There are several options available to save for retirement. Broadly speaking, retirement savings can be categorized into defined-contribution plans such as 401k and IRAs and defined-benefit plans. Both categories are exactly what they sound like. A pension plan is a defined-benefit plan, where your employer pays you a defined amount each month post-retirement. A defined-contribution plan, on the other hand, is where employee (and in some cases, employer) makes a set contribution from each paycheck into a retirement account.
In case of a traditional pension account, the onus of investment and growing the investment is with the employer. Advances in medical sciences have increased life expectancy, increasing employers’ cost in offering pension plans. As a result of this, and several other factors, many pension plans in private sector are under-funded. Not surprisingly, pension plans are becoming extinct as more and more employers are instead offering a defined-contribution plan, or a 401(k), as you may know it in the United States.
What is a 401(k) plan?
The 401(k) plan is defined in the 401(k) subsection of the Internal Revenue Code. Many private companies provide employees the option to contribute to a 401(k) plan. Employee compensation is deducted from the paycheck before taxation and invested in a retirement plan. Sometimes, an employer makes a proportionately matching contribution, up to a certain limit, to the plan. If your employer makes a contribution, always, always, always, opt into the plan. And here’s why.
Say, you are an employee earning $100,000 a year. Also,assume your employer matches up to 6%, dollar for dollar, of your contributionto the plan. That means if annual 401(k) employee contribution is $6,000pre-tax, employer will also contribute $6,000. Now your total compensationbecame $106,000. The company match is like a free bonus you received from youremployer. Furthermore, the employee doesn’t pay any taxes on the investmentincome generated from assets in the 401(k) plan until retirement.
Now, let’s discuss tax savings. If you didn’t make anycontribution to the 401(k) plan, you would have to pay taxes on your totalcompensation of $100,000. For the sake of simplicity, let’s assume a flat taxrate of 30%. Your after-tax compensation would be $70,000. But since you made a$6,000 contribution to your 401(k) plan, you only pay tax on $94,000, netting $65,800in your bank account, plus your $6,000, and the company match of $6,000 in your401(k) account.
The $12,000 in your 401(k) account is not tax-free. It is only tax-deferred. This only means that you will pay tax on the money in your 401(k) when you make withdrawals, hopefully, post-retirement. Usually after retirement, most individuals will be in a lower tax bracket, and the withdrawals will be taxed at a lower rate than if they had not opted into the 401(k) plan.
Can you contribute your entire compensation to your 401(k)? No. For 2020, the IRS caps the annual employee contribution to $19,500.
Withdrawal of funds from a 401k
Generally, you may begin to withdraw from your 401(k) planafter the age of 59½ without penalty. If you withdraw before that age, thedistribution will be included in your taxable income and you also incur anadditional tax of 10%. An early distribution always incurs an additional 10%tax with the following exceptions: death or disability of the IndividualRetirement Account (IRA) owner, series of substantially equal payments into theplan, dividend pass-through from an employee stock option program, IRS levy ofthe plan, rollover to another retirement plan within 60 days of withdrawal, andseparation of service after the age of 55.
Required Minimum Distributions
IRS requires a minimum distribution to be taken from the 401(k) plan when you reach the age of 70½. Use this worksheet https://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf to calculate the minimum distribution for your traditional IRA unless your spouse is the sole beneficiary of the plan and is more than 10 years younger than you. This worksheet is as of January 2019. For a more recent version, please visit the IRS website.
Investment options in 401k
The biggest drawback of 401(k) plans is that the onus ofinvesting and growing your retirement assets is on you, the individual and notyour employer. Most employers offer a range of investment products forindividuals to choose from. However, not all options are straightforward andsome can be difficult to understand without a deeper dive in the fundliterature. Key factors to consider are asset allocation, benchmark trackingand expense ratio. More on this later!
Aligned with the growing popularity of target-date funds, many IRA providers have begun to offer target-date retirement mutual funds. A link to target-date funds can be found here.
Happy investing!
FAQs
401(k) plan is a defined contribution plan where an employee can make contributions from his or her paycheck either before or after-tax, depending on the options offered in the plan. The contributions go into a 401(k) account, with the employee often choosing the investments based on options provided under the plan.
What is defined in a defined contribution plan Quizlet? ›
Defined contribution plan. In this type of plan the employer establishes and maintains an individual account for each plan participant. Account balance includes employer contributions, employee contributions in some cases, and earnings on the account over all the years of deferral.
What is a 401 a defined benefit plan? ›
A 401(a) plan is an employer-sponsored money-purchase retirement plan that allows dollar or percentage-based contributions from the employer, the employee, or both. The sponsoring employer establishes eligibility and the vesting schedule.
What is a 401k explained simply? ›
A 401(k) is a tax-advantaged retirement plan that is set up and managed by an employer. Basically, you put money into the 401(k) where it can be invested and potentially grow tax free over time. In most cases, you choose how much money you want to contribute to your 401(k) based on a percentage of your income.
Can you withdraw from a defined contribution pension plan? ›
If you are fully vested, your contributions and interest, along with your employer's contributions, are generally locked into the plan and are to be used to provide a lifetime retirement income. Once your pension benefits are locked in, you generally cannot withdraw funds from the plan as a cash payment.
What is the difference between a defined contribution plan and a pension? ›
The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC) . A defined contribution plan, on the other hand, does not promise a specific amount of benefits at retirement.
Which of the following is an example of a defined contribution plan? ›
The most common defined contribution plans are 401(k) plans if you work for a private company, or 403(b) plans if you are a public or nonprofit employee.
How do you account for a defined contribution plan? ›
Accounting for a defined contribution plan is relatively simple. The amount of pension expense for a defined contribution plan is equal to the amount of contribution to the plan. As the company makes the annual contribution, the journal entry will include a debit to pension expense and a credit to cash.
What do defined contribution plans favor? ›
Employers today broadly favor defined contribution plans over defined benefit plans because of their lower cost and lack of responsibility for maintaining set benefit payouts. For employees, defined contribution plans have both pluses and minuses.
What is the penalty for early withdrawal from a defined contribution plan? ›
More In Retirement Plans
Generally, the amounts an individual withdraws from an IRA or retirement plan before reaching age 59½ are called "early" or "premature" distributions. Individuals must pay an additional 10% early withdrawal tax unless an exception applies.
If you have a 401(a) with your existing employer and you leave that job, you can either keep the funds in the 401(a) plan, roll them over into another plan – such as another 401(a), 401(k), a 457, or an IRA – or cash the funds out.
What are the pros and cons of a defined benefit plan? ›
The advantages of defined benefit plans are fixed payout, protection from market fluctuations, tax benefits, and increased employee retention. The disadvantages include the limited potential for growth of investments, vesting period, and employer cost.
What happens to my 401k when I quit? ›
Generally, you have 4 options for what to do with your savings: keep it with your previous employer, roll it into an IRA, roll it into a new employer's plan, or cash it out. How much money you have vested in your retirement account may impact what decision you make.
Can you take money out of your 401k? ›
The IRS allows you to borrow from your 401(k), provided your employer's plan permits it. It's important to note that not all employer plans allow loans, and they aren't required to do so. If your plan does allow loans, your employer can set the terms.
How much money should you have in your 401k when you retire? ›
By age 35, aim to save one to one-and-a-half times your current salary for retirement. By age 50, that goal is three-and-a-half to six times your salary. By age 60, your retirement savings goal may be six to 11-times your salary. Ranges increase with age to account for a wide variety of incomes and situations.
Can I contribute to both a 401k and a defined benefit plan? ›
Due to IRS employer contribution limits, when you sponsor a defined benefit plan there will be additional limits on employer-based contributions to your other plans. However, you could continue to make 401(k) employee deferrals and catch-up contributions to the old plan(s).
What is the difference between a defined benefit plan and a company 401k plan? ›
Key Points. A defined benefit plan (e.g., a pension) is one where you know what to expect in terms of a payout when you retire. A defined contribution plan (e.g., a 401(k) or IRA) is one where you choose how much to pay in without knowing what the retirement benefit will be.
Who bears the risk in a defined contribution plan? ›
The “investment risk” falls on the employee because, unlike defined benefit plans, there is no guarantee of any specified benefit amount at retirement. Some defined contribution plans provide employees with a heightened level of control over funds.
How much can you contribute to a defined contribution plan? ›
While contributions to an individual retirement account (IRA) are capped at $6,500 per year in 2023 ($7,500 if you're 50 or older) and $7,000 in 2024 ($8,000 if you're 50 or older), employees can save much more in a defined contribution plan—up to $22,500 for 2023 and up to $23,000 for 2024, plus as much as $7,500 in ...
