What is a defined contribution (DC) plan?
A defined contribution (DC) plan is a generally tax-deferred retirement plan, such as a 401 (k) or 403 (b), in which employees pay a fixed amount or percentage of their salary into an account intended for finance their retirement. The sponsoring company, at times, will match a portion of employee contributions as an added benefit. These plans impose restrictions that control when and how each employee can withdraw from these accounts without penalty.
Key points to remember
- Defined Contribution (DC) pension plans allow employees to invest pre-tax dollars in capital markets where they can grow tax-free until retirement.
- 401 (k) and 403 (b) are two popular defined contribution plans commonly used by businesses and organizations to encourage their employees to save for retirement.
- Defined contribution plans can be compared to defined benefit (DB) pensions, in which retirement income is guaranteed by an employer. With a defined contribution plan, there are no guarantees and participation is both voluntary and self-managed.
Defined contribution plan
Understanding Defined Contribution Plans
There is no way to know how much a defined contribution plan will ultimately give an employee upon retirement, as contribution levels can change and investment returns can rise and fall over time.
According to the Investment Company Institute, defined contribution plans represented $ 8.2 trillion of the $ 29.1 trillion in total pension plan assets held in the United States as of June 19, 2019. The defined contribution plan differs from a defined benefit plan, also known as a retirement plan, which guarantees participants that they will receive a certain benefit on a specific future date.
Defined contribution plans take pre-tax dollars and allow them to grow their investments in capital markets on a tax-deferred basis. This means that income tax will eventually be paid on withdrawals, but not before retirement age (a minimum of 59 and a half, with Minimum Distributions Required (RMD) from age 72).
The idea is that employees earn more money, and therefore are subject to a higher tax bracket as full-time workers, and will have a lower tax bracket when they retire. In addition, income earned inside the account is not subject to tax until it is withdrawn by the account holder (if it is withdrawn before the age of 59 and a half, a 10% penalty will also apply, with some exceptions).
Benefits of participating in a defined contribution plan
Contributions paid to a defined contribution plan may be subject to tax deferral. In traditional defined contribution plans, contributions are tax-deferred, but withdrawals are taxable. In Roth 401 (k), the account holder makes post-tax contributions, but withdrawals are tax-free if certain conditions are met. The favorable tax status of defined contribution plans generally allows balances to increase over time relative to accounts taxed each year, such as income from investments held in brokerage accounts.
Employer-sponsored defined contribution plans may also receive matching contributions. More than three-quarters of companies contribute to employee 401 (k) accounts based on the amount contributed by the participant. The most common employer matching contribution is 50 cents per $ 1 contributed up to a specified percentage, but some companies are worth $ 1 for every $ 1 contributed up to a percentage of an employee’s salary, typically from 4% to 6%. If your employer offers to match your contributions, it is generally advisable to contribute at least the maximum amount they will match, as this is basically free money that will increase over time and benefit you in retirement.
Other features of many defined contribution plans include automatic member enrollment, automatic contribution increases, hardship withdrawals, loan provisions, and catch-up contributions for employees aged 50 and over.
Limits of defined contribution plans
Defined contribution plans, like a 401 (k) account, require employees to invest and manage their own money in order to save enough for retirement income later in life. Employees may not be financially savvy and may have no other experience investing in stocks, bonds and other asset classes. This means that some people may invest in inappropriate portfolios, for example by over-investing in stocks of their own company rather than a well-diversified portfolio of various asset class indices.
Defined benefit (DB) pension plans, unlike defined contribution plans, are professionally managed and guarantee the employer’s lifetime retirement income in the form of an annuity. Defined contribution plans do not offer such guarantees, and many workers, even with a well-diversified portfolio, do not put enough funds aside on a regular basis and will therefore find that they do not. do not have enough funds to last until retirement.
The average 401 (k) balance of Americans aged 50 to 59 in 2019, according to Fidelity. A retiree who takes 5% a year would only earn $ 8,700 a year, and that’s before taxes.
Other examples of defined contribution plans
The 401 (k) is perhaps the most synonymous with the defined contribution plan, but there are many other plan options. The 401 (k) plan is available to employees of corporations and public enterprises. The 403 (b) plan is generally available to employees of nonprofit companies, such as schools.
Notably, 457 plans are available for employees of certain types of nonprofit businesses, as well as for state and municipal employees. The Thrift Savings Plan is used for federal government employees, while 529 plans are used to fund a child’s college education.
Since individual retirement accounts often involve defined contributions in tax-advantaged accounts without concrete benefits, they could also be considered a defined contribution scheme.