A defined-contribution plan is a type of retirement fund in which you can place a portion of your income for retirement. The amount you choose to pay, your contribution, is your choice. The benefits you will receive in the future are determined by your contributions and by your investment returns. They are not determined or backed by promises made by some overseeing public or private sponsor organization.
Defined-contribution plans are often tax advantaged and have special rules.
Many retirement accounts allow employees to contribute a portion of their earnings to their retirement plan before any taxes are paid on these earnings. For these plans, taxes will be paid as regular income that you can withdraw when you retire. Such plans include traditional investment retirement accounts (IRAs), standard 401k plans, 403b plans and Keogh plans. These plans can be great ways to adjust your taxes today while you put aside funds to grow for tomorrow.
There are also retirement accounts that can be funded with after-tax money and allow withdrawals in retirement without payment of any additional taxes. These plans include Roth IRA plans and Roth 401k plans.
There are limits to how much an individual can put into these special accounts. Limits are revised from year to year, and are sometimes higher for older individuals who are in more of a rush to fund their retirements.
A defined-contribution plan allows you a variable but generally high level of customization. You can often decide where you want to put your funds; as a consequence of this level of control, you have to be mindful of reasonable allocation. If you allocate your funds poorly, your investment results and retirement funds may not be as substantial as you would like. However, you can also take this kind of plan with you reasonably easily as you change employers across your career or if you move from one financial institution to another.
A defined-benefit plan or traditional pension is a set amount of income you will receive at a certain time for life after you are vested into the program. The defined-benefit plan is becoming a less popular method of compensating employees in the modern world for a variety of reasons. First of all, people change careers more frequently, and the idea of tying your retirement to a company you only work with for a few years doesn't make much sense. Second, many firms do not want to worry about funding issues that can arise from increasing life expectancies. However, a defined-benefit plan has both advantages and disadvantages versus a defined contribution plan.
The best part of a defined-benefit plan is that your employer guarantees you continual benefits regardless of how well the fund assets perform. If you do not have a great deal of investing skill, this could not be simpler for you. You can also plan your retirement expenses as much as possible with the assumption that you can count on this monthly sum, which is a very comforting feeling.
However, there are also downsides to defined-benefit plans, primarily because they give people a false sense of security. It is possible that your pension will not fund all of its promised benefits. This can happen if your organization cannot pay and the pension is underfunded. One of these conditions is not enough. If the plan is underfunded, the employer is still required to pay. This pay will likely come out of current employee contributions, essentially creating a pyramid scheme. Similarly, if the employer goes out of business but the plan is adequately funded, your benefits are secure.
There are other issues with defined-benefit plans. Since defined-benefit plans are entirely controlled by your fund administrator, this investment manager has power over the assets that go into funding your pension. Institutional managers tend to go through fads and chase hot investment themes; they have sometimes been found guilty of taking bribes to approve contracts with outside investment managers. They do not always work in your best interests.
Retirement Plan Strategy
Now that we have covered the basic issues of retirement, we can discuss several challenges and strategies for retirement planning.
Save a lot and save early. Try to save at least enough money to max out the tax-advantaged account maximums allowed by the government.
Exploit tax-advantaged retirement accounts. If your investment portfolio is split between tax- advantaged accounts and holdings outside of these plans, give preference to assets that pay taxable interest income and dividends. Each of these investments would generate many more taxes on the outside of these special accounts:
Corporate bonds. Interest from corporate bonds is taxed as regular income.
Dividend-paying stocks. Even if these dividends qualify as long-term dividends, they get taxed and reinvested over and over again. They only get taxed once in a tax-advantaged account.
Commodity funds. Many of these funds are subject to special taxes for collectables unless they are held in a tax-advantaged account.
Real estate investment trusts (REITs). These funds and many other kinds of trusts and partnerships get taxed as regular income.
Your holdings outside your taxed advantaged account should include more:
Stocks that pay little or no dividends. The only tax you will have to pay on these stocks is capital-gains tax, making them fairly clean in terms of taxes.
Foreign stocks that pay dividends. Most international stocks are subject to dividend withholding by the home country. This money is lost in a retirement account while it can be deducted against your income in a taxable account.
Municipal bonds that are tax advantaged. You do not have to pay federal income tax on these bonds, so don't spend precious space in your tax-advantaged accounts on them.
Diversify your tax rates. This sounds crazy, but your choices among defined contribution plans allow you to choose between paying taxes at your current rates or paying taxes at future rates. When you make a contribution to a Roth-type plan, you are doing so with money that will be taxed at your current rate and will never be taxed again. Thus, additional Roth-account funding is a choice for your current tax rate. Other retirement accounts are funded with income that you take off your current taxes, and your distributions from these funds get taxed when they are withdrawn in retirement. Thus, choosing to fund traditional tax-deferred retirement accounts is a choice to pay future tax rates instead of today's tax rates.
Let's consider a scenario where a person has a steady income today with no upcoming tax events. With this in mind, your decision comes down only to how the government will change tax rates. Unfortunately, no one can predict politics on a yearly basis. With this in mind, you should consider splitting your contributions so that you pay half of your taxes today (Roth) and half of your taxes at retirement (traditional).
If you have some forewarning about your highest tax bracket, you might want to split your contributions differently. If you have a one-time source of income that flows into a higher-than-usual tax bracket, contribute less to Roth accounts and more to traditional retirement accounts. This will let you deduct more income from that higher tax bracket. This is a bet that in a later year you will either roll over your traditional retirement funds to your Roth account or pay taxes upon distribution at a lower tax rate.
If you work in a profession with high turnover or variable commission income, contribute more to your traditional Roth in years that are lean (lower maximum tax rate years) and more to your traditional account in high-income years (higher maximum tax rate years).
Remember that you can't predict many years into the future, no matter what others claim. Some people have higher incomes and pay higher tax rates as they get older, while others find that they have lower incomes and lower tax rates as they get older. Many financial professionals claim that you are bound to make less money as you get older and tap into retirement savings, and thus would fall into a lower tax bracket. This false assumption would favor contributions to a traditional retirement account. Other professionals say that tax increases are inevitable, which would favor contributions to a Roth account. No one knows, so unless you have specific information about your earnings for this tax year and the next tax year, diversify.
Do not count solely on your defined-benefit pension. This boils down to diversification. Don't put all your eggs in one basket, even if you think it's a great basket. Your employer could go out of business, making its guarantee that backs your pension meaningless. You should contribute to a defined contribution plan that you manage on your own in addition to a defined-benefit plan. If your defined-benefit plan is continuously underfunded, this is a bad sign.
Diversify away from shares of your employer, your employer's industry and your employer's region. This also applies to your spouse's employer or any other entity whose future you have a stake in. The only time you should consider these investments is if your employer is selling you them at a steep discount. Once you are able to sell shares you bought at a discount, sell them on a set schedule within a year. If a large fraction of your net worth is tied up in these shares and you cannot yet sell them, consult a financial planner about how the shares can be hedged using special strategies.