Defined contribution plans are employer-sponsored retirement plans in which employees, and sometimes employers, make regular contributions to the plan, but the payout at retirement depends on how the employee invests the money. 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 in-depth look at how defined contribution plans and common pension plans that fall into this category work.
Is 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 are 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 then you have to pay taxes on your distributions in retirement. But if you have a Roth 401 (k), you pay taxes on your initial contributions and your money then grows tax-free.
You generally cannot withdraw your 401 (k) funds when you are under 59 1/2, unless you have a valid reason, such as a significant medical expense. Otherwise, you will have to pay an early withdrawal penalty of 10%. Some plans allow 401 (k) loans – you take some money out and pay it back with interest over time – but it’s up to each employer to decide if they offer this.
If you decide to leave the business, you can take your 401 (k) with you and transfer it to your new employer-sponsored retirement plan or to an IRA that you open on your own.
Types of defined contribution plans
A 401 (k) is not the only type of defined contribution plan. Here are a few more you may have heard of:
- 403 (b): A 403 (b) is similar to a 401 (k), but it is only available to employees of public schools, certain ministers, and employees of nonprofit organizations.
- 457: This is a special type of retirement plan reserved for state and local government employees and certain nonprofit workers.
- Savings plan: These are available exclusively to federal government employees and uniformed service members, including military, police, and firefighters.
- Employee share ownership plans: These plans give employees a stake in their business and also offer tax benefits.
- Profit sharing 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 scheme work in practice? Each has its own rules, it is always best to check with your plan administrator before you start contributing. 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 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 if they have a profit sharing plan or something similar, they will pay their own employer contribution to your retirement account. These plans may have vesting schedules, which determine when you can keep employer paid funds if you leave the company. Leaving before you are fully vested could cost you some or all of your employer.
Your employer will offer you an investment option, but you decide which one is best for 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 your investment options as needed. Then, when you are ready to retire, you gradually withdraw your funds to cover your living expenses.
Defined contribution plan vs defined benefit plan
Defined benefit plans are plans that offer a guaranteed payment upon retirement. The most common type of defined benefit plan is the pension plan, but these are becoming less common because they are more expensive and more complicated for employers. Essentially, there is a formula that dictates how much you will receive from your pension upon retirement based on the time you have worked for the business or your average income as an employee. The employer is responsible for the funding in one way or another, even if it means paying an additional contribution in cash if his investments do not work as planned.
Defined contribution plans transfer most of the savings burden from the employer to the employee. This is not as desirable for you as a worker, but it might work better for you if you don’t plan to stay with your employer for a long time. You can take your defined contribution plan with you and change the way you invest your funds, but a defined benefit plan will still be tied to your former employer.
These days, you’re much more likely to have a defined contribution plan than a defined benefit plan, but it’s helpful to understand both types and how they work. Whatever type of qualifying pension plan you find yourself in, make sure you understand the rules associated with contributions or withdrawals, and speak to your company’s human resources department if you have any questions.