Retirement Investment: Understanding Fund Options For Your Future

Retirement investment funds are called pension plans. There are two types of pension plans: defined contribution plans and defined benefit plans. Defined contribution plans, such as 401(k)s, are where employees contribute a portion of their paycheck into a retirement account, while defined benefit plans, such as pension plans, are where employers invest money for employees' retirement. Other types of retirement investment funds include Individual Retirement Accounts (IRAs), Simplified Employee Pension (SEP) plans, and Cash-Balance Plans.

Retirement Investment Funds Characteristics and Values

Defined contribution plans

In a defined contribution plan, there is no guarantee of a specific amount of benefits at retirement. Instead, the employee will receive the balance in their account, which is based on contributions plus or minus investment gains or losses. This balance can fluctuate due to changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.

In a defined contribution plan, employees typically contribute a fixed amount or a percentage of their paychecks to their individual retirement account. The sponsor company may also make matching contributions as an added benefit. For instance, for every dollar contributed by the employee, the employer may add a portion of a dollar, up to a certain percentage of the employee's salary.

One of the key advantages of defined contribution plans is that they offer a tax-advantaged way to save for retirement. Contributions are often made with pre-tax dollars, and earnings produced by these contributions are tax-deferred until withdrawal. This means that income tax will only be paid on withdrawals at retirement age (minimum 59½ years old), and the tax bracket at retirement is typically lower than during full-time work.

However, there are also limitations to defined contribution plans. Unlike defined benefit plans, they do not guarantee a certain amount of retirement income, and participation is voluntary and self-directed. This means that employees need to invest and manage their own money, which can be challenging for those without financial expertise.

Overall, defined contribution plans are a popular option for retirement savings, offering employees a way to invest pre-tax dollars and grow their wealth over time.

Defined benefit plans

The employer is responsible for managing the plan's investments and risk and, unlike defined-contribution plans, assumes all the investment and planning risks. The employee, therefore, cannot withdraw funds as they can with a 401(k) plan. Instead, they receive their benefit as a fixed monthly payment or, in some cases, a lump sum at retirement age.

Pensions are an example of a defined-benefit plan.

Examples of Defined-Benefit Plan Payouts

A defined-benefit plan guarantees a specific benefit or payout upon retirement. The employer may opt for a fixed benefit or one calculated according to a formula that factors in years of service, age, and average salary. The employer typically funds the plan by contributing a regular amount, usually a percentage of the employee's pay, into a tax-deferred account.

Upon retirement, the plan may pay monthly payments throughout the employee's lifetime or as a lump-sum payment. For example, a plan for a retiree with 30 years of service at retirement may pay $150 per month per year of the employee's service, resulting in a monthly payment of $4,500. If the employee dies, some plans distribute any remaining benefits to the employee's beneficiaries.

Advantages of Defined-Benefit Plans

Defined-benefit plans offer several advantages:

• Income that shouldn't run out: One of the biggest benefits of a pension plan is that it typically pays until the recipient's death, meaning they will not outlive their income.
• No need for self-management: Pensions do not require the recipient to worry about investing their money or the returns it is making.
• Protection: The benefits in most traditional defined-benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).

Disadvantages of Defined-Benefit Plans

Defined-benefit plans also have some disadvantages:

• Less flexibility: As the payout is determined by a formula, employees with defined-benefit plans may not benefit as much as those with defined-contribution plans if the stock market performs well.
• Less portable: Defined-benefit plans are tied to the employer, so if the employee leaves the company, they may lose their plan.
• Less control: Employees cannot choose when to take their benefit, unlike with defined-contribution plans, where they can withdraw funds.

Who Are Defined-Benefit Plans For?

Defined-benefit plans are particularly suited to those aged 50 or over who can make annual contributions of $90,000 or more for at least five years and who have few, if any, employees. This includes highly compensated business owners, partners, and key employees in their peak earning years.

Individual Retirement Accounts (IRAs)

There are several types of IRAs, each with different rules regarding eligibility, taxation, and withdrawals. These include:

• Traditional IRAs: A traditional IRA is a tax-advantaged personal savings plan where contributions may be tax-deductible. The IRA allows these contributions to grow tax-free until the holder withdraws them at retirement, at which point they become taxable.
• Roth IRAs: A Roth IRA is a tax-advantaged personal savings plan where contributions are not deductible, but qualified distributions may be tax-free.
• Simplified Employee Pension (SEP) IRAs: A SEP IRA is a retirement savings vehicle that allows employees to make contributions on a tax-favoured basis to IRAs owned by the employees. Self-employed individuals can also set up SEP IRAs.
• Savings Incentive Match Plan for Employees (SIMPLE) IRAs: The SIMPLE IRA is intended for small businesses and self-employed individuals. This type of IRA allows employees to make contributions to their accounts, and the employer is required to make contributions as well.

Anyone with earned income can open and contribute to an IRA, including those who have a 401(k) account through an employer. The only limitation is on the total that you can contribute to your retirement accounts in a single year. The best IRA accounts will offer the ability to invest in a wide range of financial products, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds.

401(k) plans

A 401(k) is a tax-advantaged retirement savings plan, named after a section of the U.S. Internal Revenue Code. It is an employer-provided, defined-contribution plan, where employees can contribute a percentage of their income.

Traditional vs Roth 401(k)

There are two types of 401(k)s: traditional and Roth. With a traditional 401(k), employee contributions are pre-tax, meaning they reduce taxable income, but withdrawals in retirement are taxed. On the other hand, employee contributions to Roth 401(k)s are made with after-tax income, so there is no tax deduction in the contribution year, but withdrawals are tax-free.

In 2024, individuals can contribute up to $23,000 ($30,500 for those aged 50 or older). There are no income limits on who can contribute to a 401(k) plan.

Pros and cons

One benefit of a 401(k) plan is that it offers higher annual contribution limits than individual retirement accounts (IRAs). In 2024, the 401(k) plan max is $30,500 for those aged 50 and older, while an IRA tops out at $8,000 annually for the same age group. Another pro is that many employers offer matching 401(k) contributions, which means free money going into your retirement account.

Some disadvantages of 401(k) plans are that they often offer a more limited selection of investments and generally have higher fees than IRAs.

Pension plans

Defined-Benefit Plan

With a defined-benefit plan, the employer guarantees that the employee will receive a specific monthly payment after retiring and for life, regardless of the performance of the underlying investment pool. The employer is thus liable for pension payments to the retiree, which is typically determined by a formula based on earnings and years of service. Defined-benefit plans are also known as traditional pension plans or pension funds.

Defined-Contribution Plan

With a defined-contribution plan, the employee makes contributions, which may be matched to some degree by the employer. The final benefit to the employee depends on the investment performance of the plan. The company's liability ends when the total contributions are expended. The 401(k) plan is a common example of a defined-contribution plan.

Other Details

Both types of pension plans allow the worker to defer tax on the retirement plan's earnings until withdrawals begin. This enables the employee to reinvest the full complement of dividend income, interest income, and capital gains, which can generate a much higher rate of return over the years.

Upon retirement, when the account holder starts withdrawing funds from a qualified pension plan, federal income taxes are due, and some states will also tax the money.

Frequently asked questions