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Table of Contents

What is a defined-contribution plan?

Types of defined-contribution plans

Defined-contribution vs. defined benefit plans

Potential advantages of defined-contribution plans

Potential limitations of defined-contribution plans 

The bottom line

LearnSaving for RetirementUnderstanding Defined-Contribution Plans

Understanding Defined-Contribution Plans

Jun 21, 2022

·

7 min read

A defined-contribution plan is an employer-sponsored retirement plan in which the employee, and sometimes the employer, contribute to the employee’s retirement account.

When it comes to retirement plans, there’s no shortage of options to choose from. And while it can feel overwhelming to pore over so many, finding the right retirement plan could be a game-changer, especially for those who don’t have any savings at all. Defined-contribution plans, which include 401(k)s, are among the most popular.

What is a defined-contribution plan?

A defined-contribution plan is an employer-sponsored retirement plan in which the employee, and sometimes employer, contribute to the employee’s retirement account. Participants fund their defined-contribution plans with either a specified dollar amount or a percentage based on earnings. These plans are then invested on the employee’s behalf. The employee always has access to the account, but might face a penalty if they withdraw funds before turning 59 ½ years of age.

Defined-contribution plans have a number of different features. For instance, some employers match their employees’ 401(k) contribution up to a certain dollar amount, which can be dollar-for-dollar or a specific percentage like $0.50 for every dollar the employee puts in. Individuals can only contribute a certain amount each year to a 401(k) account. In 2022, they can contribute up to $20,500. Those 50 and older can make additional catch-up contributions, for an extra $6,500 per year.

Some 401(k) plans allow for loans against the account. These are limited to $50,000 or 50% of the plan’s vested value, whichever is less. Account owners may need to meet certain requirements to take out the loan. 

Example of a defined-contribution plan

Jane is 35 and started working for ABC Inc. earlier this year. Her employer offers a company 401(k) plan. She knows this year she can contribute up to $20,500 into her 401(k); her salary is $55,000 before taxes. But while she’d love to contribute the maximum amount, she’s not sure she can, based on her other financial obligations.

Her employer match is up to 10% of her annual salary, or $5,500 this year. She signs up to have her retirement plan auto-deduct $458 every month (or roughly $5,500 a year) from her paycheck to make the most of her company match. If she and her employer contribute the same amount every year until she retires at 65, and the returns are 6%,  she’ll have about $540,000 when she leaves the workforce. But consider this: If she expects to spend $2,000 a month in retirement for the next 20 years, she’ll need to save almost $1 million. 

Types of defined-contribution plans

Defined-contribution plans come in many flavors, including:

  • 401(k)s.

    These are tax-deferred retirement savings vehicles offered by employers. They allow workers to save for retirement, and funds can be invested in stocks, bonds, mutual funds, index funds, exchange-traded funds (ETFs), and annuities. Employees can direct a portion of their earnings into the account and defer paying income tax on it until they withdraw it in retirement. In a variation on 401(k)s, Roth 401(k)s are funded with after-tax money, but no taxes are due on withdrawals.

  • 403(b)s.

    These retirement plans are offered by tax-exempt organizations such as public schools and tend to be limited to mutual funds and annuities. One must contribute at least $200 a year from your salary to qualify for a 403(b).

  • Traditional IRAs.

    These individual retirement accounts aren’t tied to a company or business and can be opened by any individual. Contributions are made with pre-tax funds, and limited to $6,000 per year, plus another $1,000 in catch-up contributions for those over 50. Roth IRAs allow the same contribution limits with after-tax funds.

  • Thrift Savings plans.

    These savings plans are offered to federal employees and members of the uniformed services. Similar to the 401(k) plans offered by businesses, these offer the same contribution limits as traditional and Roth IRAs.

  • Profit-Sharing plans.

    These are employer-contribution plans only (if employees contribute through a salary deferral, it’s a 401(k) plan). In 2022, employers can contribute up to 100% of the employee’s compensation or $61,000, whichever is less.

  • Employee Stock Ownership plans.

    These plans are trust funds offered by businesses to their employees. Employers can contribute cash for the employees to buy company stock or contribute shares directly to the plan. Employees pay tax on the contributions when they leave the company or retire.

Defined-contribution vs. defined benefit plans

Whereas a defined-contribution plan focuses more on what an employee can contribute, a defined-benefit plan centers on benefits instead. 

A defined-benefit plan, including traditional pension plans, gives workers a guaranteed lifetime fixed income after they stop working. These plans are typically covered by the employer, although in some instances, employees can make contributions. The plan calculates an employee’s time with the company, salary, and age at retirement to figure out the fixed monthly amount when retirement comes. 

Potential advantages of defined-contribution plans

Defined-contribution plans are among the most popular types of retirement plans, but not all of them offer the same benefits. 

  • Tax-deferred.

    Most defined-contribution plans give workers a break on taxes at some point. For example, traditional IRAs let workers make contributions with pre-tax dollars. Roth IRAs are funded with post-tax dollars, but withdrawals in retirement are tax-free.

  • Potential employer match.

    Along with employee contributions, companies can opt to make a matching contribution, usually up to a certain amount. Many employer 401(k) matching contribution plans are vested, meaning the employee must remain with the company for a certain amount of time if they want to keep all of the employers’s matched contributions. 

  • High contribution limits.

    Certain plans offer high contribution limits, allowing savers to put more away. The more an individual saves, the sooner they’ll reach their retirement goals. Workers with a 401(k), for example, can contribute a maximum of $20,500 in 2022. But those 50 and older can make an additional annual catch-up contribution of up to $6,500. 

Potential limitations of defined-contribution plans 

There are a few drawbacks to keep in mind with defined-contribution plans: 

  • Requires discipline.

    Defined-contribution plans focus on contributions by the employee and, in some cases, the employer. However, if workers don’t earn enough to be able to save or they do not consistently contribute to the plan, they could run out of funds once they retire. 

  • Early withdrawal penalties.

    With a traditional 401(k), any early withdrawals (before age 59½) are subject to both income taxes and a penalty of 10%. Though Roth 401(k) contributions are not subject to this penalty, even if they’re withdrawn ahead of schedule, the gains will be subject to penalties if they’re withdrawn before the account owner turns 59½.  

  • Potential loss of company match.

    Employees own 100% of the funds they contribute themselves to a defined contribution plan, but the funds their employer contributes may be subject to vesting. If someone changes jobs, they can roll over their 401(k), for example, to another 401(k) at a new company or an IRA. But if the vesting requirements haven’t been met, they could lose their company match, which would mean leaving money on the table. 

  • Investment risks.

    Earnings can grow in defined-contribution accounts, but as with all investing, there is the risk of losing money. 

The bottom line

There are many types of retirement plans, which means they’re all handled a little bit differently. While defined-contribution plans like 401(k)s and IRAs make up the majority of retirement plans, they’re mostly based on what individuals contribute. That amount varies by plan and sometimes how much each individual can afford to put in. Since defined-contribution plans leave the majority of responsibility up to the worker, it’s important for savers to understand what their plans offer.

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