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A defined contribution plan is a retirement savings plan where you contribute pretax dollars that are invested and grow tax-deferred up until you use the money in retirement. Examples of defined contribution plans include 401(k) and 403(b) plans, SIMPLE IRAs and profit-sharing plans among others.
Let's go over how a defined contribution plan works, the pros and cons, and how these plans differ from defined benefit plans—so you can live your best life in retirement.
How Does a Defined Contribution Plan Work?
A defined contribution plan is an employer-sponsored retirement plan. The pretax dollars you invest are automatically taken out of your paycheck and invested. How much you contribute varies, as does whether (and how much) your employer contributes to your plan. Some employers match your contributions either partially or fully up to a percentage of your annual salary.
Generally, you decide how your money is invested based on the plan's offerings. That means you bear the risk of any losses if the investments slump, as well as any gains added when your investments do well. This is the main difference between a defined contribution plan and a defined benefit fund or pension that guarantees a predetermined pension amount at retirement.
Common Defined Contribution Plans
About 67% of wage earners in the private sector had access to an employer-sponsored retirement plan as of March 2020, with 52% having access to defined contribution plans, according to the U.S. Bureau of Labor Statistics (BLS). But the path to your financial future is knowing how defined contribution plans work.
Several examples of defined contribution plans include:
401(k) Plans
With a traditional 401(k) retirement plan, you make contributions out of your paycheck before taxes, reducing your taxable income. Contributions grow tax-deferred until you begin withdrawing funds in retirement. If you withdraw funds before age 59½, you'll pay a 10% penalty. Unless your plan specifies particular investments, you choose your investments based on the options provided in your plan by your employer.
For 2022, elective employee contributions are capped at $20,500 ($22,500 in 2023). If you are 50 or older, you can make an additional catch-up contribution of $6,500 ($7,500 in 2023). Some plans offer employer matching, where your employer also makes contributions up to a certain percentage.
Roth 401(k) Plans
A Roth 401(k) plan is similar to a traditional 401(k) with one main difference: A Roth 401(k) is funded with after-tax dollars. You'll pay no taxes on Roth 401(k) distributions you take in retirement as long as you begin doing so at age 59½ or older.
If you withdraw funds from your Roth 401(k) prior to age 59½ and you've had the account for less than five years, you will be taxed on any gains to your investments, and a 10% penalty may also apply to early withdrawals.
Like a traditional 401(k), your contributions are limited to $20,500 in 2022 and $22,500 in 2023. You can also make an additional catch-up contribution of $6,500 in 2022 ($7,500 in 2023) if you are 50 or older. Any withdrawals you make on contributions or earnings are not taxed, provided early withdrawal penalties don't apply.
403(b) Plans and 457(b) Plans
Akin to traditional 401(k) plans, 403(b) and 457(b) retirement savings plans are also funded with pretax contributions from your paycheck that you invest. Employers like public schools and colleges, some nonprofits and churches or church-related organizations may offer 403(b) plans.
Certain nonprofits and state and local government agencies offer 457(b) plans. Some employers offer both 403(b) and 457(b) plans and may allow you to contribute to both plans. Employers may also choose to contribute to your plan. Contribution limits are the same as traditional 401(k) limits: $20,500 in 2022 and $22,500 in 2023. You can also make additional catch-up contributions of $6,500 in 2022 ($7,500 in 2023) if you are age 50 or over.
SIMPLE IRAs
SIMPLE IRAs are generally offered by employers with 100 or fewer employees. Both employers and employees can contribute to a SIMPLE IRA plan, but your employer cannot offer any other retirement plans at the same time. Employers can make matching contributions of up to 3% of your wages.
If you're an eligible employee and choose not to contribute to your SIMPLE IRA, your employer must contribute 2% of your wages as a nonelective contribution up to an annual limit of $330,000 in 2023. Another benefit of a SIMPLE IRA is that you are always 100% vested in the SIMPLE IRA money in your account.
SEP IRAs
A SEP IRA is a simplified employee pension plan. Any employer, including a partnership, corporation, nonprofit or sole proprietorship with one or more employees, can set up a SEP plan. Under this plan, your employer contributes to an IRA (up to a certain limit), which has been established for eligible employees, including self-employed individuals.
However, not all employees are eligible. You may be excluded from a SEP IRA if you haven't worked three out of the past five years, haven't reached the age of 21, are covered by a union agreement offering retirement benefits, are a nonresident or received less than $650 in wages in 2022 ($750 in 2023). Only your employer makes contributions to a SEP IRA, and all contributions are always 100% vested. Contribution limits cannot exceed $305,000 in 2022 ($330,000 in 2023).
Employee Stock Ownership Plans
An employee stock ownership plan (ESOP) gives you and all other employees shared ownership of the company you work for in the form of shares of company stock. For this reason, you have an interest in seeing the company succeed so its stocks perform well.
ESOPs are established as trust funds with tax-free contributions, typically tied to vesting, where you can earn more shares for each year of service. As an eligible employee, you are fully vested within three to six years.
With an ESOP, you are only taxed on distributions. The amount you're taxed depends on how well the company's stock is performing, and you can roll over your distributions into an IRA or another retirement plan. However, it's usually only possible to cash out your shares if you leave the company, retire, become disabled or pass away.
When you access funds in the account, you will pay taxes on the money withdrawn as capital gains. Plus, if you withdraw funds from your account preretirement and you are under the age of 59½ (age 55 if terminated), you might face a 10% early withdrawal penalty.
Profit-Sharing Plans
Profit-sharing plans give employers the flexibility to choose how much to contribute to the retirement plan each year, including the option to make no contributions at all in some years. Employers can choose which employees can participate and when, but other features of the profit-sharing plan must meet specific requirements by law, such as how contributions are deposited into employees' accounts.
Contribution limits are the lesser of 100% of an employee's compensation or $61,000 in 2022 ($66,000 for 2023). If you withdraw funds from your account before retirement or if you are under the age of 59½, you may pay an additional 10% early withdrawal penalty.
Defined Contribution Plan vs. Defined Benefit Plan
A defined contribution plan does not promise a specific amount of benefits at retirement, whereas a defined benefit plan does. Here's how they compare.
| Defined Benefit Plans | Defined Contribution Plans | |
|---|---|---|
| Employer, employee and matching contributions | Employer-funded with specific employer contributions that are set by federal rules with penalties for failing to meet these rules. | No specific employer contributions except for safe harbor and SIMPLE 401(k)s, money purchase plans, SEPs and SIMPLE IRAs. Employers can choose to match a percentage of employees' contributions or can contribute without employee contributions. |
| Employee contributions | Employees do not typically contribute to these plans. | Many plans require employee contributions. |
| Investment management | The employer or plan supervisor manages investments. | Generally, the employee is responsible for managing the investments in their account. |
| Benefits paid at retirement | A promised benefit at retirement often uses a combination of an employee's tenure, age and/or salary. | Benefits depend on employee and employer contributions, investment performance and fees. |
| Retirement benefit payments | Traditionally, employees receive monthly annuity payments that continue for life, but some plans offer other options, like IRA rollovers. | At retirement, an employee can transfer the account balance into an IRA or receive the benefit as a lump-sum payment. Other options also exist. |
| Guarantee of benefits | The Pension Benefit Guaranty Corporation (PBGC) guarantees a certain portion of benefits. | There is no federal guarantee of benefits. |
| What happens if you leave your workplace before retirement? | Benefits can stay with the plan until the employee files a claim for it at retirement. Some plans also offer early retirement options. | Employees can transfer their account balance to an IRA or, in some cases, another employer's plan. The employee may also cash out before retirement but may owe taxes and possibly penalties. |
Pros and Cons of Defined Contribution Plans
Defined contribution retirement savings plans provide many benefits as well as several disadvantages.
Pros
- Employer match: Your employer may choose to match your contributions up to a certain percentage of your salary.
- Tax benefits: The pretax dollars that are invested in your account grow tax-deferred up until you begin to withdraw them.
- Unpredictable value: The value of your defined contribution pension account can change based on your contributions and the value and performance of the investments.
Cons
- Unknown benefit amount: Because your pension benefit is based on how well your investments perform, you won't know your benefit amount until retirement.
- Investment risk: Much of the risks and rewards fall on your shoulders because you choose your investments based on the plan's options. If you know little about investing, hiring a financial advisor can help. Your employer also likely has a plan advisor you can consult. On the flip side, choosing your investments could be a pro if you are a seasoned investor.
- Employee vesting: Some plans require you to stay with the company for a set number of years until you are fully (100%) vested.
The Bottom Line
A defined contribution retirement plan is employer-sponsored and offered as a perk for employees as a part of their job benefits. It can help build a healthy nest egg for your retirement years, no matter your career field or the size of your paycheck. Once you set up your plan, keep track of all the other aspects of your financial life by monitoring your credit with free credit monitoring at Experian. Here you can spot possible identity theft sooner and prevent surprises when you apply for credit in the future.