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Misbehaving Savings – Part 2 of 5

By Jack Towarnicky

Responding to Intriguing Participant Requests: June 1988 – But What About the Penalty Tax?

During my three-plus decades in plan sponsor roles (1979-2010), I often studied workers’ savings elections and took the opportunity to frequently ask them to explain their contribution, investment, and withdrawal decisions. In a prior blog post, I shared the first of five such encounters.

My last assignment in a plan sponsor role lasted 25 years – from November 1985 to October 2010. When I joined that firm, workers became eligible to contribute to the retirement savings plan on the first of the calendar quarter after completing three years of service (with 100 percent immediate vesting in the company match).

Soon after joining that company, I organized a benefits planning committee consisting of representatives from the human resources, finance, actuarial, legal, and tax departments. These were brilliant people – smart, savvy, highly educated, and experienced professionals.

In June 1988, the benefits planning committee discussed the changes required to comply with the Tax Reform Act of 1986. One required change reduced eligibility from three years of service to one year of service. I noted that the statute required the change take place no later than January 1, 1989. I attempted some humor, tinged with a little irony, remarking that I would complete three years of service in November 1988 so that I would be in the last group where a full three years of service would be required.

At the break, the person who I considered to be the smartest person in the room, an actuary, remarked to me in confidence that, while he had been eligible for the savings plan for a few years, he never joined. He stated, “I only planned to work here for a few years and didn’t want to lose money when I took a distribution and had to pay the 10 percent penalty tax on the entire account.” What?

Shaking my head, I noted that for every $1 he contributed for up to 6 percent of pay, he would receive $0.50 – a 50 percent match. If he invested in the Guaranteed Fund, with a guaranteed interest rate of slightly less than 10 percent, at worst the 10 percent penalty tax would reduce his distribution to $1.35 for every $1 (pretax, approximately $0.65 from net pay) that he had contributed!

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