What is a Defined contribution plan?
A defined-contribution (DC) plan, like a 401(k) or a 403(b), is a tax-deferred retirement plan in which employees contribute a fixed amount or a percentage of their paychecks to an account intended to fund their retirements. As an added benefit, the sponsoring company will occasionally match a portion of employee contributions. These plans impose restrictions on when and how each employee may withdraw funds from these accounts without incurring penalties.
Defined contribution plans invest pre-tax dollars in capital market investments that grow tax-deferred. This means that income tax will be paid on withdrawals eventually, but not until retirement age (a minimum of 59½ years old, with RMDs beginning at age 72).
What are the advantages of a Defined contribution plan?
- Contributions to a defined-contribution plan may be tax-deductible. Contributions to traditional defined-contribution plans are tax-deferred, but withdrawals are taxable.
- Matching contributions may also be made to employer-sponsored defined-contribution plans. More than three-fourths of companies contribute to employee 401(k) accounts based on the amount contributed by the participant.
- Many defined-contribution plans also include automatic participant enrollment, automatic contribution increases, hardship withdrawals, loan provisions, and catch-up contributions for employees over the age of 50.
What are the limitations of a Defined contribution plan?
Employees must invest and manage their own money in defined-contribution plans, such as a 401(k) account, in order to save enough for retirement income later in life. Employees may lack financial knowledge and have no prior experience investing in stocks, bonds, and other asset classes. This means that some people may invest in inappropriate portfolios, such as over-investing in their own company's stock instead of a well-diversified portfolio of various asset class indices.
Defined Benefit vs. Defined Contribution plan
A defined-benefit plan, also known as a traditional pension plan, guarantees a fixed payment amount in retirement. A defined-contribution plan allows employees and employers (if they choose) to contribute to and invest in funds to save for retirement over time.
These key distinctions determine who bears the investment risks—the employer or the employee—and influence the cost of administration for each plan. Superannuations are another name for both types of retirement accounts.