Retirement planning is a lot like putting a bunch of pieces together. Pension plans are one important piece to consider when you have different sources of income. Failing to factor in a pension into retirement savings, can lead to gaps in a retirement plan.
What Type of Pension Plan Do I Have?
A pension is a retirement plan provided by some employers. It gives you regular payments after you retire, based on your years of service and salary history. There are two main types of pensions: defined benefit and defined contribution.
Knowing which type you have is the first step to figuring out how to factor in a pension into your retirement savings.
You can get a defined benefit plan, which guarantees a set monthly payment when you retire. The amount depends on factors like how long you worked and your salary during that time.
Or you may get a defined contribution plan that works more like a 401k. You and your employer contribute money over time. Retirement income depends on how much you save and how your investments perform.
How Do I Calculate My Retirement Pension
To calculate retirement pension, you need to know a few key details. Start by checking your pension plan’s formula. You can also use an online retirement savings calculator with pension to make this process simpler. Just plug in your details, and it will give you an estimate of your retirement pension.
Defined Benefit Plans
The formula for defined benefit plans usually looks at:
- your salary
- how long you’ve worked
- a set percentage (often called the “multiplier”)
Here’s a simple way to calculate your retirement pension:
- Find your average salary over the last few years of work.
- Multiply it by the number of years you’ve worked for the company.
- Multiply the result by the plan’s percentage. If the plan offers 2%, multiply by 0.02.
Let's say you worked for 30 years and earned an average salary of $100,000. If your plan uses 1.5%, you’d get $45,000 per year in retirement ($100,000 x 30 x 0.015).
Defined Contribution Plans
If you have a defined contribution plan, you don't need a formula. The amount depends on how much you and your employer have contributed and how well your investments have grown.
This can make it harder for retirement planning as you won't be able to calculate it on your own. If you work with a financial advisor who specializes in retirement planning to help you with this.
How Pension Affects Your Retirement Savings Goals
Your pension is just one part of your overall retirement plan. It helps, but it likely won’t cover all your expenses. When you factor in a pension into retirement savings you also need to coordinate with other sources of income:
- 401k plans
- 403b plans
- Traditional IRAs
- Roth IRAs
- Annuities
- Social Security benefits
- Personal investments (e.g. stocks, bonds, rental income, etc.)
Social Security Benefits
Your pension may reduce the amount of Social Security you receive. This is especially true if you worked in a job that didn’t pay into the Social Security system. Reduction can happen through two provisions.
The Windfall Elimination Provision (WEP) affects those who receive a pension from a job that didn’t withhold Social Security taxes. It can reduce your Social Security benefits by up to a certain limit. Government Pension Offset (GPO) reduces Social Security spousal or survivor benefits if you also receive a pension from a job not covered by Social Security.
Taxes on Retirement Income
Pensions are usually considered taxable income. The amount you receive is subject to federal income tax, and possibly state taxes.
If your combined retirement income exceeds a certain limit, part of your Social Security benefits may be taxable. Also, think about your tax bracket. If you withdraw from tax-deferred accounts, you could push yourself into a higher tax bracket.
Lifestyle, Health Care Costs and Long-Term Care
Your pension likely won’t account for rising healthcare costs or long-term care. These are significant expenses in retirement. Even with a good pension, you’ll need more savings or insurance to cover these areas. you still need to save extra for things like healthcare, travel, and unexpected costs.
Common Mistakes to Avoid When Factoring in a Pension into Retirement Savings
When planning for retirement, it’s easy to make a few mistakes with your pension. Avoid these common ones when you factor in a pension into retirement savings:
- Don't rely only on your pension. Many just assume a pension and Social Security should cover everything. Your pension is helpful, but it may not be enough. Make sure you save extra through personal accounts.
- Don't forget about taxes. Many people forget that pension income is still taxable income. Be sure to account for that when calculating your retirement income. If you have multiple sources of income you will want to consider how each sources handles taxes.
- Don't ignore inflation and cost of living. Over time, inflation can reduce the value of your pension. The money you save, even if it grows, may not cover expenses. Consider how rising prices will impact your spending in retirement. Inflation is unpredictable and it's better to have more than you need.
- Don't ignore your pension plan’s rules. Some pensions have specific rules, like penalties for early retirement. If you face these penalties, it's great to work with a financial advisor to see how to work around them. In some cases, your savings can cushion the blow. In others, it could take a large chunk out of your pension.
Working Backwards
Your pension as one of several income streams. Adding your pension and Social Security together will give you a better idea of how much more you need to save on your own. You do this with a retirement calculator with pension, Social Security, and savings. This tool will give you a better idea of how to factor in a pension into retirement savings.
You should also create a plan of how you intend to spend your retirement. Working backwards (identifying your end goal) will help you determine where you should start. A retirement plan is best when it’s reverse-engineered with objectives in mind. You should make an estimate of how much you'll need to live the life you want. Let Asset Preservation help you put the pieces together.
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Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
A Roth conversion may not be suitable for your situation. The primary goal in converting retirement assets into a Roth IRA is to reduce the future tax liability on the distributions you take in retirement, or on the distributions of your beneficiaries. The information provided is to help you determine whether or not a Roth IRA conversion may be appropriate for your particular circumstances. Please review your retirement savings, tax, and legacy planning strategies with your legal/tax advisor to be sure a Roth IRA conversion fits into your planning strategies.
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