When you eventually retire you want to make sure that you are financially secure enough to
maintain the quality of life that you desire. This means you will need to start making plans to
invest to ensure you have the capital you need during retirement. One option you may have as
an employee is contributing to a defined-contribution retirement plan which is offered by many
employers.
Defined-contribution plan basics
With a defined-contribution plan, you would contribute a portion of your compensation from your
employer into some type of tax-deferred account, such as a 401(k) or a 403(b). Your
contribution would be a fixed proportion of your paycheck with the aim of funding your
retirement. Many times, an employer will match your contribution as a way to make it attractive
to work for the company. With defined-contribution plans you will be subject to rules that dictate
when and how you are allowed to make withdrawals without facing penalties.
How do defined contribution plans work?
Defined-contribution plans are generally funded using pre-tax funds which allows you to avoid
paying taxes on the income until you actually withdraw funds from the account upon retirement.
You will be able to start withdrawing without penalties at retirement age which is 59 ½ years old.
At the age of 72 defined-contribution plans will require that you withdraw a minimum amount
each year, otherwise known as a required minimum distribution.
Advantages of a defined-contribution plan
One advantage of a defined-contribution plan is that employees tend to earn more money prior
to retirement, putting them in a higher tax bracket. Therefore, income taxes are a higher
percentage of their income. When you retire your tax bracket will most likely be lower since you
no longer will be receiving income from your job, which means the funds withdrawn from the
retirement account will incur a lower tax bill.
A defined-contribution plan sponsored by your employer is also advantageous if your employer
offers matching contributions. This means that your employer will contribute a certain
percentage of every dollar you contribute to your retirement account. For example, an employer
may contribute 40 cents for each dollar up to a specified percentage of your salary. Usually, this
limit is around 4% to 5% of your paycheck. Generally, it is best to try to contribute at least the
the maximum amount that your employer will match.
Many defined-contribution plans will offer you various other features that you may find useful in
your retirement endeavors. This may include automatic contribution increases, loan provisions
or hardship withdrawals. A plan may also allow catch-up contributions for employees 50 years
of age or older.
Disadvantages of defined-contribution plans
Despite the many advantages provided by defined-contribution plans, there are some
drawbacks with this type of retirement account. With these types of accounts, you will be
responsible for managing your funds and making your own investment decisions. This can be
challenging if you are not particularly knowledgeable about financial markets. Potentially, this
can lead to you making poor investment decisions that can diminish the capital you need to
maintain your preferred quality of life during retirement.
Is a defined-contribution plan enough for retirement?
It is a good idea to have your retirement goals as well-defined as possible which means
deciding how much capital you need to have in order to maintain the quality of life you desire
during your golden years. You can talk to a professional financial advisor to determine if your
current defined-contribution plan will be adequate to achieve your retirement goals.
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