Cops are lucky - we really are. Not only do we have the best jobs in the world, most of us get a nice retirement pension as well. In fact, some argue that we accept lower pay than our private sector friends do because we receive a pension. Most Americans do not qualify for pensions; therefore, they have to plan for their retirement using their own funds and Social Security. Frequently, officers get the opportunity to supplement their pensions as well, using the same programs.
What are the options?
First, let's look at the easiest one to dismiss from a planning standpoint: Social Security. For those that don't know, Social Security is a federal program that is funded by a 6.2% payroll tax levied on both the employee and the employer. There is another 1.45% tax levied on each for Medicare. Employees covered by a pension, such as police officers, do not have to pay Social Security, but they may have to pay for Medicare. If you work a side job, such as helping a friend with his lawn business, you are no longer considered a pension employee, and you pay Social Security.
Social Security should not be part of your retirement planning for two reasons. The first is because of the well-published reports of Social Security's pending collapse. While there are all sorts of ways to play with the number and make the program sound stable, here's the basic problem: Social Security takes in lots of money, but doesn't pay out as much it takes in. The government takes all that extra money and puts it in the Social Security Trust Fund, which then invests it by buying the safest investment available - US Treasury bills and notes. The government then gets the money to pay off the bills and notes that are due to others. So in short, the money is spent as fast as it comes in. This is the main cause for the $4 trillion (yes, trillion) difference between the "public debt" and the "gross debt" of the federal government. That's the "trust fund."
The second reason you should have little faith in Social Security being a big part of your retirement is that you won't qualify for what you earn. Congress passed a law creating a Windfall Elimination Provision, or WEP. It specifically says that because you receive a pension, they don't care how much you may have earned in your side job or may have paid into Social Security; your earned Social Security benefits will be reduced up to $300 per month just because you earned a pension. Yes, police, firefighting and teachers' unions are working to get the WEP repealed. However, there are two problems. First, any repeal costs Social Security more money and makes it even less financially stable since we would earn more in benefits. Second, just as the law was passed and could be repealed, it could be reinstated.
OK, Social Security is out
Yes, that is a very pessimistic view of Social Security. Viewing Social Security as a non-option for retirement is actually the best way for you to plan your retirement. See, if I am wrong, you will just have more money for retirement! If I am right, you will have made a plan that doesn't count on Social Security and you will have a comfortable retirement. Either way, you win!
Now that Social Security is out of the picture, let's examine the two programs offered most often by employers for self-funded retirement. They get their names from the sections of the tax code that established them: the 401K and the 457. Many officers refer to them generically as "deferred compensation." Both are outstanding methods for saving for your future, but there are slight differences between the two.
Both the 401K and the 457 are deferred compensation plans and this is how they work: You agree to have a portion of your paycheck diverted into your account. First, this lowers your taxable income, as the deposit is made prior to your income tax calculations. Second, that money is in your account and your account only. Unlike Social Security, it is not used to pay other people for their retirement, and it cannot be used to buy anything for the city (or state) where you work. Third, that money is invested on your behalf into some sort of fund (normally a mutual fund) that is designed to help that money grow (or appreciate) over time. The nice part is that you get to select which funds receive your money and that money grows tax-free.
The 457 plan is more common for governments, as the plan was created specifically for governments. Private companies offer 401K programs, and governments can be grandfathered to offer 401K accounts. As you might imagine, since they have different names, there are slight differences in what you can and cannot do with each account. It is common for private companies to offer matching contributions to 401K accounts; that is, if the employee contributes 5% of his salary, the employer will contribute another 5% (or whatever the amount). Governments are permitted to do this as well, though few do so. In my research, I could not find evidence that governments can match deposits to a 457 account. So, if your employer offers a match on the 401K but not the 457, you are probably better off with the 401K; it's free money added to your account!
You must begin withdrawing from either account by age 70 ½. That's not normally a problem in public safety, but that's the rule. You may withdraw from a 457 at age 50 ½; you must wait until 59 ½ to withdraw from a 401K. If you are planning to retire completely with full benefits at 55, you may want to lean towards the 457. With either account, if you pull funds out too early, you are hit with a 10% penalty and pay income tax on the money you pull out.
Both types of account can be accessed for hardship withdraws. For example, if your spouse becomes severely ill and you accumulate large medical bills, you can petition the IRS for a hardship withdraw. The key is that the event has to be unforeseeable. You can also take loans from a 401K, which you cannot do from a 457. I hate mentioning that, because taking a loan from your 401K is about the worst thing you can do for your retirement, but it is an option that is not available with a 457.
So they're the same; now what?
While the accounts are similar, there are small differences. To make the right choice, you need to ask some questions:
- Are the fees the same for each account? (Consider the less expensive one)
- Are the investment options similar for each account? (Choose the one with the investment options that meet your risk level)
- Is there a matching contribution? (Almost always go with matching - and contribute the maximum that will be matched)
- Will I retire before age 59 ½? (If so, lean towards a 457)
Conclusion
While the pension is great, you can help ensure your retirement is a happy and comfortable one by planning to supplement that income. Social Security has little security, so your best option is to plan on not receiving it, even if you qualify for benefits. Choosing a deferred compensation program, in the form of a 401K or 457, is your best bet for additional income on retirement. There are differences between the two types of plans, so be sure you analyze your needs and plans before you lock yourself into one of them.
