Using Employer-Based Retirement Plans

If you are nearing retirement but still working does your employer provide a retirement plan? If so, say retirement experts grab it! Employer-based plans are the most effective way to save for your future. What’s more, you’ll gain certain tax benefits. Employer-based plans come in one of two varieties (some employers provide both): defined benefit and defined contribution.

Defined Benefit Retirement Plans. These plans pay a lump sum upon retirement or a guaranteed monthly benefit. The amount of payout is typically based on a set formula, such as the number of years you have worked for the employer times a percentage of your highest earnings on the job. Usually the employer funds the plan and it's commonly called a pension plan — though in some plans workers also contribute. Most defined benefit plans are insured by the federal government.

Defined Contribution Retirement Plans. The popular 401(k) plan is one type of defined contribution plan. Unlike a defined benefit plan, this type of savings arrangement does not guarantee a specified amount for retirement. Instead, the amount you have available in the plan to help fund your retirement will depend on how long you participate in the plan, how much is invested, and howwell the investments do over the years. The federal government does not guarantee how much you accumulate in your account, but it does protect the account assets from misuse by the
employer.

In the past 20 years, defined contribution retirement plans have become more common than traditional pension plans. Employers fund some types of defined contribution plans, though the amount of their contributions is not necessarily guaranteed.

Workers with a pension are more likely to be covered by a defined contribution retirement plan, usually a 401(k) plan, rather than the traditional defined benefit plan. In many defined contribution plans, you are offered a choice of investment options, and you must decide where to invest your contributions. This shifts much of the responsibility for retirement planning to workers. Thus, it is critical that you choose to contribute to the plan once you become eligible (usually after working full time for a minimum period) and that you choose your investments wisely.

Tax Breaks. Even though you typically are responsible for funding a defined contribution retirement plan, you receive important tax breaks. The money you invest in the plan and the earnings on those contributions are deferred from income tax until you withdraw the money (hopefully not until retirement). Why is that important? Because postponing taxes on what you earn allows your nest egg to grow faster. Remember the power of compounding? The larger the amount you have to compound, the faster it grows. Even after the withdrawals are taxed, you typically come out ahead.

The tax deduction also means that the decline in your take-home pay, because of your contribution, won’t be as large as you might think. For example, let’s assume you are thinking about putting $100 into a on income taxes is 15 percent. If you don’t put that $100 into a retirement plan, you’ll pay $15 in taxes on it. If you put in $100, you postpone the taxes. Thus, your $100 retirement plan contribution would actually reduce your take-home pay by only $85. If you’re in the 27 percent tax bracket, the cost of the $100 contribution is only $73. This is like buying your retirement at a discount.

Vesting Rules. Any money you put into a retirement plan out of your pay, and earnings on those
contributions, always belong to you. However, contrary to popular belief, employees don’t always have immediate access to the money their employer puts into their pension fund or their defined contribution plan. Under some plans, such as a traditional pensionplan or a 401(k), you have to work for a certain number of years — say 5 — before you become "vested" and can receive benefits. Some plans vest in stages. Other defined contribution plans, such as the
SEP and the SIMPLE IRA, vest immediately. You have access to the employer’s contributions the day the money is deposited. No employer can require you to work longer than 7 years before you become vested in your pension benefit.

Be aware of the vesting rules in your employer’s retirement plan. Make sure you know when you’re vested. Changing jobs too quickly can mean losing part or all of your pension plan benefits or, at the very least, your employer’s matching contributions.