A pension plan is absolutely necessary if you want to live your retirement comfortably, but what is it and how does it work? By exploring the basics of pension funds, you may find how essential it is for when you grow older.
What is a Pension Plan?
A pension plan is a retirement savings plan where an employer maintains a fund on behalf of its employees for their retirement. The money is usually invested in low-risk growth investments that are designed to be long-term. The plan is tax-deferred, meaning taxes are not deducted from funds added to your account. However, once payments begin, the pension funds will be taxed like regular income tax.
How Does a Pension Fund Work?
There are two types of pension plans that you may hear about—a defined benefit and defined contribution plan. These two programs work very differently, but both help you create a pension fund for your future.
A defined benefit plan is when you receive a defined benefit that acts as annual income after retirement. This type of pension fund is based on your earnings once you end your employment with your workplace and is the employer's promise to pay out a certain amount of income every year on retirement. When you contribute to a defined benefit plan, your money goes into a pot with that of other members. This pension fund is most often found in the public sector with government jobs at the state and local level.
A defined contribution plan is the type of pension fund most people find familiar because a 401(k) is a defined contribution program. Rather than having set payouts after retirement, you build up savings that can eventually be used to provide an income after you retire. The “contribution” aspect of this pension fund results from the contributions that you put into the investment. The money you contribute is invested into funds that hold shares or bonds and grow over the years. It is your responsibility to build up your investment and track your funds with a defined contribution plan to be sure you have enough after you choose to retire.
How Do I Start a Pension?
Starting a pension is usually easy. Most workplaces automatically enroll you into a defined contribution or benefit plan when you begin your employment. However, you do have the option to opt-out of your pension if you’d rather create personal savings account for your retirement. As mentioned before, most public sectors use a defined benefit plan whereas private businesses choose a defined contribution method. Your employer limits your fund choices to the program that your workplace uses.
For more control, you do have the ability to begin your own personal pension that gives you the choice of provider and more investment opportunities. However, choosing to create a personal plan makes it your responsibility to create, track, and manage your pension.
