Retirement plans are now all over the place as more people become aware of the importance of them.
The government has been supporting this by providing various tax breaks because they are letting us know that we cannot rely on social security benefits alone.
If you are self-employed, there are retirement plans for that. And even if there are no retirement plans at work, you can take advantage of the non-employer sponsored retirement options such as the Individual Retirement Arrangements (IRA).
If you work for the government, or the non-profit, the retirement plans are also differently called.
However, they all boils down to one thing, majority are tax deductible and some institutions provide matching contribution to motivate you to save more.
Anyways, when we’re talking about employer sponsored retirement plans, the Employee Retirement Income Security Act (ERISA) covers two types of plans: defined benefit plans and defined contribution plans.
1. Defined Benefit Plan
A defined benefit plan promises a specified monthly benefit at retirement.
The plan may state this promised benefit as an exact dollar amount, such as $1,000 per month at retirement. Or, in most cases, it may calculate a benefit through a plan formula that considers years of service, salary and age at retirement as the determining factors for calculating the amount.
For example, an employee who is age 55 can receive 80 percent of average salary for the last 3 years of employment after working for 30-years with an employer base on the company’s retirement formula. The simplest way to explain this is that this plan is similar a pension plan such as the Social Security Benefits where they give you a set amount for the rest of your life.
Defined benefit plans have been phased out by a lot of private companies in favor of the defined contribution plans. In fact, only a handful of big corporation and mostly government agencies offer this particular type of retirement.
2. Defined contribution Plan
A defined contribution plan does not promise a specific amount of benefits at retirement.
In these plans, the employee or the employer (or both) contribute to the employee’s individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually.
The retirement saving’s contributions are normally invested on the employee’s behalf and are usually invested in various investment assets such as cash equivalents, fixed income funds (a.k.a. bonds), or stock mutual funds. The employee will then receive a statement (sent either monthly or quarterly) indicating the balance in their account, which is based on contributions plus or minus investment gains or losses. The account balances will usually fluctuate due to the changes in the value of the investments.
Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.
Source: IRS.gov