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There are several kinds of retirement plans that employers can provide as a benefit to employees. Most plans fall into one of two major categories: Defined Benefit plans or Defined Contribution plans. Generally companies that begin a retirement plan for a benefits package today will opt for a Defined Contribution plan, which places employees in the driver seat.
Defined Benefit plans
Calculate employee benefits using a formula. The formula often will include factors like salary history and duration of employment. Employers control all investment risk and investment portfolio options.
Defined Contribution plans
Contain a number of investment options – mutual funds, stocks and other investment options can be available within the plans. Employees generally choose whether to contribute and how much to contribute through salary deduction. In some cases employers also contribute money to an employee’s individual plan. In every case, employees choose how to invest their own money, within the parameters of the plan options. An individual’s account balance will depend upon contributions to the plan and the performance of the investment options selected.
Smart401k provides advice to members about how to invest the money in their Defined Contribution plans. This includes several plan types:
How does a 401(k) work?
A 401(k) plan is a retirement savings plan established by an employer. Eligible employees can make pre-tax (and for some plans, after-tax) contributions through payroll deductions. The IRS sets contribution limits, which are indexed for inflation and generally change every few years.
Many employers will match employee contributions, up to a small percent of the employee’s salary, and some employers also engage in profit-sharing contributions. People who contribute to a 401(k) plan are then able to choose from a select list of investment options offered by their employer’s plan. (Employers determine which investment options will be in the plan they offer.)
As an individual’s 401(k) account value increases through investment, the growth is tax-deferred (not subject to capital gains taxes). Upon taking approved distributions (generally at retirement), people pay regular income taxes on 401(k) distributions. There are penalties for taking a distribution prior to age 59½.
The Roth 401(k) concept has recently gained popularity. Unlike traditional 401(k) contributions, Roth 401(k) contributions are after-tax. Because employees already have paid income taxes on their contributions, the money will not be taxed at the time that distributioconns are taken – regardless of gains. The account value still grows tax-deferred.
How does the Thrift Savings Plan work?
The federal government is able to offer the Thrift Savings Plan to government employees – both civilians and military personnel. Aside from the fact that this plan is sponsored by the federal government rather than a private employer, the Thrift Savings Plan functions like a 401(k): an employee makes a pre-tax contribution in the form of a payroll deduction; many government agencies match employee contributions, up to a small percent of the employee’s salary; there is a 1%-of-salary employer contribution for eligible employees, even if the employee opts not to contribute; people who have money in the Thrift Savings Plan are able to choose from a portfolio of investment options offered by the plan; the investment grows tax-deferred; and people pay regular income taxes on Thrift Savings Plan distributions upon taking approved distributions. There are penalties for taking a distribution prior to 59½.
How does a 403(b) work?
Public schools, colleges, universities, charities, state governments, local governments and other tax-exempt entities under section 501(c)(3) of the IRS code are able to offer 403(b) plans. Many of these entities have a separate, primary retirement plan – often a Defined Benefit pension plan – and the 403(b) plan is an additional vehicle for retirement savings. Sometimes the 403(b) plan is the primary retirement plan.
The 403(b) is a strictly voluntary program wherein employees can contribute money to a retirement savings account that functions almost exactly like a 401(k): an employee makes a pre-tax contribution in the form of a payroll deduction, and that money grows tax-deferred until retirement. Though there is no legal or tax restriction preventing employers from matching employee contributions, it is rare.As with 401(k) plans, there are penalties for distributions taken prior to age 59½; investment growth is tax-deferred; and approved distributions incur regular income taxes.
Unlike standard 401(k) plans, 403(b) plan documents allow multiple providers to administer, or manage, 403(b) plans – including insurance companies and investment companies – so an employee can choose which provider they prefer. Each provider will offer a different set of investment options. Most 403(b)-eligible employers have begun hiring third-party administrators to manage their provider list so that, for example, a school district does not have 30 companies that can manage district employees’ 403(b) plans. **See the note below for additional information about 403(b) plans compared with 457 plans.
What is a 457 plan?
Public schools, colleges, universities, charities, state governments, local governments and other tax-exempt entities under section 501(c)(3) of the IRS code are able to offer 457 plans. The 457 is a strictly voluntary program wherein employees can contribute money to a retirement savings account. Employees make pre-tax contributions in the form of payroll deductions, and that money grows tax-deferred until retirement.
As with 403(b) plans, many of these employers have a separate, primary retirement plan – often a Defined Benefit pension. Employers can legally engage in matching contributions, and this is more common with a 457 than a 403(b) – but not as common as with 401(k) plans. As with 403(b) plans, 457 plan documents allow multiple providers to administer the plans. The 457 plan is often called a “Top Hat” plan because it offers double-deferral when coupled with a 403(b). For example, an employee can reach the contribution limit for a 403(b) and still contribute the entire contribution limit to a 457 – or vice versa. Further, as previously noted, many of these employees also have a Defined Benefit pension plan from which they will receive retirement income. In this manner, employees who can afford to make extremely large annual contributions could choose to accumulate far more employer-sponsored retirement wealth than most people employed by corporations.
As with all of the aforementioned Defined Contribution Plans, growth is tax-deferred. Upon taking approved distributions, people pay regular income taxes on 457 distributions. The significant difference between 403(b) plans and 457 plans involves the distribution rules. Anyone still working at the employer that sponsors their 457 plan cannot take distributions until age 70½ without penalty. However, if the employee leaves that employer, the employee can take distributions at any age without penalty.**See note below for additional information about 403(b) plans compared with 457 plans.
**A note about 403(b) and 457 plans: Where applicable, people can contribute to both plans, to one plan or to neither. Often employees choose to contribute more money to a 403(b) than a 457 because of the stricter age-related 457 distribution limitations. Someone nearing retirement might not want to change jobs, fearing a lower salary elsewhere. Job change and retirement are the main options available to an employee who wants to take 457 distributions. For that reason, many people treat the 403(b) as a primary plan and the 457 as a supplemental plan. However, some people – particularly younger employees – do choose to make a 457 their primary plan because they can take distributions at any age when they stop working for the employer who sponsors the plan.
As with any investment, be sure you understand the type of plan(s) available through your employer. Plan description(s) should be available to you through your Human Resource representative or through your plan administrator. It is important to review your plan’s specific requirements and distribution options to ensure you have all applicable information.