What it means
Retirement contributions come from three main sources. Employees contribute a percentage of their pay, employers add their own payments and self-employed people pay in directly from their profits.
In many workplace plans the employee contribution is taken straight from the pay cheque before it is received, which makes saving automatic. Employers often offer a match, which means they add money when the employee contributes.
A typical arrangement is for the employer to add 50 cents for every dollar the employee pays in, up to a stated percentage of salary. Failing to contribute enough to get the full match is like turning down part of your pay.
The tax treatment depends on the country and type of account. Some plans give a deduction when the money goes in and tax the withdrawals later, while others tax the money going in and allow tax-free withdrawals.
Contribution limits are set by the tax authority and change over time, so you should check the current limit before planning. Contributions work best when they are regular and begin early.
A modest monthly payment invested for thirty years has far longer to grow than a larger payment started in the final decade of a career. Compounding (earning returns on earlier returns) does much of the work.
People on variable incomes can still contribute steadily. Setting a percentage of each payment, rather than a fixed dollar amount, keeps the habit going in lean months and raises saving automatically in good ones.
Employers should also pay attention to the accounting side. In a defined contribution plan, the employer's cost is the contribution it promises to pay, whereas in a defined benefit plan the employer carries the risk that the fund may fall short.
This difference affects the balance sheet and the cash planning of the company.
In practice
Real-world examples.
Example
A software engineer joins a company that matches contributions dollar for dollar up to 4% of salary. He sets his contribution at 4%, so on a $90,000 salary he pays in $3,600 and the employer adds another $3,600.
Example
A freelance writer has no employer to contribute for her. She sets up a standing order to move 10% of each invoice into a retirement account, so the saving happens before she has a chance to spend the money.
Example
A small manufacturing company decides to add a retirement plan for its 25 employees. The finance manager budgets for an employer contribution of 3% of payroll, which on a $1,500,000 payroll costs $45,000 a year.
Formula
Calculation
Total annual contribution = Employee contribution + Employer contribution
Employer match = Match rate x Employee contribution (up to the matching limit)
Suppose an employee earns $80,000 and contributes 6% of salary. Her contribution is $80,000 x 0.06 = $4,800. The employer matches 50% of the contribution, so the match is $4,800 x 0.50 = $2,400. The total going into her account is $4,800 + $2,400 = $7,200, which is 9% of her salary.Case study
Seen in the real world.
Westbrook Logistics is an illustrative, fictional company that noticed only half of its staff were contributing enough to receive the full employer match. The finance director suspected that many employees simply did not understand how the match worked.
The company ran a short workshop, explained the match with a simple example and moved to automatic enrolment at a default contribution rate. Employees could opt out, but few did.
In this fictional case participation rose from 50% to 90% within a year, and the company's cost of contributions rose accordingly. The finance director accepted the higher cost because staff retention improved, and the illustrative lesson is that clear explanation and sensible defaults raise retirement saving more than urging people to try harder. The company also sent each employee a yearly statement showing the projected value of their account, which kept the benefit visible.
Watch out
Common mistakes.
- Contributing less than the amount needed to earn the full employer match, which leaves free money unclaimed.
- Assuming that contributions are always tax-free, without checking the rules on the type of account being used.
- Pausing contributions during a market fall, which means buying fewer investments when prices are lower.
Questions
People also ask.
Who can make a retirement contribution?
Employees, employers and self-employed people can all contribute, depending on the type of plan and the rules of the tax authority.
Is there a limit on how much I can contribute?
Yes, tax authorities set annual limits on contributions that receive tax benefits, and those limits are reviewed from time to time.
Can I withdraw contributions before retirement?
Usually only with a penalty or tax charge, since the tax advantages are intended to keep the money invested until later life.
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