Americans are living longer than ever, and planning for a financially secure retirement has never been more important. Companies today may offer a range of retirement plans, such as pensions, 401k accounts or Roth IRAs. Understanding the differences among these plans and how they match your retirement goals is key to enjoying the retirement lifestyle you deserve.
Defined benefit vs. Defined Contribution Plans
All retirement plans fall into one of two categories: defined benefit or defined contribution. With a defined benefit plan, better known as a pension, you know exactly what you will be paid in your retirement. Pensions are usually calculated based on a formula that accounts for your length of service and final salary (or average salary of your last few years of employment). For example, a pension plan may pay 2 percent of your final salary for each year of service. So if you worked for an organization for 25 years and earned a final salary of $100,000, you would receive a pension of $50,000 a year.
With a defined contribution plan, such as a 401k, a company is agreeing to pay a certain amount into your retirement, without promising what your final payout will be. If you agree to place 3 percent of your salary into a 401k account, your employer may match it. The 401k funds you and your employer contribute are invested in stocks, bonds, mutual funds or other investment vehicles, and should grow over time.
The advantage of a defined benefit pension plan is that you are guaranteed an income in your retirement. As long as you keep living, the pension plan keeps paying. And, depending on the organization, you may need to make minimal or no payments into your pension plan during your working years.
However, pensions only fulfill their promise if employers adequately fund the plans. This has been an increasing problem for companies that are wary of making additional contributions when the stock market declines and their pension funds lose value. Many companies are eliminating their pension programs, deciding that they do not wish to maintain such long-term financial commitments to employees. If a pension fund--or a parent company--is unable to meet its financial obligations to retirees, the Pension Benefit Guaranty Corporation may step in to make payments, up to a certain limit.
401k and 403b
A 401k plan, or 403b for some not-for-profit organizations, is designed to put the employee in control of his or her retirement savings. Typically, the employee contributes a certain amount to the 401k, which is matched by the employer. The money is invested and grows over time. The more you and your employer invest, the more you should get in retirement.
401k and 403b plans have numerous benefits. You are in charge of how much you invest and whether you want the money invested in conservative or more aggressive investment vehicles. The money is deducted on a pre-tax basis, lowering your taxable income. Plus, as your investments compound over time, you can accumulate significant savings.
The downside of 401k and 403b plans is that they are subject to stock market volatility. They depend on the theory that, over time, the stock market increases in value. While this is historically true, many people have had to delay their retirements in 2008 and 2009 after a market downturn occurred close to their retirement dates. Unlike a pension plan, a 401k or 403b can run out of money.
A Roth Individual Retirement Account is a defined contribution plan similar to a 401k. The main difference is when taxes are paid. With a 401k, your contribution is deducted on a pre-tax basis. You will need to pay taxes on this income when you take withdrawals from your 401k account during retirement.
With a Roth IRA, your contribution is deducted on a post-tax basis. As a result, the income already has been taxed and will not be taxed again during your retirement. If you believe tax rates will increase over time, this could result in considerable savings.
Try to take advantage of multiple retirement plans if possible. Some organizations--especially public employers--may offer a pension and a defined-contribution plan. This will give you some control over your retirement savings, while guaranteeing you an income that is safe from market fluctuations. More employers are also offering both traditional 401k plans and Roth IRAs for employees. Talk to your financial adviser about your retirement goals and decide which makes the most sense for you.
With any defined-contribution plan, the key is to start investing early so you can compound your earnings. A small amount you contribute now can add up to a significant nest egg in retirement.
- Photo Credit Image by Flickr.com, courtesy of Balazs Gal
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