What is a defined contribution plan?

A defined contribution plan is a retirement plan in which an employee contributes money and their employer typically makes a matching contribution. 401(k) and 403(b) plans are two popular types of defined contribution plans. Today, defined contribution plans are the most widely-used type of employer-sponsored retirement benefit plan in the United States.

How do defined contribution
plans work?

Employees invest in defined contribution plans to supplement their future Social Security benefits, as Social Security alone is typically not enough to pay for the average retirement.

As an employee, you decide how much you want to contribute to your account. Your contributions are deducted from your paycheck and added to your account automatically. Many employers offer matching contributions. If you contribute a dollar, your employer will add either fifty cents or a dollar in return, up to a certain percentage of your salary (usually 3-6%; Note: these percentages may vary). You can then choose how you want your money invested. Most plans offer several investment choices, and each has its own fee structure and risk profile.

You can start withdrawing funds from your account at age 59 ½. If you withdraw before then, you’ll face a 10% early withdrawal penalty. Many defined contribution plans also offer tax benefits. For example, for a 401(k), your contributions are in pre-tax dollars; they grow tax-deferred until you’re eligible to withdraw.

Are there investment limits to
defined contribution plans?

Currently, the maximum amount an employee can contribute to a plan is $19,000 per year. If you are age 50 or older, you can also add up to an additional $6,000, for a total of $25,000 per year (also known as catch-up contributions.) The IRS lists current contribution limits for various plans.

What are the different types of
defined contribution plans?

While a 401(k) plan is the most common and popular type of defined contribution plan, there are other kinds as well – but not everybody can enroll in them. Some of the most familiar types include:

  • 401(k) plan: For employees of public corporations and businesses.
  • 403(b) plan: For employees of schools, healthcare entities and nonprofits.
  • 401(a) plan: For key government, educational and non-profit employees, to encourage employee retention. These money-purchase plans are structured so that the employer establishes custom eligibility requirements, contribution amounts and vesting schedules.
  • 457 plan: For public-sector employees, such as state and municipal workers, and employees of qualified nonprofits.
  • Thrift savings plan (TSP): For federal employees. Because this plan includes very low costs, only a small amount of your retirement savings is diminished by fees and expenses.
  • Savings Incentive Match Plans for Employees (SIMPLE): For employers and employees of businesses with 100 or fewer employees.

What is the difference between
defined contribution and
defined benefit plans?

Defined contribution plans and defined benefit plans are two very different kinds of retirement accounts:

Defined contribution plan

Defined benefit plan

Both the employee and the employer can contribute funds to the account. 

Only the employer contributes funds to the account. You get a monthly payout from the plan when you retire.

Two types of defined benefit plans

There are two types of defined benefit plans: traditional pensions and cash-balance plans. Both plans automatically enroll participants. However, for some defined benefit plans, you must wait a year before you are enrolled. After five years* with a company, you’re vested, meaning that you’re entitled to receive the funds when you retire.

Traditional pensions

Cash-balance plans

Based on a formula dictated by the number of years you served at a company and your average salary during your last few years of employment.

The company deposits a set percentage of your salary into the account each year.

How to invest in a defined contribution plan

  • Make contributions to your tax-deferred defined contribution plan every month while you’re working up to the plan limit.
  • Contribute the maximum annual amount you’re permitted.
  • Take advantage of your employer’s matching contribution to the fullest. It’s “free money.”

Support your investment to the plan

  • Don’t spend your retirement plan savings until you reach retirement. Otherwise, you’ll have less saved for your retirement when you really need it.
  • Don't be tempted to cash out your defined contribution plan and take a lump sum payment. You’ll have to pay taxes on the entire amount at one time, and you may be tempted to spend it quickly. If you instead take periodic distributions in retirement, you’ll spread your taxable income out over possibly many years.
  • You’ll be given different choices regarding how your money will be invested. If you have any questions about which investment option might be best for you, consult a financial advisor.