Getting ready for retirement doesn't happen all at once. It takes small steps to create a comfortable and secure plan that aligns with the type of life you want to live after leaving the workforce. A great place to start is exploring the defined contribution plan offered through your employer.
Defined contribution plans are a popular way to save for retirement due to their relative simplicity and potential tax advantages. However, depending on the types of defined contribution plans offered at your workplace, you may decide to choose a combination of choices rather than focus on one.
How do defined contribution plans work?
A defined contribution plan is a retirement account
You and your employer can both contribute funds into this account up to certain limits set by the IRS each year. There are usually management fees associated with the investments you can choose, but it's possible to see what the amount will be and decide on lower-expense options.
One major differentiator between a defined contribution plan and a non-401(k) investment account such as a brokerage account are the tax advantages. Typically, all investments fall into an
How do defined contribution plans differ from defined benefit plans?
Defined benefit plans offered via employers help employees plan for a specific income in retirement and incentivize a longer tenure at a company. They offer a lifetime annuity upon retirement that is set at a specific amount, typically calculated based on years of service at the company and an individual's final salary there. Today, these plans—sometimes called
Defined contribution plans, by contrast, are widely available to working adults. They don't guarantee a particular amount of income in retirement and can change in value based on the performance of your investments. A major advantage of defined contribution plans is their portability; unlike with some defined benefit plans, assets can roll over to a Traditional IRA or your new company's 401(k) plan
There are benefits and drawbacks to both kinds of plans, but defined contribution plans have grown in popularity with employers over the defined benefit plan or pension model. Ultimately, participation is dependent on what your employer offers.
Making the most of a defined contribution plan
If you don't have a defined contribution plan, you can use an
Here are strategies for making the most of a defined contribution plan.
Understand and aim for the employer match
At many companies, the employer offers a contribution match of some kind in part to encourage employees to save for retirement. This match is an amount they will contribute based on employees' level of saving. For instance, they might offer to contribute 1% of your salary to your retirement account for every 1% you contribute, up to 3%. To access this money fully, you'd have to contribute 3% of your salary into retirement—however, you are effectively compensated at 103% of your salary, which can be a nice opportunity to receive free money while saving for your future.
Keep tax strategies in mind
Traditional 401(k) tax advantages arrive early, when you first earn and contribute the money. This is most advantageous if you expect to earn a higher income now than you will later on. Meanwhile, Roth 401(k) tax advantages arrive in retirement. If you're earning a lower income now but expect your income to grow over time, paying the taxes now through a Roth 401(k) account could mean paying less overall, with no tax liability in retirement on those withdrawals.
One strategy for
Take advantage of more tax savings by also using IRAs
The limits for defined contribution plans are rather large relative to the average incomes in the United States.
The IRS limits are:
Types of defined contribution plans
2022 contribution limit
2023 contribution limit
401(k), 403(b), most 457 plans, and government Thrift Savings Plan
$20,500 per individual
$22,500 per individual
If aged 50 and over (same set of plans)
An additional $6,500, for a total of $27,000
An additional $7,500, for a total of $30,000
If you don't have $22,500 or $30,000 to contribute to a plan each year, you're not alone. However, you can compare this option against what's available for an IRA, one of the other leading methods for saving for retirement.
The IRS limits are:
2022 contribution limit
2023 contribution limit
Roth IRA and Traditional IRA
$6,000 per individual
$6,500 per individual
If aged 50 and over (same IRA plans)
An additional $1,000 for a total of $7,000
An additional $1,000 for a total of $7,500
If you find that you can afford to save more than $6,500 a year, you may want to use both an IRA and a defined contribution plan. Defined contribution plans allow you to save much more with tax advantages than you'd have with an IRA alone. IRA contributions are not always deductible on your tax return. This ability is determined based on if you or your spouse are active participants in and employer-sponsored plan and modified adjusted gross income (MAGI).
Pay yourself first to automate good saving habits
When you first start a new job or role at your company, your defined contribution plan represents a powerful opportunity. You can choose a dollar amount or a set percentage—anywhere from 1% to 10% or more—to subtract from your paycheck and contribute toward your defined contribution plan. You won't see those funds for years, so saving in this way may mean you never miss the money in the first place. It's a chance to practice good stewardship of your resources without having to make the conscious decision to save each month.
Of course, if you do have a major change in circumstances, you can always reduce that automatic contribution by working with your HR department or plan administrator. You're not locked in forever. With busy lives full of decisions, many of us value the opportunity to make a wise choice like this one time and reap the benefits for years to come.
Potential disadvantages of defined contribution plans
All forms of retirement savings have benefits and drawbacks. Knowing the structure of defined contribution plans can help you prepare ahead of time and minimize pitfalls.
Some employer contributions aren't
2. Fees may vary
While IRAs often have many investment options, some defined contribution plans only have a few choices available. These funds may have substantial management fees, which can eat into the returns you gain from your investments. Reviewing the fees on both IRA and defined contribution plan options helps you make informed decisions.
3. Retirement income is not guaranteed
Defined contribution plans do not guarantee you a given monthly or annual payout each year of retirement. You'll need to manage your account's level of risk, especially as your retirement date approaches.
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