What is a defined contribution plan (DC)?
A defined contribution plan (DC) is a tax-deferred retirement plan, such as a 401 (k) or 403 (b), in which employees contribute a fixed amount or a percentage of their paychecks to an account which is intended to finance their pensions. The company will sometimes sponsor part of the employee contributions as an added benefit. These plans impose restrictions that control when and how each employee can withdraw from these accounts without penalties.
Defined contribution plan
Understanding defined contribution plans
There is no way of knowing how much a defined contribution plan will ultimately give to the retired employee, as contribution levels can change and investment returns can go up and down over the years.
Defined contribution plans represented $ 8.2 trillion of the $ 29.1 trillion in total pension plan assets held in the United States as of June 19, 2019, according to the Investment Company Institute. The defined contribution plan differs from a defined benefit plan, also called a pension plan, which guarantees participants a certain benefit on a specific future date.
Defined contribution plans take dollars before taxes and allow them to increase their capital market investments on a tax-deferred basis. This means that income tax will ultimately be paid on withdrawals, but not before retirement age (a minimum of 59 1/2 years, with minimum distributions required (RMD) from 70½ years). The idea is that employees earn more money, and are therefore subject to a higher tax bracket, as full-time workers and will have a lower tax bracket when they retire. In addition, money that develops inside the account is not subject to capital gains tax.
Key points to remember
- Defined contribution (DC) pension plans allow employees to invest pre-tax dollars in the capital markets where they can grow on a tax-deferred basis until retirement.
- 401 (k) and 403 (b) are two popular defined contribution plans commonly used by businesses and organizations to encourage their employees to save for retirement.
- DC plans can be compared to defined benefit pensions (DB), where retirement income is guaranteed by an employer. With a DC plan, there is no guarantee and participation is both voluntary and self-managed.
Benefits of participating in a defined contribution plan
Contributions paid to a defined contribution plan may be subject to tax deferral. In traditional defined contribution plans, contributions are tax-deferred, but withdrawals are taxable. In Roth 401 (k), the account holder makes after-tax contributions, but withdrawals are tax-exempt if certain conditions are met. The tax-advantaged status of defined contribution plans generally allows balances to increase over time compared to taxable accounts.
Employer-sponsored defined contribution plans may also receive matching contributions. More than three-quarters of companies contribute to employees’ 401 (k) accounts based on the amount of the participant’s contribution. The most common employer matching contribution is 50 cents per $ 1 contributed up to a specified percentage, but some companies equal $ 1 for every dollar contributed up to a percentage of an employee’s salary, usually 4% to 6%.
Other features of many defined contribution plans include automatic enrollment of members, automatic increase in contributions, withdrawals for hardship, loan arrangements and catch-up contributions for employees aged 50 and over. .
Limitations of defined contribution plans
Defined contribution plans, such as a 401 (k) account, require employees to invest and manage their own money in order to save enough for their retirement income later in life. Employees may not be financially savvy and may have no other experience investing in stocks, bonds, and other asset classes. This means that some people may invest in inappropriate portfolios, for example, overinvest in stocks of their own business rather than in a well-diversified portfolio of various asset class indices. Defined benefit pension plans, unlike defined contribution plans, are managed by professionals and guarantee the employer’s lifetime retirement income in the form of an annuity. Defined contribution plans do not have such guarantees, and many workers, even if they have a well-diversified portfolio, do not tidy up regularly enough and therefore find that they do not have enough funds to last until retirement.
The average balance of 401 (k) of Americans aged 50 to 59 in the first quarter of 2019, according to Fidelity. A retiree withdrawing 5% per year would only earn $ 8,700 per year, and that is before taxes.
Other examples of defined contribution plans
The 401 (k) may be more synonymous with a defined contribution plan, but there are many other plan options. The 401 (k) plan is accessible to employees of companies and public enterprises. The 403 (b) plan is generally available to employees of non-profit corporations, such as schools. 457 plans are available for employees of certain types of nonprofit businesses, as well as employees of state and municipalities. The savings savings plan is used for federal government employees, while 529 plans are used to finance a child’s college education.
Since individual retirement accounts often involve defined contributions in tax-advantaged accounts with no tangible benefits, they could also be considered a defined contribution plan.