What Is a Defined Contribution Plan?
A defined contribution plan is a retirement savings account developed by employers and/or employees that allow contributions to an individual retirement account (IRA) for retirement.
While defined benefit plans guarantee an employee a specific amount upon retiring, the amount of money that an employee receives upon retirement under a defined contribution plan depends on contributions made by the employer, employee and the investment performance and fees are paid from the account (IRA). As such, the employee and/or employer are ultimately responsible for ensuring the funds will be available upon retirement.
Defined contribution plans represent the most popular type of employer retirement plan (IRA) in the U.S. and comprise a critical part of an employee's long-term retirement planning strategy; they also apply to self-employment individuals and small business owners.
Is a 401(k) a Defined Contribution Plan?
401(k) plans are one of the most common types of defined contribution plans in the United States.
For the traditional 401(k):
- The employee contributes a portion of his/her paycheck usually through payroll deduction.
- The employer may make matched or discretionary contributions.
- The employee invests the funds in a variety of investment vehicles, including but not limited to mutual funds, stocks and/or bonds.
The value of a 401(k) at your retirement will not have been established until you retire. The value will depend on the total amount of your contributions, how the invested funds have grown in value (investment performance), market conditions at the time of retirement and any fees charged within the 401(k) plan.
From a tax perspective, contributions to a traditional 401(k) plan are generally deducted from an employee's taxable income prior to being taxed, thereby reducing the amount of income taxes the employee pays on the contributions. The employee does not pay taxes on any investment growth on funds invested in a 401(k) plan until the employee withdraws funds from the 401(k) plan after he/she has retired..
How Defined Contribution Plans Are Taxed
According to IRS regulations, defined contribution plan contributions can be tax-favored in several ways, including:
- Contribution made by an employee: contributions may be made pre-tax (traditional) which reduces the taxable income of such employee at that time.
- Contribution made by an employer: generally, employer contributions to defined contribution plans are tax deductible.
- Retirement account growth: while funds remain in the account they incur no taxes.
- Withdrawal of funds: If funds are withdrawn from your defined contribution plan, they are taxed as ordinary income.
- Penalty for early withdrawal: If you withdraw all or any portion of your defined contribution plan between ages 55 and 59½, you will be subject to a 10% penalty, unless you meet an IRS exception.
- RMD: Generally, if you reach age 73 (depending on your birth year and current IRS regulations), you will need to begin paying RMDs to the IRS
What Is a Defined Contribution Retirement Plan?
A defined contribution retirement plan is a type of retirement account that allows participants to contribute money into an individual account instead of contributing to a group of participants to pay for guaranteed retirement benefits (such as pensions). The accumulation/how much the retirement benefits will be depends on the amount of money each employee contributed and any income earned on their contributions prior to their retirement.
Some examples of this type of plan include:
- 401(k) plans
- 403(b) plans
- Individual retirement accounts (Traditional and Roth)
- Self-employed individuals who use a SEP IRA or solo 401(k)
- Small businesses that use a SIMPLE IRA
Some or all plans will have both employer and employee contributions while other types of plans (like IRAs) will have only an employee contribution.
Key Differences From Defined Benefit Plans
Unlike defined benefit pension plans, defined contribution plans:
- Do not guarantee a specific monthly benefit
- Shift investment risk to the employee
- Offer greater portability when changing jobs