Ideally, your employer will offer a plan that provides you with a way to support yourself when you retire. Retirement plans generally come in two types: defined benefit plans and defined contribution plans.
- Defined benefit plans provide you with a certain amount of money in retirement. This amount is paid to you by your employer. Defined benefit plans are commonly referred to as pension plans.
- Defined contribution plans allow you to save for your own retirement. Your employer may also match some of your contribution. Two common types of defined contribution plans are 401(k) plans and 403(b) plans.
The term "pension plan" sometimes may be used to refer to retirement plans in general. Often, however, the term "pension" refers specifically to a defined benefit plan. Defined benefit pensions pay you a specific amount when you retire from work. This amount is guaranteed to you for the rest of your life. Employees of private business are not usually required to contribute to defined benefit pensions. Government employees, however, normally are required to contribute.
To receive a pension, you must work for your employer for a certain number of years. The amount you receive is determined by your working salary, your age, and your years of service. If you're employed in private industry, defined benefit pensions don't rely on your ability to save money. But they also don't allow you to participate in managing your investments. Instead, these types of plans are managed by your employer. Also, if you leave before retirement, you may become ineligible for the plan, or your retirement benefit may be reduced.
A 401(k) plan is a defined contribution retirement plan. Your employer allows you to choose a set amount and make an automatic contribution each month. Usually, you tell your company how much to take out of your paycheck to put into your plan. The money that goes into your plan is invested in stocks and bonds.
The maximum amount that can be invested in a 401(k) plan is set by the federal government. In 2009, the contribution limit is $16,500 per year. Your employer can set a limit lower than this maximum amount, so check with your employer regarding your company's plan limit. You do not pay taxes on the money you put into your 401(k). The taxes are paid only after you withdraw the money. You can judge 401(k) plans by two main features:
- Does it include an employer match? All things being equal, larger employer matches are better for you as an employee.
- Can funds be placed in a wide range of investments? The more flexible your plan is, the more likely you are to find investments that work for you.
The 403(b) plan is a defined contribution plan provided by nonprofit organizations. These plans are very much like the 401(k) plans offered by businesses. Nonprofit 403(b) plans also are known as "tax-sheltered annuities." As with a 401(k), you do not pay taxes on the amount you put into your 403(b). Taxes are paid only when you withdraw the money. You choose how the money is invested. There are limits on how much you can invest each year. In 2009, the federal limit is $16,500 per year.
Many employers match part of the amount that you invest in your 401(k) or 403(b). For example, your employer might put 25 cents into your account for each dollar you put in, up to a certain percent of your pay. An employer match is like getting a bonus. It pays to put in enough to get the maximum match.