What Are Defined Contribution Plans?

Defined Contribution Plans Explained in Less Than 5 Minutes

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Defined contribution plans are tax-deferred retirement plans managed by employers. The most common types are 401(k) and 403(b) plans. The employer often matches all or a portion of the amount the employee contributes.

If your employer offers a defined contribution plan, it would be smart to take advantage of it. We’ll talk about how these plans work and what your alternatives are.

Definition and Examples of Defined Contribution Plans

Defined contribution plans are retirement savings plans that both employees and employers can contribute to. They are different from defined benefit plans like pensions because the employee must choose how the plan is invested, which determines what the end benefit will be.

Defined contribution plans are popular among employers. They are offered for many full-time employees in the form of a 401(k) plan (used by most private companies) or a 403(b) plan (used by tax-exempt organizations). Employee contributions to the plan are not taxed—unless it is a Roth 401(k)—and upon retirement, the balance can be withdrawn either as a lump sum or converted to an annuity for monthly payments.

Funds can be accessed once the employee turns 59 ½ years old. For those who are younger, accessing these funds will mean a 10% penalty, with some exceptions.

How Defined Contribution Plans Work

401(k) and 403(b) plans are two popular accounts employers can use to help their employees save for retirement. Different employers have different rules for their plans. In many cases, if an employee contributes up to a certain amount, that amount or a fraction of it will be matched by the employer. Many financial advisors recommend taking advantage of defined contribution plans because the matched portion is compensation that can’t be obtained otherwise.

The dollars put into the plan are invested into a preset selection of assets, such as stocks, bonds, or money market funds. Many fund providers also offer target date funds that will change asset allocation each year depending on the year in which you plan to retire.

Vesting

Many employers have vesting schedules associated with their matching programs, meaning that the employee does not fully own the account until it is vested after a certain time period. Vesting works to limit the amount of the match that the employee could take if they left the company. For example, with a five-year vesting period, 20% of the cumulative matched funds would be vested each year. If the employee left the company after three years, they would only get 60% of the matched funds.

You can access the funds in your 401(k) by getting a loan. If you do not pay back the loan, the funds are considered a distribution, and you’re required to pay the penalty and tax.

Other Types of Defined Contribution Plans

Aside from 401(k) and 403(b) plans, two other common types of defined contribution plans are profit-sharing and employee stock ownership plans.

A profit-sharing plan is similar to a 401(k), but only the employer makes a contribution, and that contribution is discretionary. Often, the employer will designate a percentage of profit that is shared with employees, and then that amount will be transferred into the accounts every year.

In employee stock ownership plans, the company gives shares of its stock to employees. This is different from employee stock option plans in which the employee must shell out the cash to pay for the stock.

Alternatives to Defined Contribution Plans

The main alternative to a defined contribution plan is a defined benefit plan, commonly known as a pension. Pensions can be structured in different ways, but employees generally have to meet a certain threshold number of years to earn a pension. The longer an employee works for a company, the higher the pension payout is at the end of their career. Upon retirement, pensions are usually paid monthly, but in some cases, the employee can opt for a lump-sum amount instead.

Employers have steadily moved away from defined benefit plans because of the liability attached to them. Under defined benefit plans, the company carries the risk and must invest funds to pay out a pension indefinitely to employees. Under a defined contribution plan, the risk is transferred to the employee, who then must make smart investments.

If a pension plan is underfunded or the company goes bankrupt, employees could be out of luck many years into retirement. It is always smart for employees to come up with backup plans for retirement.

It may be better for the employee to use a defined contribution plan, where they can max out the contributions and make conservative investments.

Employees who want to have a backup plan or who work somewhere without retirement benefits can opt to use an Individual Retirement Arrangement (IRA). IRAs are tax-advantaged retirement accounts that allow people to invest up to a certain amount each year and then withdraw the balance in retirement.

Key Takeaways

  • Defined contribution plans determine the amount a company contributes to an employee’s retirement. They may include matching funds.
  • 401(k) plans, 403(b) plans, profit-sharing plans, and employee stock ownership plans are common types of defined contribution programs.
  • A common alternative is the defined benefit plan, or pension, which pays employees a set amount upon retirement.