A defined contribution plan is a retirement account where your total savings will depend on how much you, and possibly your employer, contribute over your working life, how long the funds are invested, and how well the investments inside the plan perform. It does not promise a specific amount of benefits upon retirement—that’s a defined benefit plan.
The “defined” part of the contribution plan refers to how much you decide to regularly contribute plus any employer matching funds. This is usually represented as a percentage of your salary that you select to be removed from your paycheck and invested in the plan. You should always take advantage of an employer’s matching funds—that’s when they say they will match how much you invest up to a certain amount. So, if they match up to 6% and you invest 6%, you’re really getting 12%. That’s free money, baby!
Your contributions are generally invested on your behalf by your plan provider based on a few criteria: your age, your risk tolerance, when you want to retire, and if you specify any assets you want to include or avoid. What’s nice is that you can be as involved or as uninvolved as you want in how your investments are handled! Simply speak with your plan manager or HR rep.
Many traditional defined contribution plans are tax deferred. You won’t pay taxes on the money contributed to the plan, only when you make a withdrawal. This makes the investment “tax advantaged” because it allows a bigger initial balance to grow larger over time compared to taxable accounts, which start with a smaller balance because you’ve had to pay interest on the money up front.
Once you open a defined contribution account, you will always have ownership of it, even if you change jobs. However, depending on the vestment policy of your employer, you may only have ownership of a percentage of the amount they contributed if they offered a matching program. Usually, if you have worked at the job for five years or more, you will be totally vested in your plan and have ownership of all employer contributions.
If you leave the company before retirement age, you can transfer your account balance to an individual retirement account (IRA) or, in some cases, another employer plan, where it can continue to grow based on investment earnings. If you decide to take the balance out of the plan, you will owe the taxes you didn’t pay when you put the money into the account. There are also penalties if you make withdrawals from the account before age 59 ½ (but there are a few exceptions), so be wise about how and when you move money from a defined contribution account.
Other important features of many defined-contribution plans include automatic participant enrollment, automatic contribution increases, hardship withdrawals, loan provisions, and catch-up contributions for employees age 50 and older.
Below are some examples of defined contribution plans.
- A 401(k) is available to employees of public corporations and businesses. There is a limit on how much you can contribute to your 401(k) every year, and that limit changes depending on your age and recent tax code changes, so be sure to speak with your HR rep every year.
There are several types of 401(k) plans, including traditional 401(k), safe harbor 401(k), SIMPLE 401(k), and automatic enrollment 401(k) plans.
- A 403(b) is available to employees of nonprofit corporations, such as public schools and tax-exempt organizations. How these plans are structured are comparable to 401(k) plans; however, many 403(b) plans vest funds in a shorter amount of time and may allow immediate vesting of funds.
- An employee stock ownership plan (ESOP) is a defined contribution plan in which the investments are primarily in employer stock.
- Profit-sharing plans, or stock bonus plans, are managed by the employer and funded by the profits on the company. The plan has a formula for giving participants a portion of each annual contribution. It may also include a 401(k) plan.
- 457 plans are for state and municipal employees, and employees of qualified non-profit businesses.
- Thrift savings plans are for federal employees. They have extremely low costs, guaranteeing that only a small amount of retirement savings will go to fees and expenses.
- 401(a) plans are money-purchase plans where the employer establishes custom eligibility requirements, contribution amounts, and vesting schedules. They’re normally available for key government, educational, and non-profit employees as an added incentive to stay with the organization.