Many Baby Boomers (born in the years immediately following World War II) are now collecting defined benefit pensions. Defined benefit pensions will pay you a fixed pension benefit every month based on how much you earned and how many years you worked at the company. Often, this was 60% to 80% of your last salary before retirement. Companies had to put cash for these benefits in trust. However, if these investments lost money, the company had to come up with the payments to the retirees. There were also numerous underfunded pension funds that defrauded employees. Today, very few organizations have defined benefit pensions for their employees. Only 16% of the Fortune 500 public companies still have deferred benefit pension plans. The other major organizations that still having deferred benefit pension plans are the military, and federal, state, and local governments.
For most organizations with retirement plans today, they offer their employees what are known as defined contribution retirement plans. Defined contribution (DC) retirement plans are the centerpiece of the private-sector retirement system in the United States. According to a recent report from Vanguard, more than 100 million Americans are covered by DC plan accounts, with assets now in excess of $8.8 trillion. The vast majority are 401(k) plans. A 401(k) plan is a defined contribution plan set up by firms for their employees. Typically, the employee contributes an amount each month and the employer matches some or all of the employee’s contribution. A typical arrangement is for the employee to contribute up to 6% of their gross salary and the employer to match $.50 for each dollar the employee contributes. Vanguard also reports these statistics on the millions of retirement accounts they manage:
- 71% of Vanguard managed plans contribute $0.50 for each dollar the employee contributes up to 6% of salary.
- 22% of Vanguard managed plans contribute $1.00 for each dollar the employee contributes up to 3% of salary and $0.50 for each dollar the employee contributes for the next 3% of salary.
- 6% of plans cap their contribution at $2,000.
The huge advantage of a 401(k) is that both your contribution and the employer’s contribution is tax free. The money is typically managed by a bank or mutual fund; all income from your investments is tax free. You are only taxed on the money you take out every year upon retirement. (Of course, you must begin taking distributions no earlier than at 59 ½ years and no later than 72. The IRS gets its taxes eventually). In 2020, an employee can contribute up to $19,500 to a 401(k) tax free, no matter how much their employer matches.
Non-proft organizations can set up defined contribution plans called 403(b)s. The rules and regulations are almost identical to those of 401(k)s. The most important rule for you as an employee who is eligible for a 401(k) plan is to always contribute the amount matched by the employer. The employer’s match is free money and it is tax-deferred until you retire.