Defined contribution plans are employer-sponsored retirement plans where employees, and sometimes employers, make regular contributions to the plan, but the payout at retirement depends on how the employee invests the pension. ‘silver. The government places restrictions on how much you can contribute to a defined contribution plan and when you can withdraw your funds.
Here’s a more detailed look at how defined contribution plans and pooled pension plans that fall into this category work.
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Is a 401(k) a defined contribution plan?
The best known defined contribution plan is the 401(k). Employees can contribute up to $19,500 to their account in 2021, or $26,000 if they’re 50 or older. Employers can also match some of their employees’ contributions. You determine how to invest your 401(k) funds by choosing from a list of mutual funds selected by your employer.
Most 401(k) contributions reduce your taxable income for the year, but you then have to pay taxes on your distributions at retirement. But if you have a Roth 401(k), you pay taxes on your initial contributions and then your money grows tax-free.
You generally cannot withdraw your 401(k) funds when you are under age 59½ unless you have a valid reason, such as major medical expenses. Otherwise, you will pay a 10% early withdrawal penalty. Some plans allow 401(k) loans — you withdraw money and pay it back with interest over time — but it’s up to each employer whether or not to offer it.
If you decide to leave the company, you can take your 401(k) with you and roll it over to your new employer-sponsored retirement plan or an IRA you open yourself.
Types of defined contribution plans
A 401(k) is not the only type of defined contribution plan. Here are a few others you may have heard of:
- 403(b): A 403(b) is similar to a 401(k), but it is only available to public school employees, certain ministers, and employees of nonprofit organizations.
- 457: This is a special type of pension scheme reserved for state and local government employees and certain non-profit workers.
- Savings savings plan: These are available exclusively to federal government employees and members of the uniformed services, including military, police, and firefighters.
- Employee share ownership plans: These plans give employees a stake in their business and also offer tax advantages.
- Incentive plans: A profit-sharing plan regularly gives employees a portion of their company’s profits.
Example of a defined contribution plan
So how does a defined contribution plan work in practice? Everyone has their own rules, so it’s always best to check with your plan administrator before you start making contributions. But in general, defined contribution plans work like this:
First, you create an account (or your employer will do it for you). Then you decide how much of each paycheck you want to contribute to the plan. It can be a fixed dollar amount or a percentage of your salary, and you can change your contribution rate at any time. Your employer automatically deducts this amount from your salary and places it in your defined contribution plan.
If your employer matches a portion of your contributions, or has a profit sharing plan or something similar, they will make their own employer contribution to your retirement account. These plans may have vesting schedules, which determine when you can keep employer-contributed funds if you leave the company. Quitting before you’re fully vested could cost you some or all of your employer.
Your employer will offer you an investment option, but you will decide which one best suits your retirement goals. This is an important decision because it affects the amount of investment income you will get and, therefore, the amount you must personally contribute to fund your retirement.
Once done, you continue to put money into the account, updating your employee contribution percentage and investment options as needed. Then, when you’re ready to retire, you withdraw your funds gradually to cover your living expenses.
Defined contribution plan vs defined benefit plan
Defined benefit plans are plans that provide a guaranteed payout upon retirement. The most common type of defined benefit plan is a pension plan, but these are becoming less common because they are more expensive and complicated for employers. Essentially, there’s a formula that dictates how much you’ll receive from your retirement pension based on how long you’ve worked at the company or your average income as an employee. The employer is responsible for funding this one way or another, even if it means making an additional cash contribution if their investments don’t perform as expected.
Defined contribution plans shift most of the savings burden from the employer to the employee. It’s not as desirable for you as a worker, but it might suit you better if you don’t plan to stay with your employer for long. You can take your defined contribution plan with you and change how you invest your funds, but a defined benefit plan will still be tied to your former employer.
You’re much more likely to have a defined contribution plan than a defined benefit plan these days, but it’s helpful to understand both types and how they work. Regardless of the type of qualified retirement plan you end up with, make sure you fully understand any rules associated with contributions or withdrawals, and speak to your company’s human resources department if you have any questions.