Employer Sponsored Retirement Plans

Employer sponsored retirement plans

Matching contributions, or combining an employee's contributions with that provided by employers, is a very powerful incentive, or motivator, for encouraging participation in employer sponsored retirement savings plans. It is essentially free money. In these employer sponsored retirement plans, employees choose how to distribute their investments among the many different investment products.

Employer sponsored retirement plans are generally grouped into two major categories: defined benefit and defined contribution. In a defined benefit plan (often refered to as a "pension"), the employer promises to pay a defined amount to retirees who meet certain eligibility criteria. The employer pays a lifetime monthly benefit to retirees who fulfill specific age and service requirements. Benefits are usually linked to the number of years of service and salary level.

However, due to rising costs of defined benefit plans, fewer and fewer employers offer defined benefit plans today.

An alternative to a defined benefit plan is one that defines the contributions that an employer can make, not the benefit that will received at retirement. The employee receives the proceeds in either a lump sum or annuity paid at various intervals. Since the benefit is not defined, the retirement outcomes depend on how well the employee does investing the money. In 1978, the Internal Revenue Code was modified to create 401(k) plans, authorizing the use of a new type of defined contribution plan that allows employees to make pre-tax contributions to a retirement plan.

Employee 401(k) contributiona are automatically deducted from their paycheck each pay period. This money is taken out before the paycheck is taxed. Contributions are invested at each employee's direction into one or more of the mutual fund like options defined in the 401(k) plan. Employers often match employee contributions, but are not required to do so.

An advantage of these types of employer sponsored retirement plans is that employees can choose investment products that match their personal investment goals. One drawback is that many employees do not have a basic understanding of investments, and as a result, invest in products that do not match their investment goals or their risk comfort level. With proper education, employees will become comfortable with their investment choices and feel confident about their retirement preparations. Because most young people will likely be required to fund a substantial part of their retirement, it is neccessary to begin learning about investing early in life.

Even if future workers don't have a 401(k) at work, they can set up their own Individual Retirement Account (IRA). Under an IRA, they can put aside up to $4,000 of earnings yearly, with the maximum rising to $5,000 a year in 2008. The real beauty of the IRA is that earnings accumulate on a tax-deferred basis increasing the already powerful effect of compound interest. A yearly $4,000 non-deductible IRA contribution earning at a rate of 10 percent per year compounded annually over a 20-year period will grow to about $252,000. If the earnings were taxed annually in the 25 percent bracket, the account would grow to only about $186,000. Powerful stuff for those who want to invest in themselves.

The IRA alternative can be very attractive to young people and their parents and grandparents. An IRA can be used to pay for certain college and home-buying expenses. Qualified expenses include tuition, fees, books, supplies, and required equipment. For students attending college at least half time, room and board also qualifies. If students withdraw up to a total of $10,000 to buy or build a first home, they will escape the penalty. However, they will owe income tax on the withdrawal in both cases.

On the other hand, the Roth IRA has no deduction for contributions, but insteak provides a benefit that isn't available for any other formof retirement savings: if you meet certain requirements, all earnings are free of taxes when you or your beneficiary withdraws them.

The opportunities for investing in IRAs are almost unlimited. Individuals can find sponsored IRAs in many institutions-banks, savings and loans, credit unions, mutual funds, insurance companies-offering almost every imaginable investment. If investors prefer to put together their own portfolio rather than rely on mutual fund managers, they can do it through what is colled a "self-directed IRA".

These accounts, usually set up through brokers, let investors choose what they want to investin, such as stocks and bonds of individual companies. They decide what and when to buy and sell. But if they wheel aand deal too much, commissions can eat up a good portin of a nest egg. The fees attached to this type of account demand close attentin, especially in the early years of an IRA, when it holds a relatively modest amount.

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