Saving money for retirement is important for ensuring long and comfortable work-free years. It’s all too common for people to assume they are too young to begin saving or underestimate the amount they need to save. In reality, you can never save too much or too soon.
Although Social Security is the largest source of retirement income for Americans 65 and older, two broad categories of retirement programs have become important sources of supplementary income for prospective retirees: employer-sponsored retirement plans and individual retirement plans.
For many years, Americans who worked for large companies could rely on employer-sponsored pension programs, known as defined benefit plans. In a defined benefit plan, the amount of future benefits that an employee receives is based on a formula that takes into account the individual’s salary history and years of service.
Although defined benefit plans still exist, they were replaced increasingly over the past 30 years by defined contribution plans, which offer no guaranteed return. Between 1977 and 2007, the number of participants in defined-contribution plans rose by 358 percent, from 14.6 million workers to 66.9 million.
At the same time, the number of people in defined-benefit plans dropped 31 percent, from 28.1 million workers to 19.4 million.
Differences in Retirement Plans
In defined contribution plans, employees — and in some cases their employers — contribute to individual accounts over the course of a worker’s term of service. The employee’s benefits at retirement, or at termination of employment, are based on the contributions made and any earnings or losses that result.
Like defined benefit plans, defined contribution plans are still considered employer-sponsored, even though the employee makes the bulk of the contributions. The employer is usually responsible for determining membership parameters, investment choices and, in some cases, providing contribution payments in the form of cash and/or stock.
There are several types of defined benefit plans. The most common one is the 401(k), which is named for the section of the Internal Revenue Service code that defines it. Other plans are the 403(b) plan and a 457 plan.
401(k) Plans
In a 401(k) plan, employees make regular contributions through deductions from their paychecks. They receive a tax deferment on the amounts contributed. In addition to the tax advantage of the 401(k), the heart of the plan is the “free” money that an employee can collect from employer contributions.
Not all companies offer 401(k)s, and not all that do contribute to them. But many companies do add a matching sum, or a percentage of whatever an employee chooses to contribute to the plan — usually between 1 percent and 8 percent of salary. The rationale is that it not only saves the company money compared to a defined-benefit pension plan, but it also helps encourage employees to save for retirement.
There’s also the Roth 401(k) plan, which works much like a regular 401(k), except that employees contribute after-tax income to their accounts but are allowed to withdraw their earnings tax-free during retirement.
Although employers set the broad structure of their 401(k)s, employees get to make some investment decisions. Depending upon the plan, employees can invest their money in mutual funds, money market accounts, bond funds and/or company stock.
403(b) Plans
Another employer-sponsored DC plan is the 403(b). Older than the 401(k), it was originally created for teachers and nurses at public hospitals who were not covered by pension plans.
Also called Tax Sheltered Arrangements, they are generally available to workers for any non-profit institution. As with 401(k)s, employee contributions are not subject to taxes in the year of contribution and employers may or may not contribute.
457 Plans
Other employer-sponsored DC plans include the 457 Plan, which is open to employees working for a state or local government. Both the plan sponsor and participants can make pre-tax contributions.
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