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A defined contribution plan is an employer-sponsored retirement plan funded by money from employers and employees. The money you save for retirement in a defined contribution plan is invested in the stock market, and you may also get valuable tax breaks when you make contributions.
How Does a Defined Contribution Plan Work?
A defined contribution plan is sponsored by an employer, which typically offers the plan to its employees as a major part of their job benefits.
It’s called a defined contribution plan because the account is funded by contributions from the company and the employee—although in certain cases, only the company or the employee makes contributions to the plan.
Defined contribution plans come with valuable tax benefits. These may include pretax contributions that reduce an employee’s taxable income—plus potential tax-write offs for the employer—or alternatively, post-tax Roth contributions that give an employee tax-free income in retirement.
Either way, contributions are sheltered from taxation while they remain in an employee’s account.
Companies managed defined contribution plans on behalf of their employees, and choose the various options offered by the plan. Employers can decide whether or not they want to make contributions to their employees’ accounts. Employer contributions can include profit sharing, safe harbor contributions or matching contributions.
Employees can decide whether or not they want to participate in their employer’s defined contribution plan. If they choose to participate, they decide what percentage of their salary to contribute, and select different investments for their own account, most commonly a curated selection of mutual funds and index funds.
Income in retirement entirely depends on the contributions saved in the account and the performance of an employee’s investment choices.
Defined Benefit Plan vs. Defined Contribution Plan
Defined contribution plans work very differently than defined benefit plans. Where a defined contribution plan puts most of the responsibility for contributing money and managing investments on the employee, a defined benefit plan is completely in the hands of the employer.
A defined benefit plan guarantees a specific amount of money employees can expect to receive as income each month in retirement, whether that’s an exact dollar amount or a percent of salary averaged over particular earning years.
The defined benefit plan you’re probably most familiar with is a traditional pension plan. Generally, employers make the bulk of contributions to a traditional pension plan, rather than the employee.
Pension plans used to be common in the workplace—at one point, the vast majority of private sector workers had one. Today, only 21% of workers participate in a pension plan, and they’re largely state and local government workers. Twice as many workers (43%) participate in a defined contribution plan.
Defined contribution plans are largely funded by employee contributions, and they offer no guaranteed return of income in retirement. Unlike defined benefit plans, however, they generally offer the employee control over investments made with the plan contributions.
Defined Contribution Plan Advantages
A defined contribution plan offers certain advantages, from tax benefits to high contribution limits.
• Automated retirement savings. Once an employee opts into a defined contribution plan, contributions are automatically deducted from their paychecks on a regular schedule. This lets plan participants automate their retirement savings.
• Tax benefits. Regardless of whether you choose a traditional or Roth defined contribution plan, you will receive some sort of tax break—and your investments will grow tax-free until you start taking out money in retirement.
• Potential employer match. Many defined contribution plans let employers match a portion of an employee’s contributions, such as a 100% match of the first 3% of your salary that you contribute.
• High contribution limits. While contributions to an individual retirement account (IRA) are capped at $6,000 per year in 2022 and $6,500 per year in 2023 (or $7,000 in 2022 and $7,500 in 2023 if you’re 50 or older), employees can save up to $20,500 in 2022 ($22,500 in 2023) in defined contribution plans like a 401(k) or 403(b), plus another $6,500 in 2022 if they’re 50 or older ($7,500 in 2023 if they’re 50 or older). Total contributions—from employer and employee—are $61,000 in 2022 ($66,000 in 2023), or $67,500 in 2022 if you’re 50 or older ($73,500 in 2023 if you’re 50 or older).
Defined Contribution Plan Disadvantages
A defined contribution plan, however, isn’t without its downsides.
• No guaranteed income. Unlike a defined benefit pension, there is no guaranteed payout at the end of your defined contribution rainbow. Since contributions are invested in the stock market, they are subject to investment risks and market volatility.
• High fees. Some defined contribution plans come with high fees. These may include plan administration fees, investment fees and individual service fees. If your plan has excessively high fees, experts generally recommend you invest enough to get any matching contributions from your employer, and invest the rest of your retirement contributions in an IRA.
• Limited investment options. Defined contribution plans may offer limited investment choices, depending on the selection of funds an employer offers. If you are unhappy with your plan’s investment options, consider saving some of your retirement funds in an IRA, which usually offers more choices.
• Employer contribution vesting. Some defined contribution plans require an employee to remain at a company for a number of years before they gain full ownership of employer contributions. Approximately half of 401(k) plans have some sort of vesting schedule.
• Required minimum distributions. Most defined contribution plans require you to start taking distributions once you turn 72, whether you need the income or not. Called required minimum distributions (RMDs), these can increase your taxable income. You may be able to decrease your RMDs with a Roth IRA rollover or by purchasing a qualified longevity annuity contract (QLAC).
Types of Defined Contribution Plans
Many of the retirement plans you’re already familiar with are defined contribution plans. While there are a variety of defined contribution plans, most of them offer very similar features; their different names primarily indicate the kinds of companies they’re sponsored by. Types of defined contribution plans include:
• 401(k). This is the most common defined contribution plan. Offered by for-profit companies of all sizes, 401(k)s are funded by pre-tax employee contributions as well as matching or non-matching contributions from employers.
• Roth 401(k). This version of the 401(k) lets employees contribute after-tax funds. Companies cannot contribute matching funds to Roth accounts, so employer contributions are placed in a complementary 401(k) if you opt for a Roth 401(k).
• 403(b) and 457(b) plans. These plans are offered by government agencies, public educational institutions, certain nonprofits and religious organizations. Both 403(b) and 457 plans may offer Roth accounts.
• SEP IRA. Designed for self-employed individuals and small businesses, SEPs require employers to make the same percentage-of-salary contribution to each participating employee’s plan. Employees do not make contributions, and Roth options are not available.
• SIMPLE IRA. Designed for companies with 100 or fewer employees, SIMPLE IRAs may provide employer matching or require employer contributions, regardless of employee participation. Employees are always able to contribute to a SIMPLE IRA. Roth accounts are not available.
• Thrift Savings Plan (TSP). Available for employees of the federal government and members of the armed services, a TSP allows both employers and employees to contribute. Roth accounts are available, but investment options are generally more limited than other defined contribution plans.
• Profit-sharing plans. These plans are funded only with employer contributions, typically from a business’s earnings. Each employee generally receives a percentage of earnings, although contribution amounts may change based on a business’s overall profitability.
• Money purchase plans/401(a). Money purchase plans function like profit-sharing plans, except that employers make fixed annual contributions to every employee’s account, no matter what earnings and profitability look like in a given year. Employees may be required to contribute a percentage of their salary. 401(a) plans are money purchase plans for government agencies, public educational institutions and nonprofits.
• Employee stock ownership plans (ESOPs): These plans are funded with shares of an employer’s stock.
Defined Contribution Plan Contribution Limits
Contributions are at the heart of all defined contribution plans. Here are employer and employee annual contribution limits for 2022:
• 401(k), 403(b), most 457(b) plans and TSPs. In 2022, plan participants can contribute up to $20,500 per year if they’re under 50 ($22,500 in 2023). Those over 50 can contribute an additional $6,500 ($7,500 in 2023). Employers may contribute up to 25% of an employee’s compensation, but total employee and employer contributions cannot exceed $61,000 ($66,000 in 2023), or $67,500 ($73,500 in 2023) if they are 50 or older.
• Profit-sharing plans: Employers can contribute up to the lesser of 25% of compensation or $61,000 ($66,000 in 2023).
• Money purchase plans/401(a) plans: Employers and employees can contribute up to a total of 25% of an employee’s net compensation or $61,000 ($66,000 in 2023), whichever is less.
• SIMPLE plans: Participants can contribute up to $14,000 in 2022 ($15,500 in 2023). Those 50 or older can contribute an additional $3,000 ($3,500 in 2023).
• SEP IRAs: SEPs don’t allow employee contributions, but employers can add up to the lesser of $61,000 ($66,000 in 2023) or 25% of an employee’s salary.