If you work for a company that offers a 401(k) or another type of defined contribution retirement plan, it is likely quite different from the benefits that were offered to workers and retirees in the past.
Many retirees of several decades ago could count on income from one or more sources. These included an employer pension, Social Security, and/or interest from personal savings and investments. Plus, because life expectancy was shorter with prior generations, income did not typically have to last very long.
Fast forward to today, when employers are doing away with defined benefit plans, due in large part to the expense of keeping them running. These plans are being “replaced” with plans where contributions are made by the employee participants – up to a stated annual maximum.
Regardless of how much money is ultimately saved in a defined contribution plan, there is no guarantee of how much income – if any – will be generated by the retiree. With that in mind, it is essential that you have a plan in place. Otherwise, your income and assets could run dry while you still need them.
The Key Differences Between Defined Benefit and Defined Contribution Retirement Plans
There are several significant differences between defined benefit and defined contribution plans. These include both the funding and the way the benefits are received. For instance, defined benefit plans payout a specific amount of income to the participant during retirement. The amount of the income is determined by a formula that includes certain factors like the worker/retiree’s salary, as well as the length of time they were employed by the company.
The risk of ensuring that enough income is paid out is borne by the employer, not the employee. So, if the underlying investments do not perform well, then the funds are made up for through the company’s earnings.
If the worker/retiree predeceases his or her spouse, the pension income may continue for the surviving individual. The dollar amount may either be the same or reduced. The funds that are received are taxed as ordinary income.
In contrast, the contributions that are made by employees to a defined contribution plan are typically done before tax. Therefore, the amount of income tax will be reduced in the year(s) when deposits are made.
The earnings that take place in the plan are tax-deferred, meaning that there is no tax due on the growth until the time of withdrawal. Every year, the IRS stipulates the maximum amount that may be contributed to 401(k)s and other defined contribution plans. For 2021, participants who are age 49 and younger can contribute up to $19,500 and those who are 50 and older may deposit an additional $6,500 for a total of $26,000.
The participants in 401(k) plans can usually choose from a variety of different investment options. These may include mutual funds, money markets, and/or shares of the sponsoring company’s stock (if applicable).
When the employee is ready to retire, the funds that are in the defined contribution plan can be rolled into an annuity or other type of account(s) where an income plan can be created. Unfortunately, if the underlying financial vehicles do not perform well, income could run out at a time when it is still needed.
Defined Benefit versus Defined Contribution Plans
|Defined Benefit Plans||Defined Contribution Plans|
|Employee contributions||Depends on the plan||Maximum annual amount|
|Earnings||Employer’s responsibility||Tax-deferred (but employee / participant takes all of the risk)|
|Investment risk||Employer||Employee / Participant|
One strategy for generating income from a defined contribution plan is to purchase an annuity and “roll” funds from the plan over to it. Annuities can provide a regular stream of income for either a preset period of time, or even for the remainder of the recipient’s lifetime, no matter how long that may be.
Not all annuities are the same, though, so it is important to understand which annuity will or will not work, based on your short- and long-term objectives. An Annuity Gator retirement income specialist can help.
If you have questions about how to convert your defined contribution savings into a guaranteed stream of retirement income, feel free to contact us directly by calling (888) 440-2468 or by sending us an email to our secure online contact form. We look forward to helping you create a reliable income for the future.