Defined benefit (DB) plans are all over in the news, with claims that they pay out too much and are not sustainable. Defined contribution (DC) plans are advertised by every financial institution, but most of us don’t really know what we’re getting into or what these even are. Let’s break it down so you can see what you’re working with, and how to make these work together.
So what’s the difference between a DB and DC plan?
The key difference is what’s being defined (promised). With a defined benefit plan, it’s the benefit that is being defined – the payout is what’s promised. DB plans don’t calculate your retirement check amount according to your account balance, they use a formula. Usually the formula is a combination of years worked, age at retirement, and salary earned. DB plans use the formula to determine the benefit, and it’s paid out for the retiree’s lifetime, regardless of when the account is emptied.
In a defined contribution plan (aka deferred compensation plan), it’s the contribution that is being defined – the amount put in is what’s being promised, as opposed to the payout. Defined contribution plans are basically a bucket system. You put money into the bucket, it’s invested, and when you retire you take money out of the bucket until it’s empty. Most retirement plans feature a type of optional plan – 401(k), 457, 403(b) plans – these are all classified as DC plans.
Now you know what they are – what can you do to maximize that cash?
Step 1: Find out what you’re contributing to now
When you start a job you are often asked (or, in some cases, required) to contribute to some form of pension or retirement plan (unless you’re self-employed, in which case you’re on your own). Which plan you contribute to is determined by what kind of job you have. If you work in what’s called the “public” sector (the State, schools, local government, etc), you are likely paying into a public pension system. If you work in the “private” sector (anywhere not “public”) then you likely pay into Social Security. Of course, there are about a thousand exceptions including federal plans, union plans, optional retirement plans…you see where I’m going with this. Your mandatory plan should accumulate to the majority of your retirement income.
Step 2: Fill the plate
Regardless of what type of mandatory plan you contribute to, it’s most likely that it’s not going to fill your income plate. Your pension (DB plan, optional plan, Social Security, etc.) is really the meat – or tofu – and potatoes of your retirement. But they are only the main dish -- not enough to fill the whole plate. On average it accounts for about 60% of retirement income.
So what about that other 40%? That’s where you add some veggies and rice to your plate. Some would say cut your expenses. Some would say get a job in retirement. But if you start contributing to a DC plan now, you can create income to cover that average 40% deficit. You can fill the plate.
Step 3: Pick a Veggie
Find a DC plan that works for you. What are you most concerned about? Are you investment savvy? Are you terrible with money and just want it put away where you can’t touch it? Do you want to pay taxes now or later? Does your employer match any of your contributions? What are the fees?
You can always roll money from old plans into an optional DC plan. Sometimes it’s best to consolidate to minimize those fees. Of course all of this leads to the big question of, “Which DC plan is right for me?”
Do you want to put money away pre-tax (before you see it), but also have the ability to take loans or hardship withdrawals?
401(k), 403(b) – These plans have and hardship withdrawal options, but if you quit your job and cash out, there are taxes and sometimes (most times) a Federal penalty to pay. 401(k) plans are available through most employers and financial institutions, while 403(b) plans are only available through certain employers and can have restrictions attached to how many hours you work or what kind of job you have. Both plans fall under the same maximum contribution umbrella, which means you can contribute up to $17,500.00 a year into one or both, not to exceed $17,500 altogether. If you’re 50yrs or older, you can contribute an extra $5,500.00, called a “catch up," to these plans (again, not to exceed $5,500 altogether).
Are you already contributing to a 401(k) or other DC plan, working a government or state job, and wanting to contribute MORE than the maximum?
457 – This plan is only available for government and state employees, so you’d have to get it through your employer if you’re eligible for it. The 457 has loan and hardship provisions, and there is no Federal penalty if you must cash it out. Additionally, it falls under its only maximum contribution umbrella, so you can shovel an additional $17,500 a year into this plan (plus the catch up if applicable).
Do you want to contribute to something on lock-down -- i.e. an account where it’s difficult to take the money out before retirement?
IRA – Individual Retirement Plans are often offered through banks or financial institutions. They do not offer loan or hardship provisions. You may take your funds out on what’s called a 60-day rollover, but you must pay it back within 60days or you get charged taxes and the Federal penalty. There’s a bonus rule that you can only take a 60-day once within a 12-month period. They fall under the big contribution max umbrella with the 401(k) and 403(b).
Is your number one excuse for not contributing, “I don’t make enough money?” Are you more concerned about paying taxes in retirement than now?
Roth – Roth is more of a designation than a type of account. You can get a Roth IRA, Roth 401(k), Roth 403(b)…you get the idea. Roth means that you are paying taxes now rather than later, so the important question to consider is whether or not you expect your tax rates to increase in the next 30 years.
If you are under the poverty line, you are in the lowest tax bracket possible. Does that mean you might feel pinch of a retirement contribution more than someone making $80k/yr? Sure. But you will be paying far less tax on your retirement income than they will. The added bonus here is that contributions are still invested and grow, just like any other account, but that money you earn by investing is also tax free. Contribution maximums are determined by your income usually, but are set at around $5,500 a year.
The biggest advantage anyone has is time. The more time you work, the more money you contribute to your mandatory plan. The sooner you put additional money into an optional DC plan, the bigger your mound of veggies will be…and who doesn’t love extra veggies? Ok…for metaphor purposes, maybe change the veggies to ice cream. Yeah, I’d much rather have extra ice cream.