Although traditional pension plans, which were in vogue half a century ago, have mostly disappeared, there are still a number of retirement plans that can help you build a big enough nest egg to live out your golden years in financial security.
Employer-sponsored defined-contribution plans don’t guarantee a specific dollar amount at retirement. How much you receive depends on how much you and (possibly) your employer contributed and how well your investments performed over the years. It can’t be emphasized enough that if your employer matches your contribution to a retirement plan, you should definitely be part of it. That’s free money! Your contributions plus any vested contributions made by your employer are always kept in an individual account in your name.
With defined-contribution plans, you’ll usually be able to choose from a variety of stocks, bonds, mutual funds, annuities, money market funds, or (sometimes) your employer’s company stock. The plan will spell out how frequently you can change your investment choices. Many plans allow you to manage your account online and make investment changes as often as you like.
One of the attractive features of defined-contribution plans is that they’re portable. If you change jobs, you can take your money with you. The following are the most common defined-contribution plans:
Other defined-contribution plans include employee stock ownership plans (ESOPs), profit-sharing plans, Simplified Employee Pension (SEP) plans, and Savings Incentive Match Plans for Employees (SIMPLEs). These plans all have one important thing in common: You pay no taxes on your contributions or your earnings until you withdraw the money, which you’ll be required to do once you turn seventy-two.
A 401(k) plan is an employer-sponsored retirement plan that gives a special tax break to employees saving for retirement. Here’s how the tax break works: If you contribute $2,000 a year and you’re in the 24 percent federal tax bracket, you’ll save $480 in current income taxes for the year. Your contributions get deducted from your pay before your taxes are calculated, so you’re investing with pretax dollars. If you live in one of the states where 401(k) contributions are tax deferred, and you’re in a 6 percent state income tax bracket, you would save another $120 in state taxes, for a total savings of $600. The bottom line is that you add $2,000 to your investment account, but only $1,400 comes out of your pocket ($2,000 – $600 = $1,400). You don’t pay taxes on your earnings until you withdraw them, presumably at retirement, so your investments grow faster as your untaxed earnings benefit from compounding.
Many employers match a certain percentage of your contributions. The amounts vary, but a typical match is between fifty cents and $1 for every dollar you contribute, up to 6 percent of your salary. If your employer offers matching contributions and you don’t participate in the plan, it’s like walking past money lying on the sidewalk and not picking it up. Even if you can’t take advantage of the full match, contribute as much as you can so you’ll get at least some of that free money.
The IRS sets limits, adjusted annually for inflation, on how much you can contribute to a 401(k) plan each year. For 2020, you can contribute up to $19,500. Once you reach age fifty, you’re allowed to make additional “catch-up” contributions of up to $6,500.
You always own 100 percent of your own contributions to the plan. The employer match may be subject to vesting, which means you earn the right to it gradually, over a number of years of employment with the company. About half of all employers offer immediate vesting for those matching contributions.
There are two types of vesting schedules for employers who use that method. Some 401(k) plans have cliff vesting, where you don’t own any of the matching contributions until you’ve worked for the company for a certain amount of time, but not more than three years. The other type of vesting schedule is graded vesting, where you own an increasing percentage of the employer match over several years. By law, full vesting must take place within six years. A typical vesting schedule will now be 20 percent after the second year, 40 percent after the third year, 60 percent after the fourth year, 80 percent after the fifth year, and 100 percent after the sixth year.
It’s important to consider the impact on your 401(k) when you’re thinking of changing jobs. If your plan has cliff vesting, and you leave before working the required number of years, you walk away from everything your employer has contributed as matching funds. You could possibly walk away with thousands of additional dollars in company matching funds by staying in your current job for a few more months or years. Let’s assume you had matching contributions of $6,000 and a vesting schedule of 20 percent per year for five years. If you left for a new job after three years, you’d take $3,600 ($6,000 × 60 percent = $3,600) of matching funds with you, plus all the contributions you made from your salary and any associated earnings, but you’d forfeit $2,400 ($6,000 × 40 percent = $2,400) plus any earnings that money has accumulated.
The portability of 401(k) plans is a great feature, but what do you do with your money when you change jobs? You have three choices:
The rules for rollovers are strict, so make sure you follow them carefully to avoid any tax penalties. Some plans will make a direct rollover into your new account; others will send you a check that you will need to deposit into your IRA account within sixty days to avoid tax penalties.
Taking out a 401(k) loan may not seem risky, but it is. Not only can the loan derail your retirement savings; it may also take a toll on your current finances. Here are the three big risks of 401(k) loans:
If you’re considering borrowing money from your retirement account, try to find any other way to get the money you need.
Defined-contribution plans, or 403(b) plans, work very much like 401(k) plans, and over time they have started to look more and more like 401(k) plans. Your contributions are tax-deductible and your earnings are tax deferred until you take the money out at retirement. Like 401(k) plans, the amounts that you and your employer can contribute are limited by law. With a 403(b) plan, employees can also take advantage of an extra catch-up contribution available if they have more than fifteen years of service. That extra contribution, known as the maximum allowable contribution (MAC), lets long-term employees contribute up to $3,000 extra per year for a total MAC of $15,000. The MAC is over and above any age-related catch-up contributions.
Section 457 plans are defined-contribution plans established by government agencies and some nonprofits. Like 401(k) and 403(b) plans, they allow you to make tax-deductible contributions, and your earnings grow tax deferred until retirement. Because 457 plans are “nonqualified” plans, specific issues such as catch-up contributions and early withdrawals are handled differently. For example, if you pull money out before age fifty-nine and a half, you won’t get hit with a 10 percent tax penalty (though you will still have to pay regular income taxes on the withdrawal). Catch-up contributions work differently too. Employers have the option of allowing you to make regular catch-up contributions when you reach age fifty. There’s also a special extra catch-up provision that employers can offer called the “last three-year catch-up.” With that, you can contribute twice the regular contribution limit during the last three years before the plan’s retirement age. If your employer offers both types of plans, you can contribute to both.