What is a Defined Contribution Retirement Plan?

What is a Defined Contribution Retirement Plan?

Posted by on Feb 22, 2021

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A Defined Contribution Plan is a retirement savings plan offered by an employer where an employee contributes funds to a retirement account. The contributions are usually pre-tax dollars. 

The retirement account is funded primarily by the employee through deductions from their paycheck. Some employers will match contributions, adding more to the retirement account. An employer sponsors the plan, and they determine what options will be offered. 

Some examples of Defined Contribution Plans are a 401(k), 403(b), 457 plan, Thrift Savings Plan, and a 401(a). 

Benefits of Defined Contribution Plans

Defined Contribution Plans are the most common type of retirement plan. There are many benefits, including: 

You Choose The Risks

While the employer selects what retirement and investment plans to offer, there are usually a variety of investment options available with many risk profiles to choose from. It is then up to the employee to decide how much to contribute and what risk they want to take with their retirement investment plan. Some companies have benefit managers that can help select suitable investments based on how close the person is to retirement and their overall retirement goals. 

Of course, the hope is for growth, but there can be a downside to risk. There may be the potential for loss of funds over time. A financial advisor can help you evaluate the potential risks of the investment options available to you. 

Employer Matching

Sometimes, an employer will match up to a certain percent of the employee contribution. Their contribution can range from 50 cents on the dollar, up to a dollar for dollar match. There is usually a percentage cap that they will match. For example, they will match contributions up to 3% of an employee’s salary.

If an employee wants to maximize this benefit, they might choose to contribute at least the percentage the employer will match. So, for example, if an employer matches 4% of a salary, the employee can choose to contribute at least 4% of each paycheck to their retirement plan and have it matched. 

Tax Benefits

One tax benefit of a Defined Contribution Plan is that you can usually deposit pre-tax funds and hold money in the retirement account tax-deferred. The taxpayer owes taxes when money is withdrawn from the account. 

Another tax benefit is the reduction of taxable income in the years contributions are made. This can present a large tax savings. 

It's Automatic

Once a plan is selected, the money automatically comes out of your paycheck. You won’t need to worry about payment schedules, late payments, or changing contributions each month. 

Things to Consider with Defined Contribution Plans

Defined Contribution Plans are the most popular and most easily accessible retirement plans. However, there are things to keep in mind. 

  • There are caps set by the Internal Revenue Service on how much can be contributed to Defined Contribution Plans annually. The caps increase when an individual is closer to retirement age. 
  • Penalties can occur if you withdraw funds before the age of 59.5. 
  • Any investment is a risk, and there is no promise the account will grow. 
  • There may be vesting limits to employer matching that say you must be at the company for X amount of time before receiving the matching. 

Overall, Defined Contribution Plans are readily accessible, easy to understand, and one of the most popular avenues for saving for retirement. If your company does not have a representative to discuss benefit options, it is best to consult a financial advisor to help assess your specific circumstances. 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.

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