Defined-Contribution Plans, Such as a 401(k)
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You may work for a company that provides a traditional pension plan. A traditional pension plan pays a fixed amount to qualified participants, or pensioners. The amount is determined by the participant's salary history and years of service. A traditional pension may, or may not, include a cost-of-living adjustment (COLA).
The Pension Benefit Guaranty Corporation (PBGC), a government agency, guarantees traditional pension plans. These traditional pension plans are called defined-benefit retirement plans.
More than likely, your employer uses a defined-contribution retirement plan. Defined-contribution plans rely on how much you and/or your employer contribute during your working years to your own retirement account. You invest your contributions in mutual funds or, in some cases, the stock of your employer. As a result, the size of your retirement account is also determined by the investment performance of those mutual funds and appreciation in your company's share price.
Your employer may also contribute to your retirement account. If it contributes a dollar for every dollar of yours, up to the yearly limit, it is making a fully matching contribution. If it contributes a fraction, such as 50 cents for every one of your dollars, up to the yearly limit, it is making partially matching contributions.
The most common type of defined-contribution retirement plan is a 401(k) plan. If you work for a university or non-profit organization, you may contribute to a 403(b) plan. If you are a state or local government employee, you more than likely participate in a 457 plan. All three of these plans are named after the sections of tax code that govern them. Beginning in 2006, there was a new type of plan known as the Roth 401(k). It has the same contribution limits as a regular 401(k) plan, but contributions are made with post-tax dollars and future distributions are tax-free.
With defined-contribution plans, your employer deducts a portion of your income, before taxes, and deposits it in your account. Because these are tax-deferred accounts, your contributions grow to a larger amount than if you were to pay income taxes.
As a result of the Economic Growth and Tax Relief and Reconciliation Act of 2001, you can make larger contributions to your 401(k) or other retirement plan beginning in 2003. A catch-up provision allows workers who turn age 50 to make even larger contributions.
The individual contribution limit for 401(k), 403(b), and 457 plans for 2013 is $17,500. For those who will be 50 years of age or older during 2013, the contribution limit is $23,000. Since 2007, limits have been indexed to inflation in increments of $500.
Yearly individual contribution limits (2004-2013):
Your contributions to a 401(k) or other defined-contribution plan are made to a tax-deferred account. Tax-deferred investments are allowed to compound until you begin to take out money from that account. As a result, they grow to a much larger sum than if you had to pay taxes each year along the way.
The tax advantages of tax-deferred accounts make them a great way to save for your retirement. If your employer has a 401(k) plan or other tax-advantaged retirement plan, it clearly pays to contribute as much as you can every year, and to start as soon as possible. If matching contributions are available -- whether partially or fully matching -- a defined-contribution plan makes even more sense.
The following topics affect the handling of a retirement plan that is sponsored by your employer:
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
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