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401K and other employer-sponsored retirement plans: The full breakdown

At a glance:

  • How employer retirement plans help you save on taxes

  • Defined contribution plans vs Defined benefit plans

  • 401k, 403b, and 457 plans: The basics

  • What are defined benefit pension plans?

  • Summary of employer-sponsored retirement plans

  • Practical ideas you can start with today

Contributing money to an employer-sponsored retirement account is one of the most fruitful uses of your income. Why?

For one thing, you may qualify to get your contributions matched by your employer. For another, your retirement account has the potential to grow over time.

Victoria Kozar, right, of New Milford, Conn., chats with her friend, Beth Eichelman, 91, inside Masonicare at Ashlar Village, a retirement community in Wallingford, Conn. Kozar lived at the center during her senior year at Quinnipiac University as part of an intergenerational learning program. (AP Photo/Pat Eaton-Robb)
Saving for retirement is a smart way of utilizing your income. (Photo: AP Photo/Pat Eaton-Robb)

How employer retirement plans help you save on taxes

Besides helping you build income for your retirement, retirement plans may offer the added benefit of reducing the effects of taxes. Many retirement plans have potential to build tax-deferred value, and some allow you to reduce your taxes on current income as well, by offering tax deductible contributions.

What is tax deferral?

"Tax-deferred" means that any earnings that build up in your plan are not taxed currently, as in other kinds of investments. Your earnings are free from taxation while they are in the plan. Once you draw them out, either at retirement or before, your earnings from these plans may be subject to taxes.

Even though you may have to pay taxes on your retirement plan earnings when you take them out, you may still pay less than if you had that income taxed as it was being earned. This is because you may have lower income in retirement, which may place you in a lower tax bracket.

You can contribute on a pre-tax basis

In addition to savings from tax deferral, some employer-sponsored plans allow you to contribute your income pre-tax, so you don't have to pay taxes on the money you contribute today (at least, not until you take the money out). With some non-employer-sponsored plans, your contributions can be taken as deductions from your income for tax purposes.

There is a price to be paid for all this tax freedom, however. With most plans, any money you take out prior to retirement (age 59½ for IRA plans, age 55 with separation of service for most employer plans) can be subject to a 10% federal tax penalty in addition to being taxed. There are also limitations to how much you can contribute to some plans, based on your income or employment status.

Defined contribution plans vs defined benefit plans

You may have heard of these two categories of employer-sponsored retirement plans. They dominate the landscape of retirement investing, but what is the difference between them?

What is a defined-benefit plan?

A defined-benefit pension plan is a retirement plan that defines the amount of money you will receive at retirement. It is what commonly comes to mind when you hear the word "pension."

It's called "defined benefit" because the amount of money you will receive as a benefit is predetermined, or defined, during your working years. It is promised by your employer, regardless of how well the investments in the plan perform. Your employer uses various formulas that consider your salary, your age, and your years of service to determine how much that will be.

As a wide, general rule, employees do not contribute to a defined-benefit plan (there are some exceptions, of course). The burden is on your employer to fund the plan; it assumes the risk.

State and federal pension plans are examples of defined-benefit plans. Also, some companies in the private sector still offer them, though their number has been decreasing for many years, as they have become difficult to fund.

What is a defined-contribution plan?

A defined-contribution plan defines the amount that can be contributed.

Contributions may be made by you, your employer, or both. The benefit is not defined, however. Rather, the performance of the investments in the plan ultimately determines the amount of benefit you will get. The risk is therefore borne by whoever makes the contributions.

Examples of defined-contribution plans include 401k’s, 403b’s, 457b’s, and individual retirement accounts. Many Keogh plans also fall into this category.

401k, 403b, and 457 plans: The basics

401k, 403b, and 457 plans are retirement plans set up and sponsored by employers for their employees. They are among the various incentives that employers provide to attract and keep employees. The chief differences among them lie in who provides them:

  • 401k's are provided by private corporations.

  • 403b's are provided by public education entities and most other nonprofits.

  • 457s are for state and municipal employees.

These plans are called defined contribution plans because you determine and make contributions to them from your earnings. Your employer takes money out of your paycheck and puts it right into the account before it can be taxed. In many cases, your employer may make a matching contribution to them. The money in the account builds up as long as you have it, and you do not pay any taxes on it (or on any money it earns) until you finally take it out, typically beginning at age 59 1/2.

Retirement contributions vary by generation. (Graphic: David Foster/Cashay)
Retirement contributions vary by generation. (Graphic: David Foster/Cashay)

How they work

All of these plans work largely the same way. Your employer has a selection of investments (usually mutual funds or annuities) that will fund the account, and you choose from among them.

If you leave your job, you still keep control over the account, though you may roll it over to a different account if you want.

There are Roths

There are also Roth versions of each of these accounts. A Roth account takes money out after it has been taxed. However, when you withdraw your money at retirement, you will not be taxed on it, provided you have met all the conditions set by the IRS. Also the non-IRA Roth variations have some required minimum distributions. Choosing a traditional vs. a Roth version involves estimating your tax burden now and at retirement, as well as your various financial needs.

A final note

401k, 403b, and 457 plans are a major part of the retirement landscape in the United States, and they form a significant part of many people's financial planning.

What are defined benefit pension plans?

Defined benefit pension plans are what we usually think of when we hear the word pension. They are the older, more traditional plan that employers provided as a benefit to attract and retain employees.

How they work

In a defined benefit pension plan, an employer commits to paying its employee a specific benefit for life beginning at his or her retirement. The amount of the benefit is known in advance and is usually based on factors such as age, earnings, and years of service.

How are they funded?

A defined-benefit plan must be funded. Contributions from the employer—and sometimes from employees—are put into a fund set aside to pay the benefits. The fund is reviewed by actuaries yearly to ensure that it will meet payments to retirees. In the current investment environment, however, many defined benefit plans are underfunded. That means that the value of promised future benefits presently exceeds the value of the funds that have been set aside to pay those benefits. Pension plans provided by state and local governments are in many cases underfunded.

How you get paid from them

Defined benefit plans distribute their benefits through life annuities. In a life annuity, employees receive equal periodic benefit payments (monthly, quarterly, etc.) for the rest of their lives. If you are married, upon your death your surviving spouse may continue to receive distributions of at least 50 percent of your periodic payment amount.

Some plans may also allow you to receive your entire benefit in one lump sum at your retirement.

Summary of employer-sponsored retirement plans

Employer retirement plans can help you save for retirement and defer taxes as well. Because they are tax-deferred, retirement plans allow your savings to grow uninterrupted by taxes than if the funds were invested in a taxable savings or investment account.

Furthermore, some retirement plans allow you to deduct all or part of your annual contribution to the plan from your current income so your current income taxes are lower as well. As the life expectancies of retirees continue to grow, their retirement income needs grow, too. Taking advantage of these tax-deferred retirement accounts can help meet your retirement goals.

Practical ideas you can start with today

  • Calculate the value of a tax-qualified plan at retirement.

  • Set up a budget or plan for making contributions to your retirement plan(s).

  • Open up a defined-contribution or pension plan to begin saving for your retirement.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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