What Is a Retirement Fund?
- The world of retirement--and indeed the world of work--has changed a great deal in just a short period of time. Only a few decades ago, many people spent their entire careers with the same employer and were rewarded with generous pensions after those careers were over. Today, that situation is very much the exception, and most of today's workers need to take steps to fund their own retirement.
- The defined benefit plan is what many people think of when they picture retirement, and for some lucky workers this type of retirement fund is still in place. With a defined benefit plan, workers know ahead of time how much they will receive each month while they are retired. The formulas vary, but in most cases the calculation will be based on such factors as years of service and the worker's average salary.
- Although defined benefit plans were once the standard, this has been changing during the past couple of decades. Although many large manufacturers and most government agencies still fund traditional pensions for their workers, most private businesses today use what are known as defined contribution plans to help their workers save for retirement. Unlike a defined benefit plan, a defined contribution plan does not guarantee a set income for life. Rather the plan allows workers to save for their own retirement, with the company often kicking in additional money as well. It is up to the employee to manage his funds and make the appropriate decisions.
- Named for the part of the tax code that created it, the 401(k) plan is one of the most widely used defined contribution plans in the world of business. With a 401(k) plan, workers can set aside a percentage of their salaries on a pretax basis, thereby reducing their tax liability and helping to fund their retirement. The money in the 401(k) plan is taxed only when it is actually pulled out of the plan. In many cases, the employer will match a certain level of contributions--a 50 percent match on the first 6 percent of contributions is common, essentially providing the worker with a bonus for funding her own retirement.
- The 403(b) plan works in much the same way as the 401(k) plan; while the 401(k) plan is used by private businesses, the 403(b) plan is used by school districts and some other public service organizations. The available investment options will very from agency to agency, but most good 403(b) plans will include a mixture of stock mutual funds, bond funds and cash equivalents to give workers of all ages an appropriate choice of investments.
- Individual retirement accounts, known by the acronym IRAs, are another part of the retirement fund picture. The traditional individual retirement account allows workers who meet certain income requirements to set aside money for retirement and deduct those funds on their tax returns. In exchange for this preferential tax treatment, the retiree will need to pay ordinary income taxes when the money is withdrawn in retirement.
- The Roth IRA flips this tax treatment on its head. The money invested in a Roth IRA is not deductible from current taxes, but when the funds are withdrawn in retirement they are not subject to tax. A Roth IRA can therefore be a good deal for young workers with decades to go before retirement. The idea is that the funds will have plenty of time to grow, and the tax-free treatment down the road can more than make up for the lack of up front tax deductibility.