Investing at Work
Employer-sponsored plans can be a great way to prepare for your retirement. They come in two basic flavors: defined benefit plans and defined contribution plans.
A defined benefit plan, often called a pension, is the older of the two. It gets its designation from the way your ultimate retirement benefit is calculated. Your employer determines your retirement pay or pension based on a formula that may include years of service, salary, or other employment factors. This calculation defines your benefit. In most cases, you do not contribute to the plan.
A defined contribution plan focuses not on the ultimate benefit, but on how you fund the plan. Your 401(k) is a defined contribution plan, which offers you the chance to invest pre-tax dollars in a selected group of investments, frequently mutual funds. Your employer may match some part of your contribution. The market value of your investments and any matching contribution by your employer determine the ultimate benefit of the plan.
The basic structure of most 401(k) plans is the same, with some flexibility in how individual organizations choose to administer the plans. Companies often hire a plan administrator to handle the investments. Here are some of the features:
Most plans give employees the opportunity to invest a percentage of their salary up to a maximum dollar amount set by law.
Some employers match part of your contribution up to a predetermined amount. For example, your employer may match up to three percent of your salary if you contribute that much. The match may be "dollar for dollar," 50 cents for every dollar, or another amount. There is no requirement that your employer match any of your contribution.
Your employer may require you to work for a set amount of time (six months or one year, for example) before you can enroll in the plan. Other employers automatically sign you up, and if you don't want to participate you must request out of the plan.
Plan providers can set a vesting period. Vesting refers to a time requirement set by the employer before any matching funds are property of the employee. The employer may schedule a gradual vesting (for example, 20 percent per year) or a complete vesting at the end of a set period (for example, 100 percent after three years). Your contributions belong to you and are not subject to vesting.
- The 401(k) plans are qualified retirement programs, meaning your contributions and any matching funds from your employer grow in a tax-deferred environment. You pay ordinary income taxes on withdrawals after age 59½, and if you choose to withdraw your money earlier, you may be subject to a ten percent penalty.
Your employer deducts contributions from your wages before taxes are calculated, meaning you are paying less in immediate income taxes.