Understanding the pension system is essential for every professional, including teachers, to plan for retirement. Each paycheck you receive has some contribution towards your pension that you will receive after you retire. Let’s try to understand how a teacher’s pension works, including the factors that can influence the amount of pension you receive at the time of retirement.
What is a pension?
A pension is a fixed amount of money you receive periodically, usually each month, after your retirement for the rest of your life. There are two types of pension plans:
- Defined Benefit Plan
- Defined Contribution Plan
Defined Benefit Plan
In a defined benefit plan, your benefit is defined and according to a formula, and you are provided with a guaranteed benefit irrespective of the performance of the investments in your retirement account. The risk of the investments’ underperformance is borne by the employer due to which any shortfall in the employee’s pension benefits is compensated by the employer. To be eligible for the defined benefit plan, you must have to complete 10 years of service with your employer, which is called the vesting period.
Educators employed by the public schools in most states are covered by a defined benefit plan, which means teachers will get a fixed amount of money according to a formula each month after retirement for the rest of their lives. Some defined benefit plans provide survivor benefits as well which makes your beneficiary eligible for pension benefits if the beneficiary lives longer than you.
Defined Contribution Plan
In a defined contribution plan, you and your employer deposit a certain amount each month till your retirement into a retirement account where the amount earns interest and accumulates to become a sizable amount on your retirement. Most private schools and organizations offer defined contribution plans that serve as a pension for you at the time of retirement. So, if you are employed at a private educational institute, you are likely to get a defined contribution plan instead of a defined benefit plan.
The advantage of a defined contribution plan is that you can access your funds whenever you want irrespective of where you are employed and how long you are employed. However, the downside to a defined contribution plan is that the risk of a fall in investment value lies on you, and your retirement benefit will depend on the performance of your investment in your retirement account.
What will your pension payment be?
The amount of pension you will receive on your retirement depends on the following three factors:
1- Number of years of your service
Years of service is defined as the number of qualifying years you have worked for your employer within the pension plan.
2- Your final average paycheck
The final average salary means 5 or 3 highest annual salaries a teacher earned. You can estimate the amount of your annual salary each month by adding a certain percentage of increment to your salary. For example, if your salary increases 5% annually, you can calculate your annual salary for each year by increasing your salary by 5% each year, after which you can then easily calculate the average of the highest 3 or 5 annual salaries you earned. You will also have to account for the rate of inflation as the cost of living would have increased 25 to 30 years from now.
3- State’s pension multiplier
A pension multiplier is used to determine the percentage of the final average salary that will be paid to you as a retirement benefit. The pension multiplier typically used for calculating the percentage of final average salary is 2%.
For example, if your final average salary is $50,000 and you have worked for 30 years and the pension multiplier is 2%, your pension would be $50,000 x 2% x 30 = $30,000 per year. You will receive $30,000 each year for the rest of your life.
How to top up your retirement income?
As an educator, you need to know that the defined benefit plan offered by your public educational institute might only replace 50% to 60% of your pre-retirement income. If you teach at a private educational institute, your 401(k), 403(b), or employer-sponsored plan might also be underfunded, leaving you short of cash after retirement. To make up for the shortfall, you should top up your defined benefit plan through additional retirement plans. You can consider the following options as your secondary retirement plans:
Traditional Individual Retirement Accounts (IRAs)
You can set up your individual retirement account with a financial institution. The contributions you make to the IRA account can be tax-deductible, subject to certain conditions such as tax filing status, taxable income, and other factors. By contributing to your IRA account, you defer taxes on capital gains and dividends until you make a withdrawal. You can claim tax deductions of $6,000 for the year 2020-21 and pay taxes on them only when you withdraw the amount on your retirement.
Roth Individual Retirement Accounts (Roth IRAs)
Roth IRAs are private individual retirement accounts offered by financial institutions where you can invest your money to top up your retirement savings. The contributions you make to the Roth IRAs are not tax-deductible. Instead, you will be exempted from paying taxes on returns and contributions after you start withdrawing your funds at the time of your retirement. IRA, both traditional and Roth, can help you make up the shortfall in your retirement savings, allowing you to lead a financially stable life after your retirement.
Teachers need to understand what retirement benefits they will get and how much pension they can expect to receive when they retire. By understanding the available pension and retirement schemes, private and public sector teachers can achieve their desired amount of post-retirement benefits by topping up their default employer-sponsored pension plans. While retirement may be a long time away, you should start planning for it now to secure a better financial future for yourself and your loved ones.