Understanding Retirement Plans: 401(k)s and Defined Contribution Options

Retirement plans generally allow employees to postpone paying taxes on income that they defer for their elder years. Many companies, especially smaller ones, have replaced their defined benefit retirement plans (pensions, for example) with those identified as defined contribution plans, such as 401(k)s. These programs shift the majority of the responsibility for funding an employee's retirement directly to the employee. With a defined contribution plan, the employee decides what, and how much, to invest in, as well as whether or not to participate in the program at all. The risks inherent in this type of approach are that the employee may choose not to take advantage of the 401(k) plan, and that he or she may invest their money in the plan too aggressively or conservatively, thereby hindering the accumulation of the finances needed for retirement.

Defined benefit plans guarantee monthly benefits to employees – the benefit is 'defined', or spelled out. The employers decide how the pension funds are to be invested, and they are responsible for investing the money prudently. Employees who take part in the plan become vested -- or, entitled to the benefits that they've earned -- typically after one- to five years of employment. The size of the employee's benefit usually depends upon the number of years that he or she has worked, along with his or her average earnings during the last few years of employment.

With defined contribution plans, employees can put away any amount of money up to a fixed percentage of their earnings. In other words, the contribution is 'defined'. Most employers – over ninety percent of those that offer 401(k) plans -- match those employee contributions with smaller amounts, up to a percentage (typically six percent) of the employee's salary. With this type of plan, the employee is not guaranteed a certain amount to be received at retirement. The amount that the employee gets will depend upon how much is put into the plan and how those funds are invested. The employee, therefore, must see to it that investing is done wisely and according to his or her own retirement goals.

Employees in defined contribution plans typically have at least three choices of where to put their money: stocks, fixed-income investments (such as bonds), and a combination of stocks and bonds (also known as a balanced fund). Many defined contribution plans also allow the employee to borrow money from their plan account before they reach retirement age. As long as it's paid back, no income taxes are incurred on the borrowed funds.

Some other types of defined contribution plans include 403(b) plans for employees of nonprofit, charitable, religious, or educational organizations; Section 457 plans for state and local government employees; and federal thrift savings plans for employees of the federal government. Keogh plans (also known as HR-10 plans) are for self-employed workers, including freelancers who may be covered by retirement plans from their employers. Simplified Employee Pensions (SEPs) are similar to other defined contribution plans, but require much less paperwork. Individuals need not be self-employed to participate, and they can be set up in the same year that contributions are made. SIMPLE (Savings Incentive Match Plan for Employees) plans are designed for small business. Because of their streamlined features, they aren't subject to the rigorous qualification requirements of other tax-qualified retirement plans. Their costs are, therefore, considerably less.