Defined Contribution Plans: A Smart and Convenient Way to Save More for Retirement

While Social Security benefits provide Americans with a stream of income once they leave the workforce, most employees today will need an additional revenue source to enjoy a comfortable retirement. This is where defined contribution plans can really make a difference.

A defined contribution plan is a retirement plan that is established and sponsored by an employer for the benefit of its employees. It is so named because employees define and make contributions to the plan directly from their job earnings. Traditionally, the employer transfers money from an employee’s paycheck to the plan before it is taxed. In some cases, employers may make additional contributions to employees’ accounts to incentivize them to save.

Over time, the assets in the plan have the potential to build up. The total amount saved will depend on several factors, including:

• how much has been contributed during the employee’s working years,

 

• how much the employer may have contributed,

 

• how long the funds have been invested and

 

• how well investments within the plan have performed.

 

When an employee is ready to retire and wants to begin accessing money from the account, the amount available may be based on the factors above. (It’s important to be aware that defined contribution plans typically have restrictions on when funds can be withdrawn, and penalties apply if assets are withdrawn before age 59 1/2.)

Types of Defined Contribution Plans

There are several types of defined contribution plans, which largely work the same way as one another. The main difference lies in who provides the plan:

• 401(k) plans are provided by private corporations,

 

• 403(b) plans are provided by public education entities and nonprofit organizations and

 

• 457 plans are provided for state and municipal employees as well as employees of qualified nonprofit businesses.

 

There are also Roth versions of each of these accounts available at some workplaces. A Roth account is funded with after-tax dollars and allows contributed money to grow tax-free. One of the primary benefits of a Roth plan is that when employees begin withdrawing money at retirement, they will not be taxed, provided they have met the conditions set by the IRS.

How Defined Contribution Plans Work

With a defined contribution plan, employees determine how much money they want to contribute within annual limits that are subject to change. Usually, employees contribute a fixed percentage of their earnings or a specific dollar amount. Contributions are then deducted from the employee’s paycheck and transferred into the plan automatically.

Once the plan is funded, the employee decides how to invest the money. Most plans offer a broad array of investment options that come with their own fees and potential risks and rewards. The employee, not the employer, accepts all investment risk and enjoys any investment gains. The employee also maintains ownership of the assets, even if he or she leaves the company. But be aware there are strict rules regarding the timing of withdrawals. Typically, employees face a stiff penalty for withdrawing funds prior to reaching age 59½ (though there are a few exceptions).

Contribution Limits

The maximum amount that can be contributed to a defined contribution plan is determined by the IRS and can rise from year to year, as it is indexed to inflation. The amount can be increased through catch-up contributions starting in the year in which the employee turns 50 years old. This enables employees who are getting closer to retirement the opportunity to invest more and "catch-up" on their contributions, with the goal of optimizing their retirement savings. 

More details about plan contribution limits can be found at IRS.gov.

One Piece of a Larger Strategy

For most employees today, contributing to a defined contribution plan is a smart way to supplement retirement savings. Some employers make the process easy and convenient to encourage their employees to be better prepared for life after work. Again, some employers offer a matching contribution to attract and retain top personnel and encourage their workers to save.

Like any investment, though, contributing to a defined contribution plan should be considered one part of a larger, more comprehensive strategy for retirement. Employees should consult with their employer, and may wish to speak with a financial professional and their legal and tax advisors, to help them determine how to best integrate a defined contribution plan into their overall plan for the future.