Defined Contribution Pension Plans

Many companies provide their employees with traditional pension plans. Under these plans, qualified participants, or pensioners, are paid a fixed amount that is often determined by the participant’s salary history and years of service with the company. These traditional pension plans sometimes include a cost-of-living adjustment or COLA.

Traditional pension plans have been guaranteed by the Pension Benefit Guaranty Corporation (PBGC). These plans are also called defined-benefit retirement plans.

Of the possible employer-sponsored retirement plans, it is most likely that your employer sponsors a defined-contribution retirement plan for employees. The value of the defined-contribution plan is usually based on how much you and your employer contribute to the plan during your working years. These contributions are frequently invested in working funds, but in some cases may be invested in the stock of your employer.

In some cases, your employer may also make contributions to your retirement account. This is done with either a fully matching contribution, where your employer contributes a dollar for every dollar you contribute, or with a partially matching contribution, where your employer contributes a fraction of a dollar for every dollar you contribute.

Of all of the different types of defined-contribution retirement plans, the 401(k) plan is the most common. Should you work for a university or non-profit organization, you can contribute to a 403(b) plan. If you are employed by the state or local government, it is likely that you are contributing to a 457 plan. All three defined-contribution retirement plans are named after the specific sections of the tax codes that govern them.

Defined-contribution plans are established and enlarged when your employer deducts a percentage of your income, before taxes, and deposits it into a retirement account for investment. Because these investments are tax-deferred, there is a greater growth advantage than if you’d had to pay income taxes on the earnings before the deposit was made.

As a result of the Economic Growth and Tax Relief and Reconciliation Act of 2001, larger contributions to your 401(k) or other retirement plan are now allowed. An additional ‘catch-up’ provision allows workers who turn 50 to contribute even greater amounts to their retirement plans.

As with other defined-contribution plans, your contributions to a 401(k) plan are made to a tax-deferred account. Because tax-deferred accounts are allowed to compound until they are withdrawn, they are able to grow to a much larger sum of money than if you’d had to pay taxes on your contributions each year until they were withdrawn.

When it comes to saving for your retirement, the tax advantages of tax-deferred accounts make them greatly appealing. Should your employer have a 401(k) plan or other tax-deferred plan, contributing as much as you can afford each year, and as soon as possible, will greatly benefit you when it comes time to retire.

The following points deal specifically with how a retirement plan sponsored by your employer is handled:

Early withdrawals. Should you decide to withdraw money from your 401(k) plan before you turn 59½, you will have to pay income taxes on the amount of the withdrawal. In addition, you are likely to be penalized with a 10% early-withdrawal fee.

Required Minimum Distributions. Due to the fact that the IRS requires you to begin taking required minimum distributions (RMDs) every year from the point you turn 70½, qualified Roth contribution programs have added appeal because they do not require RMDs.

Rollovers. Defined-contribution plans allow you to move the assets from 401(k) plans to an IRA plan of another employer should you choose to change jobs or retire. This process of transferring from one retirement plan to another is called a rollover. It is important to handle a rollover carefully to ensure that you do not have to pay early-withdrawal fines or income taxes.