The Basics Of Pension Plans
It is not the purpose of this overview to furnish legal or accounting advice. It should be considered a somewhat detailed "sketch" and can serve as a reasonable guideline, although its accuracy is compromised both by new legal decisions and by factors which have been omitted for the sake of brevity.
A pension plan is a tax deferred savings plan. Typically, during years of employment, monetary contributions are made by the employee and/or on behalf of the employee by the employer to a retirement plan. The contributions and the earnings generated accumulate over time, tax free, until retirement. Upon retirement, the employee will receive a specific monthly income for life or a lump sum payment. There are two general types of retirement plans: the Defined Benefit Plan and Defined Contribution Plan.
Types of Retirement Plans
- Defined Benefit Plan
This type of plan promises that upon retirement the employee will receive a defined (known) monthly income for the duration of their lifetime. The yearly contributions necessary to provide the promised monthly benefit upon retirement are unknown, however, these contributions are dependent upon a number of variables, such as:
- the amount of the monthly benefit to be received upon retirement;
- the number of years an employee has left until retirement.
- the length of time benefits will be received after retirement.
- the amount of income that can be earned from the accumulating yearly contributions.
- Defined Contribution Plan
This plan is one in which the contributions to the plan are known (defined). However, the amount of money to be distributed upon retirement is unknown. This amount of money will be dependent upon the manner in which the yearly contributions have been invested and how much they have grown in value over the years of employment.
EXAMPLE: The employee and/or the employer contributes yearly into the plan a fixed percentage of the employee's earned income each year. The money contributed to the plan is used to purchase stock, bonds, mortgages, certificates of deposit, treasury notes, etc. The value of these investments and the interest generated as a result will be distributed to the employee in one lump sum upon retirement. Upon receiving this lump sum distribution, the employee usually purchases an annuity which provides him with a specific monthly income for life.
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