Whether you’re years into an established career or have only recently joined the workplace, it’s never too soon to start thinking about retirement. Even if you don’t have funds to invest in stocks, property, or other investment products, you can start chipping away at your savings goals through an employer-sponsored retirement plan provided by your workplace.
Employer-sponsored retirement plans generally fall into two categories: defined benefit plans and defined contribution plans.
Defined Benefit Plans
Also known as a pension plan, a defined benefit plan promises a specified payout at retirement. This amount typically replaces a certain percentage of your pre-retirement income when combined with your Social Security benefits.
An important note: when contemplating your employment and retirement decisions, a vital consideration is the Windfall Elimination Provision, which may reduce the amount you receive in Social Security benefits if any past employer did not withhold Social Security taxes from each paycheck. This can severely impact your retirement income. Learn more about the Windfall Elimination Provision.
Both employer and employee contribute to a worker’s pension plan. The amount you receive upon retirement usually depends on a few different factors:
Salary
Age
Years of service with the company
Amount of Social Security benefits you expect to receive
Employers may require their employees to work for a certain number of years in order to receive full pension benefits.
If your employer offers a pension plan, it may offer a few different payment options:
Single Life Annuity: you receive a fixed benefit amount, which is discontinued upon your death. Continued benefits are not available to any surviving spouse or dependent after your death.
Qualified Joint & Survivor Annuity: you receive a fixed amount until your death, after which your surviving spouse (or other specified dependent) will continue to receive benefits (at least 50% of the original amount) until their death.
Lump-Sum Payment: rather than receiving monthly payments, this option allows you to receive the entire value of your pension plan in a single sum.
Unlike defined contribution plans, pension plans are not based on underlying investments; therefore, you know from the get-go exactly how much you can expect to receive upon retirement.
Defined Contribution Plans
Unlike pension plans, defined contribution plans do not promise a specified payment amount upon retirement; instead, you, your employer, or both make regular contributions to a retirement account comprised of a number of investments. Retirement benefits from a defined contribution plan are based on how much money is contributed to the plan and how its underlying investments perform; therefore, the value of the account fluctuates with changes in the value of these investments.
Common types of defined contribution plans include:
401(k) plans
403(b) plans
Employee stock ownership plans
Profit-sharing plans.
A major difference between defined contribution plans and defined benefit (pension) plans is the distribution of financial risk.
Employees shoulder the risk with a defined contribution plan, whereas pension plans place the expense, risk, and management responsibilities with employers. Because pension plans are more risky and expensive for employers, they have become less popular among companies in favor of defined contribution plans.
Subscribe below to stay up to date with our blog, Accounting Demystified.
Comments