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Chapter 1. What Is a 401(k)? > Taking Advantage of Protective Shells - Pg. 5

What Is a 401(k)? 5 Make sure that you understand what retirement programs (we call them protective shells) your employer offers, and be very selfish about how you use them. Taking Advantage of Protective Shells Companies offer all types of retirement programs, and for different reasons. While it's important for you to understand why your company provides its retirement program, it's much more important to understand what your company has and how you can take advantage of it. Retirement programs such as pension plans, cash- balance or account plans, profit-sharing plans, money purchase plans, employee stock ownership plans (ESOPs), individual retirement accounts (IRAs), and, yes, 401(k) plans are really nothing more than protective shells. What do they protect your money from? Taxes! And as long as you keep your money in the protective shell, you don't pay taxes. Terms to Know Protective shells are different types of programs that protect you from paying taxes, at least for now, on the money that goes into these shells. Contrary to popular belief, these protective shells are not investments. The biggest misconception in America today is that an IRA is an investment. It isn't. It's a protective shell. There are two general types of protective shells: · Defined-benefit (DB) plans · Defined-contribution (DC) plans The difference between the two is fairly straightforward but will require a little bit of effort on your part--like reading the next paragraphs. Defined-Benefit Plans Defined-benefit plans (pension plans) promise to pay you a specific amount of money when you retire, based upon three facts of life: · Service--How long you've worked at the company · Retirement age--How old you are when you retire · Average pay--How much money you've earned over your career or other period of time You take these three facts and pump them into the plan's "formula," and you have the estimated monthly benefit that you'll get when you retire. Notice that we didn't mention investment return. That's because the company decides how to invest pension money, not you. And the company keeps any gains or absorbs any losses on this money along the way. Traditional pension plans have two general drawbacks: · You've got to be around forever (or at least until 55) to get anything meaningful out of them.