The title of this blog is actually a common search among planning retirees. This search can end up confusing people even more than when they first typed it into google. Understandable as retirement plans have many different options with confusing language that can make it difficult to know which direction to go into. 

In fact, a 401(k) is an example of a retirement plan that can be classified into a defined contribution plan. There are two central categories to understand when speaking of retirement funds. They are Defined Contribution Plans and Defined Benefit Plans. 

Before getting into the details of 401(k)’s let’s first understand what a Defined Contribution Plan is and what a Defined Benefit Pan is. It’s noteworthy to compare and contrast the two while understanding the different types of funds within each that may be of use to us. 

Defined Contribution Plan

Defined-contribution plans in 2019 made up $8.2 trillion of the $29.1 trillion in retirement savings. Defined-contribution plans are incredibly popular among employees because of their ability to control how much goes into the fund.

However, while there are benefits there are also downsides. 

What is it?

A defined-contribution plan (DC) is a retirement plan that is typically tax-deferrable; meaning until the owner does something with the money they won’t have to pay taxes on the investment until then. A 401(k) and 403(b) are both DC plans that are tax-deferrable. 

These defined contribution plans are where the employee contributes a percentage or a fixed amount of their check to an investment fund that is meant to be used for retirement. This is completely up to the employee how much they put into their retirement savings and there is no guarantee of the amount they will collect when retired. There are limits however that the IRS places as a dollar amount. 

Often an employer may match up to a certain amount or percentage as a benefit for working for their company. A pretty common ratio will be 50 cents to the dollar. 

Once an employee chooses the type of retirement plan they will also choose what kinds of funds they want to invest in, in their 401(k) (I.E mutual funds, stocks, bonds, etc).

The two most popular defined contribution plans are 401(k)s and 403(b)’s Let’s talk a little more about these specific plans. 

401(k)

This is a tax-advantaged type of retirement fund as discussed because of its ability to defer taxes until the funds are taken out. Often employees will make payments to their accounts by using an automated system. This means that the amount that will go into the 401(k) will be deducted from your paycheck each time so you don’t have to worry about it. 

There are however two types of 401(k)s where the taxes differ. There is the Traditional 401(k) and the Roth 401(k).

Traditional: This is the 401(k) we have been referencing as far as taxes go. You will be taxed when you go to withdraw which is typically at retirement. You must be 59 ½ years old to make withdrawals from this fund or meet other IRS requirements. The line of thinking is that if you are going to be subject to lower taxes upon retirement based on things like where you live, this is a great direction to go into. 

Roth: The big difference between the Roth 401(k) and the traditional is the taxes. In the Roth, you pay taxes upfront and can make tax-free withdrawals after 59 ½ years old.  The opposite reasons for why a person may opt for the traditional will be the reason they get into the Roth. If your retirement sees higher taxes in the future then pay them now to avoid them later. 

In both accounts, if you withdraw early you may be subject to a 10 percent early withdrawal fee along with any taxes you owe upon withdrawing. 

403(b)

403(b)s are also a tax-advantaged retirement plan but are slightly lesser known than the 401(k) retirement plan. This is because the plan itself is only geared towards a certain clientele. These types of professions include doctors, teachers, school administrators, government employees, and librarians. These are all professions in tax-exempt organizations. 

This type of fund has a significantly limited amount of options to invest in as opposed to the 401(k) that offers more in the private sector. The limits to how much you can contribute remain equal to the ones of the 401(k) plans. 

However, one of the benefits of a 403(b) is that there is a great ability to make catch-up contributions. An additional benefit is there seems to be more protection from creditors in this kind of retirement plan than the other. 

Similar to the 401(k) you can have both opinions when it comes to taxes. You can choose the traditional and pay taxes when you go to withdraw or you can do the Roth which taxes you as you go.

These funds also require you not to withdraw before 59 ½ or you will be subject to the same kinds of penalties at 10 percent not including tax as the 401(k).

Defined Benefit Plan

A Defined Benefit Plan can most commonly be referred to as a pension. Defined Benefit Plans are becoming decreasingly popular among the private sector. This is because private companies are offering more Defined Contribution Plans instead of pensions.

However, you will still find a lot of pensions in the public sector like government jobs, education, and more. This retirement plan is pretty different from the above-mentioned because of the guaranteed paid amount by the employer. 

What Are The Specifics?

A Defined Benefit Plan is different because it is a fund that the employer contributes to so that when you are retired you will be guaranteed a specific dollar amount. The benefits are referring to the specific amount you get which is determined by the length of working history with that employer and the history of employee salaries for that employer. 

As opposed to managing your money yourself and the payments, the employer is the sole responsible party for this and often will hire outside management to do the funds and assess the level of risk. Pension plans require an employee to meet a certain age requirement to start using any funds, unlike the DC plans where they can withdraw without penalty. Often if you don’t meet a certain work length history with an employer you will not become eligible for a pension retirement fund. 

The guarantee comes from the fact that the employer is the one coming up with calculated benefits and if they fall short due to bad investments etc., they are legally required to make a cash payout to make up for the funds.

Now, once an employee becomes eligible for the funds they can take their funds in two different forms. They are lump-sum and annuity payments. 

Let’s get into the differences between the two. 

Annuity

This is where the employer gets paid on a monthly basis with the calculated benefit amount that was determined upon job acceptance. This type of payment requires monthly checks until death. If an employee worked for 35 years for a company and the benefit was 150 a month types the number of years that they were an employee, then the monthly payment would be $5.250. 

Single-Annuity: This means that this type of plan is meant for someone who is single and the benefits will stop once that person has died. 

Joint-Annuity: This is referred to as qualified survivor and joint annuity. This means that if the employer has unfortunately passed, it would allow the surviving spouse to collect the monthly benefit or lump-sum payment. 

In both accounts, if you withdraw early you may be subject to a 10 percent early withdrawal fee along with any taxes you owe upon withdrawing. 

Lump-Sum

This the alternative to monthly payments and sounds just as it is. This is when the employee or the surviving spouse of the employee decides to take the agreed or guaranteed amount in on a lump sum payment. 

Factors

IT’s best to discuss with a financial advisor what the best plan is for you in how to take the money as both options offer vastly different things. 

Another factor to consider is when entering a pension plan working another year has a large effect on the amount of money you will receive. It will not only boost your multiplier of how many years worked but it also provides an opportunity to increase your salaries which will also increase your calculated benefit. 

Key Difference Review

There are several key differences between the two types of funds that one should really know if given the option to choose. Let’s compare and contrast with bullet points to have an organized understanding. 

Defined Contribution Plan: 

• There is no guarantee for the amount of money you will have upon retirement.

• The contributions are completely up to the employee and may be matched by the employer to a certain percentage.

• There are penalties for withdrawing early but there is the ability to access it beforehand. 

Defined Benefit Plan:  

• There is an exact guarantee in the dollar amount that will be available to you for retirement. 

• This fund is completely managed by the employer where the employee doesn’t have control of the investment. 

• An employee must reach a certain milestone in years worked for an employer in order to access their pension plans. 

Note: Sometimes an employer will allow an employee to do a combination of both. This is less common but if both are offered or even a combination of two, then it is important to understand what you are going to receive as far as retirement savings go. 

Understanding Your Options

Now that you understand that a 401(k) is a part of one of the two major types of retired plans it will be easier to understand what kind of plan you are getting into. The direction you head in terms of choosing between a Defined Contribution Plan and a Defined Benefit Plan will largely depend on the type of profession you have.

The private sector will cater towards the DC plans because of the popularity of a 401(k) and the ability to allow an employer to contribute their own desired amount to their retirement funds. This also allows an employer to offer a competitive match based on a certain percentage that does not go over the limit that the IRA puts in place. 

If you work in the public sector your choices become more of the pension plan under the Defined Benefit Plan or possibly the 403(b). In the pension option, you are leaving your retirement savings completely up to the hands of your employer where they are legally required to pay you a cash difference if their calculated benefit amount is not fulfilled for whatever they receive. 

If given the option, most people will opt for a 401(k) or another type of Defined ContributionPlan because of the flexibility it offers in several different categories. It allows the employee to have control of their retirement with how much they put in (to a limit) as well as withdraw should there be an emergency (not recommended). It also allows the employee to have more say over what types of funds they are investing in, allowing them to take as much or little risk as offered. 

With all that being said, it’s not a bad idea to still follow up with a financial advisor to reaffirm and go over the different types of retirement plans available to you and your family 

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