When you eventually retire you want to make sure you are financially secure enough to maintain the quality of life you desire. This means you will need to start making plans to invest to help 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 you withdraw a minimum amount each year, otherwise known as a required minimum distribution (RMD).
Advantages of a defined-contribution plan
One advantage of a defined-contribution plan is employees tend to earn more money prior to retirement which puts them in a higher tax bracket which means income taxes at a higher percentage of their income. When you retire your tax bracket may be lower which means the funds withdrawn from the retirement account will incur a lower tax bill.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 your employer will contribute a certain percentage of every dollar you contribute yourself 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 maximum amount your employer will match.
Many defined-contribution plans offer you various other features 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 want 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.