Learn About Financial Planning

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9. Employer Fitness Program

Does your employer provide a retirement plan? If so, say retirement experts
. . . grab it! Employer-based plans are the most effective way to save for your future. What's more, you'll gain certain tax benefits. Employer-based plans come in one of two varieties (some employers provide both): defined benefit and defined contribution.

Defined Benefit Plans. These plans pay a lump sum upon retirement or a guaranteed monthly benefit. The amount of payout is typically based on a set formula, such as the number of years you have worked for the employer times a percentage of your highest earnings on the job. Usually the employer funds the plan - commonly called a traditional pension plan - though in some plans workers also contribute. Most defined benefit plans are insured by the federal government.

Defined Contribution Plans. The popular 401(k) plan is one type of defined contribution plan. Unlike a defined benefit plan, this type of savings arrangement does not guarantee a specified amount for retirement. Instead, the amount you have available in the plan to help fund your retirement will depend on how long you participate in the plan, how much is invested, and how well the investments do over the years. The federal government does not guarantee how much you accumulate in your account, but it does protect the account assets from misuse by the employer.

In the past 20 years, defined contribution plans have become more common than traditional pension plans. Employers fund most types of defined contribution plans, though the amount of their contributions is not necessarily guaranteed.

Workers with a retirement plan are more likely to be covered by a defined contribution plan, usually a 401(k) plan, rather than the traditional defined benefit plan. In many defined contribution plans, you are offered a choice of investment options, and you must decide where to invest your contributions. This shifts much of the responsibility for retirement planning to workers. Thus, it is critical that you choose to contribute to the plan once you become eligible (usually after working full time for a minimum period) and, even if you are automatically enrolled in the plan, to contribute as much as possible. Invest wisely - review your plan investment options and revisit your choices at least once a year.

Tax Breaks. Even though you may be responsible for funding a defined contribution plan, you receive important tax breaks. The money you invest in the plan and the earnings on those contributions are deferred from income tax until you withdraw the money (hopefully not until retirement). Why is that important? Because postponing taxes on what you earn allows your nest egg to grow faster. Remember the power of compounding? The larger the amount you have to compound, the faster it grows. Even after the withdrawals are taxed, you typically come out ahead.

The tax deduction also means that the decline in your take-home pay, because of your contribution, won't be as large as you might think. For example, let's assume you are thinking about putting $100 into a retirement plan each month and that the rate you pay on income taxes is 15 percent. If you don't put that $100 into a retirement plan, you'll pay $15 in taxes on it. If you put in $100, you postpone the taxes. Thus, your $100 retirement plan contribution would actually reduce your take-home pay by only $85. If you're in the 28 percent tax bracket, the cost of the $100 contribution is only $72. This is like buying your retirement at a discount.

Vesting Rules. Any money you put into a retirement plan out of your pay, and earnings on those contributions, always belong to you. However, contrary to popular belief, employees don't always have immediate access to the money their employer puts into their pension fund or their defined contribution plan. Under some plans, such as a traditional pension plan or a 401(k), you have to work for a certain number of years - say, 3 - before you become "vested" and can receive benefits. Some plans vest in stages. Other defined contribution plans, such as the SEP and the SIMPLE IRA, vest immediately. You have access to the employer's contributions the day the money is deposited. No employer can require you to work longer than 6 years before you become vested in your pension benefit.

Be aware of the vesting rules in your employer's plan.

Make sure you know when you're vested. Changing jobs too quickly can mean losing part or all of your pension plan benefits or, at the very least, your employer's matching contributions.

Retirement Plan Rights. The federal government regulates and monitors company retirement plans. The vast majority of employers does an excellent job in complying with federal law. Unfortunately, a small fraction doesn't. For 10 warning signs and other information on protecting your pension rights, call EBSA's toll-free number at 1-866-444-3272 and request the booklet What You Should Know About Your Retirement Plan.

The following are some of the most common types of defined contribution plans. For a more detailed description and comparison of some of these plans, go to the Web site http://www.dol.gov/ebsa and click on the Retirement Savings Education Campaign, then follow the prompt to the Small Business Advisor.

401(k) Plan. This is the most popular of the defined contribution plans and is most commonly offered by larger employers. Employers often match employee contributions.

403(b) Tax-Sheltered Annuity Plan. Think of this as a 401(k) plan for employees of school systems and certain nonprofit organizations. Investments are made in tax-sheltered annuities or mutual funds.

SIMPLE IRA. The Savings Incentive Match Plan for Employees of Small Employers is a simpler type of employer-based retirement plans. There is also a 401(k) version of the SIMPLE.

Profit-Sharing Plan. The employer shares company profits with employees, usually based on the level of each employee's wages.

ESOP. Employee stock ownership plans are similar to profit-sharing plans, except that an ESOP must invest primarily in company stock. Under an ESOP, the employees share in the ownership of the company.

SEP. Simplified employee pension plans are used by both small employers and the self-employed.

Other retirement plans you may want to learn more about include money purchase plans; 457 plans, which cover state and local government workers; and the Federal Thrift Savings Plan, which covers federal employees. If you are eligible, you may also want to open a Roth IRA.

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