What Are Defined Contribution Plans?
As defined by the IRS, this plan is “a retirement plan in which the employee and/or the employer contribute to the employee’s individual account”.
Defined contribution plans are tax-advantaged accounts that see an individual contribute a fixed amount to the plan.
They are also known as 401(k) plans, after the section of the Internal Revenue Code (26 U.S.C.) under which they are authorized.
Defined contribution plans were first authorized by the Employee Retirement Income Security Act of 1974 (ERISA).
Defined Contribution Plans vs. Defined Benefit Plans
Defined contribution plans are similar to defined benefit plans in that both types have a predetermined future benefit.
Defined benefit plans offer a guaranteed benefit instead of a guaranteed contribution.
However, unlike defined benefit plans, defined contribution plans do not promise any specific future payments - instead, they promise a payment based on the amount contributed by the employee during their tenure at the company and the performance of the investments used to fund them.
Defined contribution plans also allow employees a degree of control over their retirement savings, rather than being forced to rely on employer-provided benefits.
Contribution Limit
Employees who are part of defined contribution plans are typically allowed to contribute up to 100% of their salary.
For each employee, defined contribution plans have a maximum yearly contribution of $66,000 in 2023, subject to cost-of-living adjustments for later years.
How It Works
There are many defined contribution plan types that generally work in the same way. The funds are invested in a range of different assets, which may include stocks, bonds, and money market funds.
When the employee decides how much they want to contribute, the employer then puts the money into an account on the employee’s behalf.
Contributions are deducted from the employee’s paychecks and placed into the account automatically.
Many employers also match the employees' contribution, typically 50 cents for every dollar an employee contributes, ranging from 3% to 6% of their salary.
Defined contribution plans offer the option to invest in various assets, which gives the responsibility of assuming the risks that come with the chosen investment portfolio.
As with any retirement savings plan, defined contribution plans carry some level of risk - specifically that the value of the funds will decrease - and participants may end up withdrawing less than they originally anticipated.
Investment Allocations
Participants in defined contribution plans are typically able to select their own investments.
They are also required to make an initial investment allocation choice, which determines the percentage of plan assets they will invest in each investment option available through the defined contribution plan.
Many defined contribution plans offer participants a selection of investment options, which may include the following:
- Stable Value Fund: invest in high-quality fixed-income securities with principal stability, including government bonds and other ultra-high quality municipal or corporate obligations
- Government Securities Fund: invest in short-term, high-quality government securities
- Common Stock Fund: invest primarily in the common stock of public corporations
- International Equity Index Fund: invest according to a predefined international equity index
- Bond Fund: invest in fixed-income securities, such as bonds and money market investments
- Cash Reserve Fund: keep a certain percentage of assets in cash and equivalents (such as bank accounts and short-term, highly liquid securities)
- Company Stock Fund: these investments typically allow participants to invest in company stock, which is often the least risky investment available
- Target Date Fund: designed to follow a "glide path" that becomes more conservative as the target date draws near
Types of Defined Contribution Plans
Many companies are adopting defined contribution plans for their employees. Defined contribution plans have different requirements depending on the plan on offer.
The following are examples of defined contribution plans:
401(k) Plans
They are most commonly offered in the United States and allow employees to contribute a percentage of their salary, with employers often matching some or all of these contributions.
457 Plans
Are similar to 401(k) plans and may be offered to state and local government employees or employees of qualified non-profits.
Simplified Employee Pension (SEP) Plans
These are available to sole proprietorships, partnerships, and privately held corporations.
403(b) Plans
Plans for public education entities and tax-exempt employers, such as non-profits.
401(a) Plans
These are money-purchase plans where the employer establishes custom eligibility requirements, contribution amounts, and vesting schedules.
They are normally available for key government, educational, and non-profit employees as an added incentive to stay with the organization.
Thrift Savings Plans (TSPs)
These are also for federal employees. They have extremely low costs, guaranteeing that only a few retirement savings go to fees and expenses.
Profit-Sharing Plans
Allow employer contributions determined by a fixed formula, separate from an employee's salary.
Money Purchase Plans
Contributions are fixed, and employers make annual contributions to each employee’s account no matter how the company performs.
Employee Stock Ownership Plans (ESOPs)
This can be part of the employee's compensation or voluntary purchase primarily invested in employer stock.
Savings Incentive Match Plans for Employees (SIMPLE)
Employees contribute through salary deferrals, and employers match some or all contributions. Available for businesses with no more than 100 employees.
Pros and Cons of a Defined Contribution Plan
There are several benefits to defined contribution plans, including the following:
- Contributions are made to an individual's account. Defined contribution accounts can be used as savings to supplement social security income later in life
- Employees control their defined contribution account investments and how much they contribute each year
- With defined contribution plans, employees can save for retirement at their own pace, in terms of when and how much they contribute
- Defined contribution plans also allow employers to structure contributions depending on the company's financial situation
There are drawbacks associated with defined contribution plans, which include:
- Employees may not save enough for retirement, which can lead to a worse standard of living after retiring
- Defined contribution accounts are not protected by the Federal Deposit Insurance Corporation (FDIC)
- An employer may terminate or freeze an employee's defined contribution plan. If this happens, employees will not be able to make contributions and will lose all of the money in their defined contribution account
- Most defined contribution plans are only offered to employees of larger, well-established companies because they require time and commitment to manage
- Defined contribution plans also have higher setup fees than defined benefit plans
- Do not guarantee pension benefits - if the money is not saved, it may not be there by the time an individual retires
Conclusion
A defined contribution plan is a type of retirement plan where employees contribute a percentage of their salary, with employers often matching some or all of the contributions made by their employees.
There are several benefits to defined contribution plans, including the fact that employees have control over their investments and how much they contribute each year. It also allows employers to structure contributions in different ways depending on the company's financial situation.
However, there are drawbacks associated with defined contribution plans, which include the fact that employees may not save enough for retirement and defined contribution accounts are not protected by the Federal Deposit Insurance Corporation (FDIC).
When deciding what type of retirement plan to offer its employees, a company must weigh the pros and cons of each type of plan.
FAQs
1. Who can contribute to a defined contribution plan?
Employees at least 21 years old who have worked for a company for at least one year - or the calendar year prior to enrollment in the defined contribution plan - can contribute to defined contribution plans.
2. How much can an individual contribute to defined contribution plans?
Each person's eligibility and contribution amount varies depending on the defined contribution plan established by their company. An employer may set a minimum contribution percentage or might require employees to contribute the maximum.
3. How are defined contribution funds invested?
Defined contribution plans invest account holders' money in different investment options, including stocks, bonds, mutual funds, Exchange Traded Funds (ETFs), and many more.
4. What happens to defined contribution plans when an employee retires?
Employers are required to make provisions for employees who are retired or plan to retire within five years under defined contribution plans, but this is not always the case. It depends on the defined contribution plan established by each company.
5. Are defined contribution plans eligible for tax benefits?
Yes, defined contribution plans are often eligible for tax benefits. Defined contributions can be deducted from taxable income, which reduces an individual's overall taxable income amount.
