What is a defined benefit pension plan? If you are working as a teacher in a public school system, you may be eligible for a state-sponsored defined benefit pension plan that provides you with a fixed monthly payment after your retirement. However, you need to determine whether the benefit you get from the defined benefit will be enough to fulfill your post-retirement needs. If you feel that the plan is insufficient to meet your expenses after retirement, you will need a supplemental plan that will top up your existing defined benefit plan. Most teachers use defined contribution plans to complement their primary defined benefit plans.
However, if you are not eligible for a government-sponsored defined benefit plan, your only choice is to go for defined contribution plans that are offered by most private employers to their employees. In this article, we explain what defined contribution plans are, and how they can help teachers to retire comfortably.
Defined Contribution Plans
Defined contribution plans are retirement plans in which employees contribute a percentage of their salaries or a fixed amount to a retirement account each month, with employers potentially making a matching contribution.
How Defined Contribution Plans Work
The employer-sponsored defined contribution plans work by setting up a retirement account that is funded by getting contributions from the employer, employee, or both. The contributions made to the retirement account are generally tax-deferred, which means that you don’t have to pay taxes on the contributions or the profit your contributions earn while in the retirement account. However, you will have to pay taxes when you make withdrawals.
Types of Defined Contribution Plans
Two of the most popular and common types of defined contribution plans are 401(k) and 403(b) plans. Defined contribution plans are provided by your employer and can only be created when you are an employee. Outside of your employer, you can also opt for IRAs or individual retirement accounts, such as a Roth IRA or traditional IRA.
1- 401(k) plan
401(k) plans allow for tax-deferred contributions to the retirement account, and the amount an employer and employee can contribute to the retirement fund is limited by the IRS. Employers offering their employees a 401(k) plan allow them to choose from a range of investment options, including stock and bond mutual funds, cash, and sometimes alternative investments such as Real Estate Investment Trusts, or REITs.
For the year 2021, the contribution limit for employees under age 50 is $19,500 per year, whereas employees above age 50 are allowed catch-up contributions of $6,500 on top of the $19,500 yearly contribution limit.
The terms of 401(k) defined contribution plan define the formula for matching contributions from employers. Some employers elect to contribute generously to the retirement fund of their employees. For example, your employer may opt to fully or partially match your contributions up to a certain percentage of your annual salary.
2- 403(b) Plan
403(b) plans are offered to employees of public schools and some tax-exempt organizations. Similar to 401(k) plans, contributions to 403(b) plans are also tax-deferred and have similar contributions limits. For the year 2021, employee contributions are capped at $19,500 if you are under age 50. Or $26,000 if you are age 50 or older.
Employees can also get matching contributions from employers, depending on the terms of the plan. Matching contributions by employers provide employees with free money, which employees must exploit by making the required amount of contributions. Suppose, your employer matches 50% of your contributions up to 5% of your annual salary. If you contribute $5,000 per year, your employer would contribute an additional $2,500.
3- Roth IRAs
Roth IRAs are individual retirement accounts in which tax is deducted upfront on your contributions. Withdrawals from the fund after age 59.5 are tax free, as long as the Roth account has aged 5 years or more. The maximum annual contribution an individual below the age of 50 can make to Roth IRAs is capped at $6,000 for the year 2021. For individuals aged above 50, the maximum limit is $7,000. Roth IRAs are suitable for those individuals who expect to fall in a higher tax bracket at the time of their retirement and, hence, prefer paying taxes on the contributions now to enjoy tax-free withdrawals after their retirement.
4- Traditional IRAs
Traditional IRAs are individual retirement accounts in which you can make contributions that are tax-deductible, which means that you lower your income tax for qualified contributions to your IRA. Taxes are taken out upon withdrawal at any time, plus an additional 10% early withdrawal penalty applies for withdrawals that occur before reaching age 59.5. For 2021, the contribution limit for individuals aged below 50 is $6,000 annually, whereas the limit for individuals aged above 50 is $7,000 annually.
There are plenty of defined contribution retirement plans available for teachers who want to supplement their defined benefit plans to accumulate a sizeable retirement income. You can even subscribe to a combination of different plans, such as 403(b) and Roth IRA, but you will have to comply with the contributions limit set by the IRS. It is important to plan for your retirement now and save as much as you can to lead a prosperous retirement life.