Pensions vs. 401(k)s: Retirement Plan Essentials
A pension plan is an employee benefit plan established or maintained by an employer or by an employee organization (such as a union), or both, that provides retirement income or defers income until termination of covered employment or beyond.
A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, for example, $200 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service - for example, 2 percent of average salary for the last 4years of employment for every year of service with an employer. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).
401(k) Plans (also known as defined contribution plans), on the other hand, 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% of earnings annually. These contributions generally are invested on the employee's behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments.
How much can you save with a 401(k)?
401(k) plans allow for both Employee and Employer contributions. As of 2020, the maximum employee contribution limit for a 401(k) plan is $ 19,5000 per year ($19,000 for 2019). Employees who are aged 50 and older are able to save $19,500 as well as a “catch-up contribution” amount of $6,500 ($6,000 for 2019).
Overall Limits on Contributions:
Employers have the ability to match 401(k) contributions or add elements to the 401(k) plan, such as a profit sharing feature, to increase the overall yearly savings rate. The annual limit of both employee & employer contributions cannot exceed the lessor of 100% of the participants compensation or $57,000 ($63,5000 including catch-up contributions) for 2020 ($56,000 for 2019).
How do I get started as an Employee?
Pick a percentage of your monthly paycheck that you are comfortable sweeping into long term savings and commit to increasing that amount by 1% each year. For example, if you decide to sign up for your company 401k plan at a contribution rate of 3% of your 2020 income, then in 2021 you would increase that amount to 4%, and then in 2022 increase again to 5%, and so on.
It is also important to find out if your company offers a “401k Match”. If they do, the minimum amount you should contribute to your 401k plan should start at the percentage which allows you to receive the full benefit of their match. Don’t leave free money on the table!
Many 401k plans will offer a core set of investments which are your options for automatically investing your weekly, bi-weekly or monthly contributions. It is important to make sure your cash contributions are working for you by picking investments aligned appropriately with your time horizon, meaning the length of time before you reach the average retirement age.
About the Author:
Adam Angibeau, CFP® is a Certified Financial Planner, Financial Advisor, and Vice President of NS Capital with over a decade of experience in the financial industry. Adam provides asset management and portfolio construction services for individuals and small businesses that are looking for a different approach to having their assets managed. Throughout his career, has had the privilege of advising hundreds of clients throughout the greater Tri-State area to help them achieve their long-term financial goals. Feel free to write to Adam at firstname.lastname@example.org with any questions or comments.
Disclaimer: The preceding article is for discussion purposes only and does not represent the full details on the subject matter. The author and NS Capital LLS are not responsible for regulation changes which may deem this information outdated or incorrect. Readers are encouraged to contact their CPA, Financial Advisor or Company 401(k) Plan Administrator for more information.