When a full-time employee starts a new position that includes a retirement benefit, their employer will usually introduce them to their retirement package in their first few days on the job. During this time, it can be easy for one to feel like they are drowning in an ocean of acronyms with regard to their retirement security.
Below, we offer a breakdown of the most common retirement plans and what they mean for a worker’s retirement planning.
Defined-benefit (DB) pensions
A DB pension is an employer-sponsored retirement plan that provides a modest, guaranteed monthly benefit for life. Benefits are calculated based on a formula that includes an employee’s years of service, final average salary, and a benefit multiplier. Both employers and employees contribute to the pension plan, and these funds are collectively pooled and professionally managed, leaving employees less vulnerable to the whims of the stock market.
Defined-contribution (DC) plans
A DC plan is another employer-sponsored retirement plan that is usually referred to as a 401(k), after the section of the tax code in which they were created in 1978. Employees can opt-in to contribute a part of their pre-tax paycheck into a plan, and employers can choose whether or not to offer a matching contribution.
A DC plan differs from a DB plan in that it places all the investment and longevity risk on an individual worker. Since the investments in a 401(k) are not collectively pooled, an economic downturn could threaten one’s retirement savings. And since there is no guaranteed retirement benefit, workers could also risk outliving their savings.
The median 401(k) account balance in one of the country’s largest 401(k) providers, Fidelity Investments, is just $24,500, which is not enough to retire with security.
Individual retirement account (IRA)
An IRA allows individuals to establish a retirement savings account with a broker, bank, or other financial institution. There are two major forms of IRAs: a traditional IRA, and a Roth IRA. The contrasts between them are mostly related to taxes.
In a traditional IRA, one can make tax-deductible contributions to their account, but withdrawals in retirement are subject to tax and there is also a required minimum distribution (RMD) from the IRA beginning at age 72.
With a Roth IRA, one doesn’t earn an immediate tax benefit for contributing, but withdrawals in retirement are not subject to tax and there is no RMD. However, Roth IRAs are only eligible for those who make under a certain amount. The Internal Revenue Service (IRS) is responsible for setting income limits for those who can and cannot contribute to a Roth IRA.
The most one can contribute to a traditional and Roth IRA in one year is $6,000 for those younger than 50, and $7,000 if you’re 50 and older.
Small businesses and self-employed individuals can also open a Simplified Employee Pension (SEP) IRA or a Savings Incentive Match Plan for Employees (SIMPLE) IRA. Both follow the same tax rules of a traditional IRA.
On August 14, 1935, President Franklin D. Roosevelt signed the Social Security Act into law. This act established the Social Security program, a federal initiative that provides disability, retirement, and survivor benefits.
Social Security is primarily financed through employers and employees with payroll taxes. Employers and employees both pay a 6.2% tax on wages up to the taxable maximum of $142,800 (as of 2021), while the self-employed pay a 12.4% payroll tax. For evaluating one’s retirement benefits, the Social Security Administration will calculate a worker’s average indexed monthly earnings during the 35 years in which they earned the highest wages.
It’s important to note that roughly one out of four state and local public employees in the United States is not eligible to participate in Social Security, making their DB pension their primary vehicle for retirement security.
While there are several retirement programs in the United States, DB pensions ultimately remain the best way to guarantee a secure retirement for the dedicated public employees who have devoted their lives to serving our communities.