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Investing for Retirement -- Use Employer's Plan

It is important to personally save for retirement. However, one in three workers report they have not started. A good way to save for retirement is to take advantage of retirement options through your employment, says Pat Swanson, CFP® and families specialist with Iowa State University (ISU) Extension’s Invest Wisely Project (www.extension.iastate.edu/investwisely). There are several types of plans available.

“Traditionally employer-provided pensions have been defined benefit plans in which the employer promises a benefit based on a formula that considers the employee’s years of service and salary,” Swanson says. “However, these traditional pensions are becoming less common. Instead employers are offering defined contribution plans. A defined contribution plan provides an individual account for each participant. The benefit at retirement depends on the amount contributed and the returns earned by the investments in the account.”

A 401(k) plan is the most common defined contribution plan; it is available to employees of many private companies. Other defined contribution plans are 403(b) plans available to public school teachers and employees of nonprofit organizations and 457 plans for state and municipal workers. These plans get their names from the sections of the Internal Revenue Code that authorize them.

Defined contribution plans also are known as salary reduction or tax deferral plans, according to Swanson. Employee contributions to the plans are pre-tax contributions. “You save on your tax bill and invest for retirement at the same time. The earnings on the growth on your investments in the plan are not taxed until you withdraw money in your retirement.”

To illustrate the impact of tax deferral, Swanson describes two 30-year-old individuals who both have $4,000 available to invest each year until age 68. One individual would have the full $4,000 to invest if he contributes to his 401(k) plan each year while the other individual would only have $2,800 if he invests with after-tax dollars (assuming a 30 percent federal and state tax rate). Assuming both earn an annual average return of 9 percent, at age 68 the individual who invested through a salary deferral plan such as a 401(k) would have accumulated more than $1.13 million while the other would have slightly more than $790,000.

The maximum contribution allowed by law is $15,500 annually ($20,500 if age 50 or older) but the company plan may specify a maximum contribution that is less than this. Some plans automatically enroll employees in the plan and deduct part of the employee’s salary into the plan unless an employee opts out. The company may match your contribution in whole or in part. For example, an employer may add 50 cents for every dollar you contribute up to a maximum amount. “It is a good strategy to take advantage of this employer match,” Swanson says.

A defined contribution plan gives the employee choices as to how the money is invested. These typically are mutual funds including stock, bond and money market funds. “The amount of money in your defined contribution account at retirement will depend on your investment choices and the returns these have made over the years. It is important to consider your risk tolerance, your return needs, and time horizon when making your selections,” Swanson concludes.

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The ISU Extension Invest Wisely Project provides a series of newspaper, radio, and web resources for investors.  It is funded by a grant from the Investor Protection Trust (IPT).  The IPT is a nonprofit organization devoted to investor education.  Since 1993 the IPT has worked with the States to provide the independent, objective investor education needed by all Americans to make informed investment decisions.  www.investorprotection.org.

 

 

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Updated January 28, 2008