Defined Contribution Plans
Unlike defined benefit plans which promise a certain benefit at retirement (for example, 30% of salary for life), defined contribution plans don't offer you the same kind of retirement
benefit. They're more focused on contributions. In these plans, you, or your employer (or both) contribute to your individual account, sometimes at a set percentage of your salary.
These contributions are then invested on your behalf. At some point, you'll receive the balance in the account adding up to all of your contributions and any related gains or losses,
and based on your vesting level, the vesting portion of any employer contributions made on your behalf and related gains or losses.
Defined contribution plans come in many varieties in both the private and public sector. Examples of defined contribution plans include 401(k), 403(b), and profit sharing plans.
The terminology can sometimes be confusing, since one type of defined contribution plan is called a money purchase pension plan.
The term "pension plan" can refer to both defined benefit and defined contribution plans. If a certain pension amount promised to you at retirement, then that's a defined benefit.
Otherwise, it is likely a defined contribution plan.
If you have a defined contribution plan, you're going to know a lot more about how much goes into your account than what will ultimately come out. Your contribution is defined
(usually as a percentage of salary), but not the ultimate benefit. Your benefit at retirement will depend on the size of the contributions made by you and/or your employer and
the future performance of the investments in your account.
Contributions to a defined contribution plan are typically made with pre-tax money. That means the contributions aren't subject to income tax at the time they are paid into the
plan. For example, if you contribute $3,000 of your $50,000 salary to a defined contribution plan, such as a 401(k) on a pre-tax basis, the $3,000 isn't counted as salary for income
tax purposes. You'd report $47,000, not $50,000, on your income tax return, reducing your taxable income.
The Benefits of Tax Deductible Contributions
If your contributions are not taxed, you'll have more money invested. When you contribute $3,000 to a plan, you'll have the full amount working for you, not $3,000 less taxes.
Your contributions are typically sheltered as you put them in, and often taxed at a lower rate when you take them out. How can you expect to pay lower taxes? When you're retired,
you're likely to be making less money and tax rates are generally lower on lower levels of earnings.
Even better, your contributions and earnings will be protected from income tax until you take the money out. You have more growth potential, since the entire amount stays invested,
and untaxed, year in and year out.
Making Contributions Automatic
You can easily set up automatic payroll contributions to your defined contribution plan. Employers may match or make all the contributions.
Most 401(k) plans allow employees to make contributions and provide for partial or full matching contributions by the employer. If your employer matches even half of your contributions,
you get a 50% boost in the size of your retirement account.
Employee pre-taxable contributions cannot exceed $10,500 in the year 2000. The total of employee and employer contributions to a 401(k) plan has a limit equal to the lesser of
25% of compensation, or $35,000.
Under other types of defined contribution plans (e.g., profit sharing plans and money purchase pension plans), the employer makes contributions. Employee contributions may or may
not be part of those plans.
Accounts under most defined contribution plans can be transferred to another qualified retirement plan or IRA. If you separate from a company, you'll usually have the option to
roll over your account.
In some cases, you can delay your distributions beyond age 70½. That's the age at which you must begin to take out your distributions, by law. If you choose to keep working, for
instance, you may be able to continue the tax-deferred growth of your retirement account.
Retirement Plan Contributions vs. IRAs
As of 2000, IRA contributions are limited to $2,000 per year ($4,000 per year for married couples). A new law has recently passed that will soon raise these limits. Under defined
contribution plans, the contribution limits can be much higher. Some limits apply to employee contributions; others to employer contributions; and some apply to the combined amount
of employee plus employer contributions.
With traditional IRAs you may qualify to get an income tax deduction for your contribution. You make contributions to a Roth IRA with after-tax dollars, getting no deduction for
the contributions. However, with the Roth IRA, you may receive distributions free of income tax.
Your rights to benefits vest when they become non-forfeitable, when you own them. You are always 100% vested in employee contributions and any earnings on those contributions.
Your vesting rights to employer contributions vary with the type of plan you're in, as well as the plan provisions and the laws governing the plans.
The way you vest and the contributions you receive will vary with the type of plan you're in, as well as with the plan provisions. You may be 100% vested immediately or it may
take up to 7 years to be fully vested. Government plans may have different provisions.
Paying Income Tax on Distributions
Defined contribution plans are tax-deferred, not tax-free retirement plans. The growth of your investments is sheltered from income tax while your assets are in the retirement
plan, but you'll eventually have to pay income tax on the cash distributions you take out. (The exception? When you make a qualified rollover or qualified transfer to another plan).
The current federal income tax rates range from 15% to 39.6%. Retirement plan distributions are subject to these ordinary income tax rates unless special tax averaging applies.
Taking Responsibility for Your Financial Future
In many ways, defined contribution plans put additional responsibilities on employees. If you are an employee, your plans may be your only source of your retirement benefits. Making
sound investment decisions will help that money grow.
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Charles M. Bloom, Registered Principal offers securities
and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.
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