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 many 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 provide retirement income based 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.

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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. A Roth 401(k) 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.

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 2020 is $19,500. For those who will be 50 years of age or older during 2020, the contribution limit is $26,000. Since 2007, limits have been indexed to inflation in increments of $500.

Yearly individual contribution limits (2004-2020):

YearYearly limitAdditional contributions (age 50 or older)Catch-up limit

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 on the income each year along the way.

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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:

  • Early withdrawals. If you take out money from your 401(k) plan before you turn age 59-1/2, you will owe income taxes on the amount of the withdrawal. More than likely, you will also have to pay an early-withdrawal penalty of 10% on the amount. There are very few exceptions to the 10% penalty.
  • Required minimum distributions. The IRS requires you to begin taking distributions every year after you turn 72. These are called required minimum distributions. RMDs are also called MRDs.
  • Rollovers. If you leave your employer or retire, you can move your 401(k) plan assets to an IRA or retirement plan of another employer. This process of moving your retirement plan is called a rollover. Be sure to handle a rollover carefully so that you avoid any early-withdrawal penalties or income taxes.

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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