. Do. This.

Now

1. Find out if your pension includes a defined contribution component and if and how much you are contributing to it.
2. From your payroll (or benefits) department, find out what options you have for 403(b) and/or 457(b) programs. It’s likely a list of companies and/or sales representatives. 
3. If you already have a 403(b) or 457(b) account, review your current contributions and how that money is being invested.

Next

1. Do some research on the defined contribution options you have as part of your pension or as separate investments in 403(b) or 457(b).
2. If you aren’t already investing in a 403(b) or 457(b) plan, get an enrollment form and get started. Most plans have no or low thresholds for making monthly or quarterly contributions.
3. If you are already investing in a 403(b) or 457(b) plan, consider increasing your contributions or adding a new plan.
4. While it’s not quite the same as winning the lottery, imagine what you’d do if you became an FIE (Financially Independent Educator).
5. If you haven’t already, calculate your net worth to begin assessing your state of financial independence.