Fifty years ago, there was one type of retirement plan: a pension. And once you retired from your company with 25 years of service and a gold watch, you received a steady paycheck for the rest of your life. Today, there is a dizzying array of choices, and let’s be honest — very few of us are retiring with 25 years of service from anywhere.
The pension still exists, although most companies have done away with them. Pension plans are also known as defined benefit plans because, in the end, the paycheck you will receive (the “benefit”) is set, and the company has to fund it, no matter how much it ends up costing. Companies are moving away from this because, with stock market fluctuations and life expectancies growing, their bill is much more than they imagined.
The other alternative is a defined contribution plan. Defined contribution plans are much more attractive to employers because they contribute a certain amount (often a percentage of salary) and don’t have to worry about it. Within defined contribution plans, however, there are several different types:
- 401(k) plans are run by an employer for the benefit of the employee. 403(b) plans are identical to 401(k)’s, except they’re run by a non-profit employer. (In case you were wondering, 401(k) and 403(b) are the subsections of the Internal Revenue Code where these items are addressed.)
- IRAs (Individual Retirement Arrangements) are the other primary type of defined contribution plan. Most IRAsare not tied to an employer—they are set up by an individual. (I say “most” because there are some types of IRAs—such as SEP and SIMPLE—that are arranged by an employer, but still funded totally by the employee.) Even within this category, there are different types.
- Traditional IRAs provide a tax advantage today—you can contribute a certain amount (defined each year by the IRS—up to $6,000 in 2012) and then take a deduction on your tax return for the contribution. However, when you draw the money out upon retirement, you will pay taxes at that time.
- Roth IRAs provide a tax advantage later—you contribute today and receive no tax benefit, but your withdrawals are tax-free upon retirement. The contribution limit is the same as the traditional IRA.
Most of the time, it is advantageous to take the tax benefit now (with a traditional IRA), since upon retirement, your income will probably be lower, putting you in a lower tax bracket. However, there are fairly strict restrictions on the tax deduction for traditional IRAs, especially if you have the option of participating in a 401(k) or 403(b) plan at your place of employment.
Regardless of which type of retirement plan you have, the important thing is to contribute to it. In our current environment, we can’t rely on our employers any more—we have to take charge of our own future. There are some great free sites out there to help you calculate the best contribution (or you can consult your CPA or financial planner), but in general, contribute as much as possible. I’d much rather have too much money in retirement than not enough!
Disclaimer: This post is intended to be for general informational purposes about retirement plans and overall IRS tips. Please do not consider any of this consultation for your individual tax or legal needs. I urge you to consult your own tax expert with further questions. Any information contained in this post is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is contained in this document.