A pension plan is a type of retirement plan typically offered by employers as an incentive to attract and keep workers. Pensions may be completely or partially funded by the employer but often involve combined employer and employee contributions. An individual retirement account, or IRA, is a specific type of retirement account usually established by an individual, although some IRAs may be handled through an employer. In many respects, the two types of accounts are similar, but some important differences exist as well.
Defined Benefits Pension
A defined benefits pension plan is one that offers a specific set of benefits to the pensioner. Benefits are typically based on how long the person was employed by a company and his annual earnings. Contributions may be made by the employer only, the employee only, or both. The employer guarantees the employee a certain payout, and the employer assumes the investment risk. Whether or not the investments go well, the employee will still receive the same level of pension income. Taxes are due on pension plans when the money is distributed to the retiree.
Defined Contribution Pension
Pensions established as defined contribution plans are those where the employee’s retirement payout depends on how well the plan investments do. If the investments make money, the employee will end up with a larger amount of funds in retirement than he will if the investments perform poorly. The ultimate risk lies with the employee rather than the employer, and payout is not guaranteed. As with other pension plans, funds are protected from theft or mishandling by the Employee Retirement Security Act of 1974, commonly called ERISA.
A traditional IRA is a retirement account that can be set up through an employer, but more often, it is set up independently outside of the workplace. Traditional IRAs may be entirely funded by the employee, although some plan types, such as SEP and SIMPLE IRAs, may include employer-matched funds. Money contributed to an IRA is not taxed until it is taken out of the account, when the account owner is often in a lower tax bracket. Both contributions and earnings are taxed at that time. Withdrawals before age 59 ½ are penalized with an additional 10% excise tax. The maximum annual contribution as of 2011 is $5,000, or $6,000 if the contributor is 50 or over.
A Roth IRA is similar in some respects to a traditional IRA in that it is set up to be a source of retirement income. Penalties are assessed for early withdrawal. However, funds contributed to a Roth IRA are taxed prior to being deposited in the account, and qualified disbursements are tax-free. The contribution limits are the same as for a traditional IRA, but an income cap applies – single persons earning more than $107,000 a year and couples earning more than $169,000 are not permitted to contribute to a Roth IRA.
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