Your Employee Retirement Benefits Explained
Gain clarity on your workplace retirement plan by understanding its structure, the key rules that govern it, and the critical decisions you'll face.
Employee retirement benefits are a form of compensation provided by an employer to help their workforce save for retirement. These programs are designed to provide a source of income for employees after they stop working. Participation in these plans is a common way for individuals to accumulate funds over their careers, though the structure and availability of plans can vary significantly between employers.
Defined Benefit Plans
A defined benefit plan, often called a traditional pension, is a retirement plan where the employer promises a specific monthly benefit to an employee at retirement. This benefit is calculated using a predetermined formula that considers an employee’s salary history, years of service, and age. For example, a common formula might be 1.5% of the average of the employee’s final five years of salary, multiplied by the total years of service.
Under this plan, the employer is responsible for funding the plan and making investment decisions. The employer bears the investment risk, meaning if investments perform poorly, the employer must make up the shortfall to ensure promised benefits are paid. This structure provides a predictable income stream for retirees.
The Pension Benefit Guaranty Corporation (PBGC), a federal agency, insures most private-sector defined benefit plans. If a company with such a plan goes bankrupt and cannot pay the promised benefits, the PBGC will pay a portion of the benefits up to a legal limit, providing a safety net for employees.
The employer or a third-party administrator handles the plan’s administration, which includes managing assets, calculating benefits, and making payments. The employee’s role is generally passive, as they are not involved in investment decisions.
Defined Contribution Plans
Defined contribution plans establish an individual account for each employee. The retirement benefit is determined by the total contributions from the employee and employer, plus the account’s investment performance. Unlike defined benefit plans, the employee bears the investment risk.
The most common type is the 401(k), offered by for-profit companies, while the 403(b) plan is available to employees of public schools and certain tax-exempt organizations. Both plans allow employees to defer a portion of their salary into their accounts. The primary difference between the two lies in the type of employer that can offer them.
Employees can often choose between making pre-tax or Roth contributions. Pre-tax contributions are made before income taxes, reducing current taxable income. The contributions and their earnings grow tax-deferred, and withdrawals in retirement are taxed as ordinary income.
Roth contributions are made with after-tax dollars, so they do not reduce current taxable income. The benefit is that both contributions and earnings can be withdrawn tax-free in retirement, provided certain conditions are met. The choice depends on an individual’s current and expected future tax situation.
Key Plan Rules and Features
The Internal Revenue Service (IRS) sets annual contribution limits that can change yearly. For 2025, the employee contribution limit for 401(k) and 403(b) plans is $23,500. Those age 50 and over can make a catch-up contribution of $7,500, while a special, higher catch-up of $11,250 is available for individuals ages 60 through 63. The overall limit, including employee and employer contributions, is the lesser of 100% of compensation or $70,000 for 2025.
Many employers offer a matching contribution to encourage employees to save for retirement. A common formula is a 100% match on employee contributions up to a certain percentage of salary, such as 3%, or a 50% match on the first 6% of contributions. These matching contributions can substantially boost retirement savings.
Employer contributions are often subject to a vesting schedule, which determines when an employee has full ownership of them. With cliff vesting, an employee becomes 100% vested after a specific period, such as three years of service. If the employee leaves before this time, they forfeit all employer contributions.
Graded vesting allows an employee to gradually gain ownership. A common schedule might be 20% vesting after two years of service, with an additional 20% each year until the employee is 100% vested after six years. An employee is always 100% vested in their own contributions.
Managing Your Plan During Employment
While employed, you are responsible for managing the investments in your defined contribution plan. Your employer provides a menu of investment options, and you decide how to allocate your contributions. A common choice is a target-date fund, a diversified portfolio that automatically becomes more conservative as you near your retirement date.
Plan loans allow you to borrow from your account balance. The IRS limits loans to the lesser of $50,000 or 50% of your vested balance. These loans must be repaid with interest, typically over five years, and leaving your job may require immediate repayment to avoid being treated as a taxable distribution.
Hardship withdrawals may be permitted for specific needs, such as for medical or educational expenses, or to prevent eviction. These withdrawals are subject to income tax and a 10% early withdrawal penalty if you are under age 59 ½. While they can provide access to needed funds, they can also hinder the growth of your retirement savings.
Handling Retirement Funds After Leaving a Job
When you leave a job, you have several options for the funds in your retirement account.
- Leave the money in your former employer’s plan, if permitted. This is a simple choice, but you cannot make new contributions and may have limited investment options.
- Roll the funds over to your new employer’s retirement plan. This can be a good way to consolidate your savings, but you must confirm that the new plan accepts rollovers.
- Roll the funds over to an Individual Retirement Arrangement (IRA). An IRA may offer a wider range of investment options and more control over your investments.
- Cash out the account. This option is not recommended, as withdrawals before age 59 ½ are subject to income tax and a 10% early withdrawal penalty. Your former employer must also withhold 20% of the distribution for federal income taxes.