Ch5. Retirement Benefits — 401(k), Pension Plans, and Severance

Overview of Retirement Benefits

US retirement benefits framework:
Primary federal law: ERISA (Employee Retirement Income Security Act of 1974)
Tax authority: Internal Revenue Code (IRC)

Key decisions for employees:
① Does the employer offer a pension and/or 401(k)?
② What are the vesting requirements?
③ How much does the employer match?

No federal mandate requiring employers to offer retirement plans.
→ If a plan exists, ERISA governs its administration and fiduciary duties.

Plan eligibility:
Generally: age 21 + 1 year of service (1,000 hours)
Employer may set less restrictive eligibility criteria.

Benefit payout:
Generally available at age 59½ without early-withdrawal penalty
Required Minimum Distributions (RMDs) begin at age 73

Defined Benefit (DB) Plans — Traditional Pensions

Defined Benefit (DB) Plan:
- The retirement benefit is predetermined by a formula
- Typical formula: years of service × final average salary × benefit multiplier
  (e.g., 30 yrs × $80,000 × 1.5% = $36,000/year)

Investment responsibility: employer (plan sponsor)
Investment risk: employer bears it
Benefit security: guaranteed up to PBGC limits ($90,288/year in 2024)

PBGC (Pension Benefit Guaranty Corporation):
Federal insurer for private-sector DB plans
Pays benefits if the plan terminates underfunded

Best for: long-tenure employees who stay with one employer
Declining trend: most private employers have shifted away from DB plans

Defined Contribution (DC) Plans — 401(k), 403(b)

Defined Contribution (DC) Plan:
- The employer contribution is defined (not the benefit)
- Most common: 401(k) for private sector; 403(b) for nonprofits/schools

Employee contribution: pre-tax deferrals (traditional) or after-tax (Roth)
2024 deferral limit: $23,000 ($30,500 if age 50+)

Employer match:
Typical: 50–100% of employee deferrals up to 3–6% of salary
Match is NOT required but is common

Investment responsibility: employee chooses from menu of funds
Investment risk: employee bears it

Best for: employees who change jobs frequently (account is portable)
Vesting schedule:
- Immediate vesting (employer match is fully vested from day 1), OR
- Cliff vesting: 100% vested after 3 years, OR
- Graded vesting: 20% per year, fully vested at 6 years

DB vs. DC Comparison

┌──────────────────┬──────────────────┬──────────────────┐
│ Feature          │ Defined Benefit  │ Defined Contrib. │
├──────────────────┼──────────────────┼──────────────────┤
│ Benefit fixed?   │ Yes (at retire.) │ Contribution     │
│ Investment risk  │ Employer         │ Employee         │
│ Portability      │ Low              │ High (rollover)  │
│ Best for         │ Long tenure      │ Frequent movers  │
│ Salary increase  │ Favorable        │ Neutral          │
└──────────────────┴──────────────────┴──────────────────┘

IRA and Rollovers

IRA (Individual Retirement Account):
- Traditional IRA: pre-tax contributions; taxed on withdrawal
- Roth IRA: after-tax contributions; tax-free growth and withdrawal
- 2024 contribution limit: $7,000 ($8,000 if age 50+)
- Income limits apply to Roth IRA contributions

Rollover on job change:
Employees may roll over 401(k) balance to:
  → New employer's 401(k), OR
  → Traditional IRA (tax-free if direct rollover)

Tax benefits:
Traditional IRA/401(k): contributions reduce current taxable income
Roth accounts: no deduction now, but qualified withdrawals are tax-free
Penalty for early withdrawal (before 59½): 10% + ordinary income tax

Hardship Withdrawals and Loans

Hardship Withdrawal (if plan allows):
Permitted for immediate and heavy financial need:
① Medical expenses
② Purchase of primary residence
③ Tuition and educational fees
④ Preventing eviction or foreclosure
⑤ Funeral expenses

After withdrawal:
No repayment required; subject to income tax + 10% penalty (if under 59½)
No reset of contribution clock (unlike Korean mid-term settlement)

401(k) Loan:
Up to 50% of vested balance or $50,000 (whichever is less)
Must repay within 5 years (longer if for primary home)
Interest paid back to own account
Risk: if you leave employer, full repayment often due within 60–90 days

401(k) Formula ★★★★★ : Employee defers up to $23,000/year pre-tax. Employer may match. Investment growth is tax-deferred. Withdrawals taxed as ordinary income. Memory tip: 401(k) = tax-deferred savings with employer match

DB vs. DC — Who Bears the Risk ★★★★★ : DB = employer invests and guarantees the benefit (employer risk). DC = employee invests and outcome varies (employee risk). Memory tip: DB = company’s problem; DC = your problem

ERISA Vesting Rules ★★★★☆ : Employer match must vest within 3 years (cliff) or 6 years (graded). Your own contributions are always 100% vested immediately. Memory tip: your deferrals = always yours; employer match = check vesting schedule

Practice Quiz

Q. An employee with 3 years of service leaves a job where the employer uses a 3-year cliff vesting schedule. How much of the employer match does the employee keep?

100%. With cliff vesting, the employee becomes fully vested at the completion of 3 years of service. All accumulated employer matching contributions are retained.

Q. When is a DC plan better than a DB plan for an employee?

When the employee changes jobs frequently: DC account balances are portable and can be rolled over to a new employer’s plan or an IRA without loss. DB plans typically penalize early departure because the benefit formula rewards long tenure. DC plans are also preferable when investment returns are expected to be high, since the employee captures all the upside.